Debtor-in-possession funding

An Economic Zombie Survival Guide

Everyone surely hopes that zombies will remain confined to the growing list of horror movies. But unless we shut them down, insolvent firms can become economic zombies that suffocate innovation and growth.

As the COVID pandemic continues, policymakers will face some difficult decisions. Many businesses are coming under increasingly severe financial stress. Some, like dry-cleaning establishments that rely on laundering clothing for office workers, have limited prospects even after the pandemic subsides. But there are others that have a bright post-COVID future if they can hold on long enough. Without a way to distinguish these two groups, we face an unpleasant choice of either creating zombies or allowing viable firms to perish.

In our view, the solution to this problem is to reinforce and modify the bankruptcy process. This means ensuring that there are sufficient resources to restructure the debts of those whose expected future profits exceed their liquidation value, while allowing the remainder to close. In the case of large corporations, we can make use of Chapter 11. For smaller firms, if it is not already too late, we need a low-cost mechanism more tailored to their needs.

In the remainder of this post, we discuss these two related issues: zombie firms and the use of bankruptcy procedures to identify and sustain viable firms.

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Ending Too Big to Fail: Resolution Edition

The failure of Lehman on September 15, 2008, signaled the most intense phase of the Great Financial Crisis of 2007-2009, fueling a run on a broad array of intermediaries. Following Congress’ approval of TARP funding that was used mostly to recapitalize U.S. financial firms, the mantra of U.S. regulators became “…we will not pull a Lehman” (Financial Crisis Inquiry Report, page 380). Thereafter, to ensure that another large institution did not fail, policymakers chose bailouts to contain the crisis. As a result, today we still have intermediaries that are too big to fail.  

The autumn 2008 experience convinced many observers of the need for a robust resolution regime in which financial behemoths could be re-organized quickly without risk of contagion or crisis. The question was, and remains, how to do it. Dodd-Frank provided a two-pronged answer: the FDIC would first rely on the bankruptcy code (Title I), and second, on a resolution temporarily funded (if necessary) by government resources (Title II). The second piece is commonly known as Orderly Liquidation Authority (OLA), which is funded by the Orderly Liquidation Fund (OLF).

In response to dissatisfaction with parts of this solution, Congress and the President are working on refinements. Last month, the House passed a bipartisan revision of the bankruptcy code (Financial Institutions Bankruptcy Act, or FIBA) that would expedite the resolution of adequately structured intermediaries. And, on April 21, President Trump ordered a Treasury review of OLA, expressing concern that the OLF authorization to use government funds “may encourage excessive risk taking by creditors, counterparties, and shareholders of financial companies.”

This post considers FIBA and how it fits in with the existing Dodd-Frank resolution mechanism....

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Regulating Wall Street: The Financial CHOICE Act and Systemic Risk

With the shift in power in Washington, among other things, the people newly in charge are taking aim at financial sector regulation. High on their agenda is repeal of much of the Dodd-Frank Act of 2010, the most far-reaching financial regulatory reform since the 1930s. The prime objective of Dodd-Frank is to prevent a wholesale collapse of financial intermediation and the widespread damage that comes with it. That is, the new regulatory framework seeks to reduce systemic risk, by which we mean that it lowers the likelihood that the financial system will become undercapitalized and vulnerable in a manner that threatens the economy as a whole.

The Financial CHOICE Act proposed last year by the House Financial Services Committee is the most prominent proposal to ease various regulatory burdens imposed by Dodd-Frank. The CHOICE Act is complex, containing provisions that would alter many aspects of Dodd-Frank, including capital requirements, stress tests, resolution mechanisms, and more. This month, more than a dozen faculty of the NYU Stern School of Business (including one of us) and the NYU School of Law published a comprehensive study contrasting the differences between the CHOICE Act and Dodd-Frank.

Regulating Wall Street: CHOICE Act vs. Dodd-Frank considers the impact both on financial safety and on efficiency. In some cases, the CHOICE Act would slash inefficient regulation in a manner that would not foster systemic risk. At the same time, the book highlights the key flaw of the CHOICE Act—the failure to address systemic risk properly....

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