NOTE CONTENTS INTRODUCTION I. THE DEMAND FOR LIQUIDITY AND THE ROLE OF BANK INSOLVENCY LAW A. Banking as Liquidity Creation B. Implications for Bank Resolution II. THE STRUCTURE OF SHADOW BANKING A. Securitization: Bank Lending Unbundled B. Repos: Shadow Bank "Deposits" III. BANKRUPTCY-PROOFING SHADOW BANKING A. Securitization and Bankruptcy-Remoteness B. The Repo Safe Harbors IV. ASSESSING THE REPO SAFE HARBORS V. SYNTHETIC SECURITIZATION AND THE DERIVATIVE SAFE HARBORS A. Credit-Risk Transfer in Shadow Banking B. Ongoing Challenges C. The Scope of the Rationale for the Derivative Safe Harbors CONCLUSION INTRODUCTION
The tremors that shook Wall Street in 2008 radiated from a set of novel asset markets straddling the boundary between commercial banking and the capital markets. Mortgage-backed securities and related funding instruments had transformed the credit landscape during the preceding years, enabling institutional investors to supply capital for residential mortgages and other opportunities once accessible only to deposit-taking banks. (1) Thus a "shadow" banking system emerged alongside the regulated banking sector, and grew to rival it in size by its 2007 peak. (2) Only a year later this system collapsed, (3) taking with it many of the country's leading financial institutions and plunging the economy into a deep recession. (4)
Despite the complexity of the transactions involved, the basic dynamics of the 2008 crisis were distressingly familiar. A classic banking panic had occurred, (5) although it struck outside the traditional banking sector and the regulatory institutions protecting it. (6) Banking crises occur when depositors demand more withdrawals than the system's limited cash reserves can satisfy, forcing banks to liquidate assets or seek emergency assistance. (7) Like traditional banks, shadow banks such as Bear Stearns and Lehman Brothers held large portfolios linked to mortgages and other conventional bank receivables. However, these institutions funded themselves using commercial paper and other short-term borrowing markets that lacked the stabilizing influence of FDIC deposit insurance. (8) This left shadow banks vulnerable to a dramatic loss of liquidity as capital fled from mortgage-related assets in 2007 and 2008, (9) forcing officials to rescue entities that lacked access to backstops such as the Federal Reserve's discount window. (10)
Complicating matters, shadow banks faced a paradoxical legal situation as they edged toward the precipice in 2008: although they were regulated as nonbanks, applicable insolvency law treated these institutions rather like traditional banks. As we shall see, this paradox meant that shadow banks were excluded from both the regulatory safeguards available to commercial banks under Title 12 and certain bankruptcy protections available to nonbanks under Title 11.
Banks are not eligible debtors under the Bankruptcy Code, (11) and the Federal Deposit Insurance Act provides neither a general stay nor avoiding powers to protect them from their depositors' claims. (12) In contrast, the Bankruptcy Code gives debtors protection from their creditors' recovery efforts through the automatic stay, (13) avoidance of preferential transfers, (14) and related provisions. (15) Yet unlike most debtors, shadow banks traded heavily in contracts that are exempt from protections ordinarily available to debtors in bankruptcy. (16) These include repurchase agreements (repos), a short-term borrowing instrument that Bear Stearns, for example, used to stay afloat during its final months as an independent company; (17) and derivative contracts, which Wall Street firms used to trade mortgage-related risk. (18) The statutory exemptions for these contracts allow the parties to enforce their contractual rights outside of bankruptcy proceedings. (19) These typically include the right to liquidate collateral from, and to terminate dealings and net mutual obligations with, a distressed counterparty. (20)
The statutory carve-outs, or "safe harbors," are traditionally justified by the need to protect the financial system from the fallout of a major market participant's failure. (21) Yet the exercise of these rights facilitated a kind of bank run on weak institutions as their counterparties moved to protect themselves from the deepening crisis in 2008.
The run on the shadow banking system was most apparent in the repo market, which provided "the main source of funds" for the securitization process. (22) Like bank depositors, repo lenders have the option to withdraw credit almost immediately, as many repo loans mature overnight and must be rolled over daily. (23) By 2008, much of the collateral that shadow banks could offer to secure their repo borrowings consisted of structured products tied to the mortgage market or otherwise affected by the credit squeeze. (24) As this form of collateral grew increasingly unacceptable to repo lenders, Bear Stearns and other institutions struggled to raise the cash necessary to continue operating. (25)
Major institutions also hemorrhaged cash through their derivative contracts, which gave parties the right to demand collateral as their counterparties weakened and terminate contracts in events of default. (26) For example, MG and other firms that had sold "protection" against losses on mortgage-backed securities were required to put up cash as these securities plunged in value and as their own finances weakened. By mid-September 2008, AIG had posted more than $19.5 billion in collateral on credit default swaps written by its Financial Products subsidiary. Mounting demands from its counterparties ultimately forced a costly rescue by the New York Federal Reserve and the Treasury Department. (27)
These episodes have motivated a growing body of scholarship calling for a rollback of the safe harbors for repos and derivatives, so that distressed firms can invoke traditional bankruptcy protections against their counterparties under these contracts. (28) Proponents of a more protective insolvency regime find three principal defects in the safe harbors. First, by permitting counterparties to withdraw credit and seize collateral from weak institutions, the safe harbors may expose weak firms to a sudden loss of liquidity that can quickly spread to other firms. (29) Second, the race to grab the assets of an insolvent firm can hamper its orderly resolution and destroy going-concern value. (30) Third, counterparties whose contractual rights are unfettered by bankruptcy procedures may lack optimal incentives to monitor their counterparties' risk-taking and may overuse contracts protected by the safe harbors. (31)
Breaking with the emerging consensus, this Note argues that repealing the safe harbors would be a misdirected response to the fragility of nonbank financial companies. Part I lays the foundation for an account of the role of the safe harbors in the supply of liquidity through the shadow banking system. I proceed from the premise that "financial instruments, markets, and institutions arise to mitigate the effects of information and transaction costs." (32) On this view, bank deposits, for example, create valuable liquidity by offering an investment contract free from the due-diligence and other transaction costs that hamper trading in virtually every other asset class, from home loans to technology stocks. (33) Banks accomplish this by issuing what I call liquidation rights, or options to convert assets to cash. For example, a bank depositor indirectly invests in the bank's loan portfolio but retains the right to withdraw her investment without taking a loss. In this way, banking transforms illiquid portfolio assets into a liquid investment contract that enlarges the supply of capital that households are willing to invest.
The subsequent Parts argue that rights allowing repo and derivative counterparties to liquidate these contracts outside bankruptcy play an analogous role in attracting capital from these "depositors" in the shadow banking system. (34) In this way, the safe harbors may not only expand the supply of loanable capital, but they may also make that supply more resilient by insulating investors from bankruptcy risk. If it was a loss of repo credit that ultimately felled Bear Stearns, this was because other funding sources with fewer privileges in bankruptcy had long since become unavailable to the troubled investment bank. (35)
My claim that the law should enforce bank-issued liquidation rights should not be confused with an argument that the banking system should be allowed to fail during a crisis. (36) Critics of the safe harbors are undoubtedly right about the consequences of allowing a large institution to unravel under pressure from its repo and derivative counterparties. (37) Yet if Lehman Brothers should have gained protection from its counterparties in September 2008, this should have come in the form of emergency liquidity, not a judicial stay imposed after the firm was already in bankruptcy. (38) Curtailing the safe harbors would seemingly do little to expand the options available to troubled firms ex post, while doing much to undermine the liquidity and stability of the repo and derivative markets ex ante.
The challenge for regulators, then, is to supply a framework that reduces the incidence of bank runs at minimal cost to bank liquidity creation. If this task seems daunting, it may be helpful to recall that today's regulated banking sector was once "an inherently fragile, shadow banking system operating without credible public-sector backstops and limited regulation." (39) Yet twentieth-century regulators enacted a mix of deposit insurance and prudential oversight that largely ended the threat of panics in the traditional banking sector. An insolvency regime that curtailed depositors' rights in order to prop up weak banks was conspicuously absent from this formula, since it would have undermined the very liquidity services that...