Europe's failure to prepare for the next financial crisis affects us all.

Author:Hartlage, Andrew W.
Position:III. U.S. and European Approaches to Financial-Firm Resolution A. Resolving Insolvent Firms 2. Shadow Banks through V. Conclusion, with footnotes, p. 873-902
  1. Shadow Banks

    In contrast to the decades-long track record of successful resolutions in the traditional banking sector, governments in both Europe and the United States were largely unprepared for an eruption of similar problems in the nonbank sector. These weaknesses remain unaddressed in Europe, but U.S. policymakers have built a resolution mechanism for systemically significant nonbanks that will likely be able to defuse future systemic threats in the shadow banking system.

    1. The United States

      As is the case for individuals and most real-economy companies, nonbanks threatened with default on their debt could petition for relief under the Bankruptcy Code. (125) Reorganization or liquidation under the Bankruptcy Code was, and continues to be, the preferred method of dealing with insolvent nonbanks. (126) Under the Code, once a voluntary petition is filed with a bankruptcy court, collection activities of most creditors against nonbanks are automatically stayed until the bankruptcy case is closed or dismissed. (127) While the stay is in effect, the debtor and its creditors work to reorganize or liquidate the firm with varying degrees of cooperation. (128) In this way, the Bankruptcy Code aims to preserve value in struggling firms, increase recoveries for debt holders, and thereby improve the efficiency of credit markets without government intervention or at least without non-judicial government intervention.

      Some of these goals may be at odds with financial stability, and the Bankruptcy Code could not stop the transmission of insolvency problems around the shadow banking system in the recent financial crisis. First, some financial transactions critical to shadow banking, such as repo transactions, are exempt from the Bankruptcy Code's automatic stay. (129) This special treatment was introduced when these markets were still in their infancy and resulted in part from a belief among regulators that these markets "were beneficial enough to warrant special treatment." (130) Second, there is no similar guaranteed public funding source for post-petition debtors under the Bankruptcy Code similar to the Deposit Insurance Fund, (131) which helps fund FDIC bank resolution. (132) Nonbanks unable to secure private funding after filing for bankruptcy would be exposed to funding problems, especially with respect to obligations that are exempt from the automatic stay.

      These two provisions increased systemic risk in two critical respects. First, by exempting shadow banking market transactions from the bankruptcy automatic stay, participants in the market would have had fewer incentives to monitor the creditworthiness of their counterparties, which could have allowed riskier lending. (133) Second, if a crisis were to occur, repo participants would have been expected to run on their repo counterparties if they feared that their counterparties might become insolvent, similar to the uninsured depositors in bank runs. (134)

      The failures of large shadow banks in 2008 demonstrated how contagion may be transmitted by these means throughout the shadow banking system. The Lehman Brothers bankruptcy filing on September 15, 2008, frightened investors and caused investors to run on markets and institutions across the financial system. (135) Some money market mutual funds (MMMFs) had significant exposures to the Lehman bankruptcy, which precipitated a market-wide run in MMMFs. (136) Large MMMF redemptions led to a severe contraction in commercial-paper and repo market liquidity, creating short-term funding problems for other financial firms and many large real-economy companies. (137) Extraordinary measures from the Treasury Department and Federal Reserve prevented a cascade of bankruptcies and a catastrophic financial implosion. (138)

      To combat the problems caused by the failure of a systemically significant nonbank, Congress instituted a new nonbank resolution mechanism as part of the Dodd-Frank Act that addresses the contagion transmission problems of the shadow banking system. Under the Orderly Liquidation Authority (OLA), nonbanks in default or in danger of default whose resolution would have serious adverse effects on financial stability may be placed under FDIC receivership. (139)

      Provisions in the OLA statute specifically address the weaknesses in the Bankruptcy Code's ability to support systemic stability during a financial crisis. First, the OLA addresses the issue of post-petition funding by creating public funding sources to draw from during a crisis. The FDIC, acting as receiver, is empowered to borrow from the Orderly Liquidation Fund, a separate fund set up within the U.S. Treasury. (140) The FDIC may then use this money to fund firms in resolution under the OLA, whether to sustain systemically important activities or support a sale to a third party. (141) Second, the OLA provides for a stay of one business day for repos and derivative transactions. (142) This stay, although short, nevertheless gives the FDIC the opportunity to move systemically important transactions to a bridge financial company, (143) where they may be funded through public borrowing. (144)

      The post-Dodd-Frank Act resolution mechanism for insolvent shadow banks is much improved. The ability to pursue resolution under the OLA will ensure that contagion effects are minimized.

    2. The European Union and Its Member States

      Shadow banking represents less of a threat to Europe than to the United States: shadow banking activities form a significantly smaller part of the European financial system, (145) and banks are responsible for over eighty percent of both mortgage and corporate lending in Europe. (146)

      The EU mechanism for resolving systemically important nonbanks closely resembles the regime established under the U.S. Bankruptcy Code. Most European repo transactions are exempt from automatic stays during insolvency proceedings. This works through a daisy chain of choice-of-law provisions: EU law requires that repo transactions be resolved under the laws chosen by the parties or applicable to the market as a whole rather than the law controlling the insolvency proceedings, (147) and most firms choose to form repo contracts under English law, (148) which treats repos in insolvency proceedings similarly to the U.S. Bankruptcy Code. (149) Thus, the substance of EU law governing important shadow banking markets resembles closely the pre-crisis law of the United States.

      Europe had no large shadow bank failure similar to that of Lehman Brothers during the recent crisis; Europe's failures were in its traditional banking system. (150) Understandably, policymakers have thus focused on improving financial stability in the banking sector. Nonetheless, the European Commission has identified five outstanding issues with the regulation of the European shadow banking system, including the problems of secured lending and repurchase agreements. (151) No concrete plans for EU legislation or other actions have been announced. (152)

      Insolvency issues were at the core of the recent financial crisis. The United States was able to respond effectively to problems in the traditional banking system, but had fewer tools to fix insolvency issues in the shadow banking system. Shadow banking was less of a problem for Europe, but its weaker bank resolution mechanisms led to public bank bailouts in nearly every EU member state. (153) U.S. policymakers have addressed the weaknesses in shadow banking resolution capabilities through the new Orderly Liquidation Authority, but European leaders have yet to address the gaps in the European framework. Below, Part IV discusses possible paths forward.

      1. Supporting Illiquid Firms

      Walter Bagehot's insight into financial panics was that central banks could alleviate crises through unrestrained lending to solvent firms. (154) Financial panics--after the enactment of deposit insurance and the creation of a strong central-bank LOLR--were largely thought to be a "thing of the past," (155) but runs in new parts of the financial system in 2008 led to a near-collapse of the global financial system. Section III.B.1 analyzes the efforts of the Federal Reserve and the European System of Central Banks (ESCB) to support banks with emergency liquidity assistance. These efforts successfully prevented systemic breakdowns in the U.S. and European traditional banking systems. Section III.B.2 describes how both the Federal Reserve and the European Central Bank (ECB) each stepped into the role of shadow-banking LOLR, despite disagreements on each institution's authority to act in this capacity. This Section argues that the Federal Reserve and the ECB could act as LOLRs for U.S. and European shadow banks, respectively.

  2. Traditional Banks

    Central banks have used LOLR powers to combat banking panics since at least the Panic of 1825 in England. (156) The government's ability to stop panics through emergency lending had been so successful that the United States suffered no systemic bank runs for over seven decades. And a similar LOLR system created with the euro has disproved critics and helped avert a deeper financial panic in Europe during the recent financial crisis.

    1. The United States

      The United States suffered from regular financial panics in the late-nineteenth and early twentieth centuries. (157) At the time, the United States had no central bank to act as LOLR, (158) and bankers fought panics by suspending the convertibility of bank deposits and checks into currency, (159) or by arranging emergency liquidity from private sources such as bank consortia. (160) But these measures had significant drawbacks: suspension of convertibility could create a "currency famine" and bring commerce to a halt, (161) and private actors who would have the ability to coordinate lending across the financial system were rare (162) and were not necessarily motivated by incentives that aligned with the public's interest in financial stability.

      By the 1910s, U.S...

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