MAKING FAILURE FEASIBLE Working Group on Economic Policy Many of the writings associated with this working group are published by the Hoover Institution Press or other publishers Materials published to date, or in production, are listed below Books that are part of the Working Group on Economic Policy’s Resolution Project are marked with an asterisk Making Failure Feasible: How Bankruptcy Reform Can End “Too Big to Fail”* Edited by Kenneth E Scott, Thomas H Jackson, and John B Taylor Bankruptcy Not Bailout: A Special Chapter 14* Edited by Kenneth E Scott and John B Taylor Across the Great Divide: New Perspectives on the Financial Crisis Edited by Martin Neil Baily and John B Taylor Frameworks for Central Banking in the Next Century Edited by Michael Bordo and John B Taylor Government Policies and the Delayed Economic Recovery Edited by Lee E Ohanian, John B Taylor, and Ian J Wright Why Capitalism? Allan H Meltzer First Principles: Five Keys to Restoring America’s Prosperity John B Taylor Ending Government Bailouts as We Know Them* Edited by Kenneth E Scott, George P Shultz, and John B Taylor How Big Banks Fail: And What to Do about It* Darrell Duffie The Squam Lake Report: Fixing the Financial System Darrell Duffie et al Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis John B Taylor The Road Ahead for the Fed Edited by John B Taylor and John D Ciorciari Putting Our House in Order: A Guide to Social Security and Health Care Reform George P Shultz and John B Shoven The Hoover Institution on War, Revolution and Peace, founded at Stanford University in 1919 by Herbert Hoover, who went on to become the thirty-first president of the United States, is an interdisciplinary research center for advanced study on domestic and international affairs The views expressed in its publications are entirely those of the authors and not necessarily reflect the views of the staff, officers, or Board of Overseers of the Hoover Institution www.hoover.org Hoover Institution Press Publication No 662 Hoover Institution at Leland Stanford Junior University, Stanford, California 94305-6003 Copyright © 2015 by the Board of Trustees of the Leland Stanford Junior University All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without written permission of the publisher and copyright holders For permission to reuse material from Making Failure Feasible: How Bankruptcy Can End “Too Big to Fail,” ISBN 978-08179-1884-2, please access www.copyright.com or contact the Copyright Clearance Center, Inc (CCC), 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400 CCC is a not-for-profit organization that provides licenses and registration for a variety of uses Efforts have been made to locate the original sources, determine the current rights holders, and, if needed, obtain reproduction permissions On verification of any such claims to rights in the articles reproduced in this book, any required corrections or clarifications will be made in subsequent printings/editions Hoover Institution Press assumes no responsibility for the persistence or accuracy of URLs for external or third-party Internet websites referred to in this publication, and does not guarantee that any content on such websites is, or will remain, accurate or appropriate Cataloging-in-Publication Data is available from the Library of Congress ISBN: 978-0-8179-1884-2 (cloth : alk paper) ISBN: 978-0-8179-1886-6 (epub) ISBN: 978-0-8179-1887-3 (mobi) ISBN: 978-0-8179-1888-0 (PDF) The Hoover Institution gratefully acknowledges the following individuals and foundations for their significant support of the Working Group on Economic Policy: Lynde and Harry Bradley Foundation Preston and Carolyn Butcher Stephen and Sarah Page Herrick Michael and Rosalind Keiser Koret Foundation William E Simon Foundation John A Gunn and Cynthia Fry Gunn Contents List of Figures and Tables Preface John B Taylor | The Context for Bankruptcy Resolutions Kenneth E Scott | Building on Bankruptcy: A Revised Chapter 14 Proposal for the Recapitalization, Reorganization, or Liquidation of Large Financial Institutions Thomas H Jackson | Financing Systemically Important Financial Institutions in Bankruptcy David A Skeel Jr | Resolution of Failing Central Counterparties Darrell Duffie | The Consequences of Chapter 14 for International Recognition of US Bank Resolution Action Simon Gleeson | A Resolvable Bank Thomas F Huertas | The Next Lehman Bankruptcy Emily Kapur | Revised Chapter 14 2.0 and Living Will Requirements under the Dodd-Frank Act William F Kroener III | The Cross-Border Challenge in Resolving Global Systemically Important Banks Jacopo Carmassi and Richard Herring About the Contributors About the Hoover Institution’s Working Group on Economic Policy Index List of Figures and Tables Figures Example of CCP Default-Management Waterfall of Recovery Resources 6.1 Resolution Has Three Stages 6.2 Unit Bank: Balance Sheet Overview 6.3 Determination of Reserve Capital and ALAC Requirements 6.4 Prompt Corrective Action Limits the Need for Reserve Capital 6.5 Unit Bank with Parent Holding Company 6.6 Parent Holding Company/Bank Sub: Balance Sheet Overview 6.7 Bank Subsidiary Is Safer Than Parent Holding Company 6.8 Resolution of Parent 6.9 Banking Group with Domestic and Foreign Subsidiaries 6.10 SPE Approach Requires Concurrence of Home and Host 7.1 Insolvency Event for a Dealer Bank 7.2 Recapitalization’s Ability to Stop Runs Sparked by Insolvency 7.3 Lehman Stock and Bond Prices January–December 2008 7.4 Lehman Corporate Structure 7.5 Market Valuation of Lehman’s Solvency Equity 7.6 Liquidity Losses over Lehman’s Final Week 7.7 Only Holdings Files 7.8 Counterfactual Timeline of Chapter 14 Section 1405 Transfer 7.9 Structure of the Section 1405 Transfer 7.10 Recapitalizing Subsidiaries after Sale Approval 7.11 Post–Chapter 14 Asset Devaluations Short of Insolvency 7.12 G-Reliance on Fed Funding during the Financial Crisis 7.13 New Lehman’s Initial Public Offering 7.14 Approving a Plan and Paying Claimants 9.1a Number of Subsidiaries of the Largest US Bank Holding Companies 9.1b Number of Countries in Which US Bank Holding Companies Have Subsidiaries 9.2 Evolution of Average Number of Subsidiaries and Total Assets for G-SIBs 4.1 Tables 6.1 6.2 6.3 Bail-In at Parent Does Not Recapitalize the Subsidiary Bank Bail-In at Subsidiary Bank Recapitalizes the Subsidiary Bank Decision Rights during Resolution Process 7.1 7.2 7.3 9.1 9.2 Lehman’s and Holdings’ Balance Sheets Post–Chapter 14 Hypothetical Liquidity Stress Test 9/8–9/26 Holdings’ Balance Sheet, Recoveries, and Claims Profile of G-SIBs Disaggregation of Subsidiaries of 13 G-SIBs by Industry Classification (May 2013) Preface John B Taylor Motivated by the backlash over the bailouts during the global financial crisis and concerns that a continuing bailout mentality would create grave dangers to the US and world financial systems, a group of us established the Resolution Project at the Hoover Institution in the spring of 2009 Ken Scott became the chair of the project and George Shultz wrote down what would be the mission statement:1 The right question is: how we make failure tolerable? If clear and credible measures can be put into place that convince everybody that failure will be allowed, then the expectations of bailouts will recede and perhaps even disappear We would also get rid of the risk-inducing behavior that even implicit government guarantees bring about “Heads, I win; tails, you lose” will always lead to excessive risk And we would get rid of the unfair competitive advantage given to the “too big to fail” group by the implicit government guarantee behind their borrowing and other activities At the same time, by being clear about what will happen and that failure can occur without risk to the system, we avoid the creation of a panic environment This book—the third in a series that has emerged from the Resolution Project—takes up that original mission statement once again It represents a culmination of policy-directed research from the Resolution Project of the Hoover Institution’s Working Group on Economic Policy as its members, topics, and ideas have expanded and as the legal and market environment has changed The first book, Ending Government Bailouts as We Know Them, published in 2010, proposed a modification of Chapter 11 of the bankruptcy code to permit large failing financial firms to go into bankruptcy without causing disruptive spillovers while continuing to offer their financial services—just as American Airlines planes kept flying and Kmart stores remained open when those firms went into bankruptcy The second book, Bankruptcy Not Bailout: A Special Chapter 14, published in 2012, built on those original ideas and crafted an explicit bankruptcy reform called Chapter 14 (because there was no such numbered chapter in the US bankruptcy code); it also considered the implications of the “orderly liquidation authority” in Title II of the DoddFrank Wall Street Reform and Consumer Protection Act, which was passed into law after the first book was written This third book, Making Failure Feasible: How Bankruptcy Reform Can End “Too Big To Fail,” centers around Chapter 14 2.0, an expansion of the 2012 Chapter 14 to include a simpler and quicker recapitalization-based bankruptcy reform, analogous to the singlepoint-of-entry approach that the Federal Deposit Insurance Corporation (FDIC) proposes to use under Title II of the Dodd-Frank Act And while Chapter 14 2.0 is the centerpiece of the book, each of the chapters is a significant contribution in its own right These chapters provide the context for reform, outline the fundamental principles of reform, show how reform would work in practice, and go beyond Chapter 14 2.0 with needed complementary reforms Recent bills to modify bankruptcy law in ways consistent with the overall mission of the ... Wall Street Reform and Consumer Protection Act, which was passed into law after the first book was written This third book, Making Failure Feasible: How Bankruptcy Reform Can End Too Big To Fail, ”... How Bankruptcy Reform Can End Too Big to Fail * Edited by Kenneth E Scott, Thomas H Jackson, and John B Taylor Bankruptcy Not Bailout: A Special Chapter 14* Edited by Kenneth E Scott and John... conclude, “Although too- big- to- fail is too- costly -to- continue, a solution to the problem remains elusive.” So one might look forward to yet another book in this series, or at the least to more policy-driven