Daily Times

Pressure is building in Congress to repeal significant portions of President Barack Obama’s signature Dodd-Frank Act, signed into law after the financial crisis of 2008. In particular, critics are targeting a provision in the law known as “orderly liquidation authority,” which is designed to give the federal government the power to step in and prevent a systemwide collapse during financial emergencies.

The idea behind the law was to avoid a future Lehman Brothers – to give federal regulators the ability to liquidate a large financial holding company in an orderly way and thereby avoid triggering the kind of panic that occurred after the investment bank filed for bankruptcy in 2008.

Opponents see orderly liquidation authority as a mechanism to protect “too big to fail” banks. They argue that it encourages large financial institutions to take outsize risks with the knowledge that, if those risks lead to the firm’s failure, federal regulators will be there to bail them out.

This “moral hazard” argument, however, mistakes how this provision of Dodd-Frank is designed to work. Unlike with the financial bailouts implemented by the federal government in the wake of Lehman Brothers’ collapse, the statute requires firms in need of federal help to wipe out their shareholders, replace their management and force their creditors to take losses ahead of any funds the government may provide to facilitate the liquidation of the failed institution.

This is worth emphasizing: If the government were to lose money as a consequence of liquidating a large financial institution, the firm’s unsecured creditors would be wiped out and other banks in the system would have to pick up the tab to make sure the government were made whole.

The “safety net” under Dodd-Frank, therefore, is not a safety net for the failing firm’s shareholders, management or creditors. Rather, it is a safety net for the rest of us, intended to mitigate the harm that the failure of a large, deeply interconnected financial institution could inflict on the economy.

In creating a specialized regime to deal with the failure of large financial holding companies such as Lehman Brothers, Dodd-Frank filled a dangerous gap in the statutes governing the bankruptcy of financial institutions. Following the deregulation of the financial industry in 1980, huge financial conglomerates were assembled, bringing broker dealers, asset managers, depositories and insurance companies under the umbrella of a single holding company. Congress had previously created specialized bankruptcy law for each of the regulated entities within these complex conglomerates, but it never created a bankruptcy regime for holding companies until it passed Dodd-Frank.

Those who want to do away with Dodd-Frank’s liquidation authority would have us believe that a special chapter of the bankruptcy code could address the procedural problems that Lehman Brothers faced when it filed for bankruptcy. And while those procedural issues should be addressed, two important features of Dodd-Frank designed to protect the public are not addressed by the proposed revisions to the bankruptcy code.

First, federal financial regulators wouldn’t have the power to coordinate the commencement and conduct of bankruptcy proceedings for a failing financial holding company with regulators of its domestic and foreign subsidiaries. Second, without access to an established source of liquidity as provided under Dodd-Frank, the federal government could not forestall the kind of fire sale of assets and defaults on short-term debt that set off the widespread panic that the start of the Lehman Brothers bankruptcy triggered.

Repealing orderly liquidation authority in favor of a new chapter of the bankruptcy code would leave the stability of the financial system hostage to one large firm’s failure, without the important tools available under Dodd-Frank to contain the contagion its failure would certainly precipitate.

By all means, Congress should amend the bankruptcy code to give bankruptcy courts the tools needed to mitigate the kinds of problems revealed by Lehman Brothers’ bankruptcy proceedings. But we should retain orderly liquidation authority – just in case regulators need to break the glass to protect the financial system against the economic contagion that the bankruptcy of a large, deeply interconnected firm could provoke.