Rethinking the Unthinkable: Bankruptcy for Large Financial Institutions

Jeffrey Lacker

Speech from Federal Reserve Bank of Richmond

Abstract: The bankruptcy process is an effective tool for reconciling the incentives of creditors and debtors. Yet the government has a long history of handling large complex financial institutions outside the Bankruptcy Code. This has created two mutually reinforcing conditions: Investors feel protected by an implicit commitment of government support, and policymakers feel compelled to provide that support to avoid a disruptive adjustment of expectations. The Orderly Liquidation Authority created by the Dodd-Frank Act retains many of the flaws of ad-hoc pre-crisis practices and does little to improve creditors' incentives to monitor risk-taking. A better strategy for ending "too big to fail" is the provision in the Dodd-Frank Act requiring large financial firms to prepare "living wills" detailing how they could be resolved under the Bankruptcy Code. Resolution planning is difficult work, but living wills must be credible in order for policymakers to commit to using them rather than relying on government backstops.

Date: 2014-10-10
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