The Foundry

The financial reform bill that is currently before the House would give regulators virtually unlimited power over “too big to fail” financial institutions. Those are large, complex and usually international entities whose failure could cause such a shock to the interconnected financial system that others would be endangered. Under the House bill, if one of them does get into trouble, the FDIC would step in to reorganize and run the financial institution until it could be closed or sold. The FDIC has done an acceptable job closing small and medium banks, but does not have the expertise necessary to deal with such complex companies.

A better approach – described here and here — would be to add a new chapter to the bankruptcy code that is explicitly designed to meet the special circumstances of “too big to fail” financial institutions. Properly structured, the new chapter would make it easier for large financial firms to be closed in an orderly way that reduces the potential for systemic risk. It would not give regulators virtually unlimited powers and would free the process from political interference by giving control to an unbiased court system that already has extensive experience with complex modern firms. By creating an open process controlled by an impartial judiciary guided by established statutory rules, financial firms, investors, taxpayers, and others would have the advance knowledge that large financial firms that were once known as “too big to fail” can now be closed if necessary without risking disaster.

This is one of several interesting ideas contained in a substitute to the House financial reform bill that will be proposed by Rep. Spencer Bachus (R-AL) and several other legislators. Bankruptcy is a far better way to deal with “too big to fail” financial institutions than any other alternative.