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The “American economy will need a coordinated response, particularly if the entire financial system suffers a panic or lack of liquidity.” Bankruptcy judges cannot provide this response. It is best left to the Treasury, Federal Reserve and FDIC.
The “American economy will need a coordinated response, particularly if the entire financial system suffers a panic or lack of liquidity.” Bankruptcy judges cannot provide this response. It is best left to the Treasury, Federal Reserve and FDIC.

[OP-ED]: Preparing for the next panic -- or not

When the next financial crisis hits -- an event that may be years or decades away -- we will learn whether this Congress and the president drew the right…

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The debate goes to the heart of the government’s role in the financial system. During the 2008-09 crisis, the Federal Reserve, Treasury and Federal Deposit Insurance Corporation (FDIC) rescued a variety of large financial institutions, including the insurance company AIG, Citigroup, and many banks and lenders. But the rescue provoked a public backlash; many Americans felt that Wall Street was protected while Main Street wasn’t. 

To address this complaint, the Dodd-Frank law -- the Obama administration’s response to the financial crisis -- created a complicated system under which troubled financial institutions could borrow temporarily from the Treasury (via the FDIC). This would, arguably, prevent a panic, as these institutions would otherwise lack the money to repay their lenders. But ultimately, these shaky institutions would be broken up, with their viable segments preserved or sold to other firms and the rest shuttered.

Among banking experts, the process is referred to as Orderly Liquidation Authority, or OLA. It seems a complex solution to a complex problem. Yet, it did not convince skeptics, who argued that for all its twists and turns, OLA would simply be another mechanism to bail out mismanaged banks and financial institutions. A better solution and a sure-fire defense against bailouts, retorted the skeptics, would be to put collapsing financial institutions into legal bankruptcy, where they would be closed or reorganized. 

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So that’s what the Republican majority of the House Financial Services Committee did in May. There would be no borrowing from the Treasury. Troubled firms would go straight into bankruptcy. End of story? No. A letter from 122 law professors and economists, led by Jeffrey N. Gordon of the Columbia Law School and Mark J. Roe of the Harvard Law School, argued that the House proposal is unworkable and could trigger the panic that the legislation aimed to avoid. 

The bankruptcy of one major firm isn’t the main threat. The larger danger is “a financial crisis that threatens the economy [and involves] multiple institutions failing or tottering simultaneously,” said the letter. The “American economy will need a coordinated response, particularly if the entire financial system suffers a panic or lack of liquidity.” Bankruptcy judges cannot provide this response. It is best left to the Treasury, Federal Reserve and FDIC.

Earlier, Ben Bernanke -- chairman of the Federal Reserve Board during the financial crisis -- made similar points on his blog. He also denied that OLA represented a bank bailout, because “all losses are borne by the private sector.” Shareholders would almost certainly be wiped out; top managers would lose their jobs. If government loans could not be repaid, there would be a financial assessment on healthier financial institutions to fill the gap.

This is an enormously important debate. We shouldn’t gut Dodd-Frank unless the critics can make the case that what they propose is demonstrably better. They haven’t yet.

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