The Law and Finance of Bank and Insurance Insolvency Regulation

Abstract:     
In the bank and insurance company contexts, the insolvency framework has long been pervasively regulatory in nature. Regulators determine whether and when to initiate an insolvency proceeding; and they control nearly aspect of the insolvency process, including the ultimate issue of how to resolve the financial distress. The savings and loan, banking and insurance company crises in the past two decades underscored some of the limitations of a regulator-driven system. Regulators were widely viewed as having waited too long to initiate insolvency proceedings for many financial intermediaries, for instance, due at least in part to perverse incentives they have to delay rather than initiating in a timely fashion. Commentators also were critical of regulators' disposition decisions.In the banking context, commentators proposed a variety of alternatives to the existing framework, each of which would give creditors or the market a much greater role, particularly at the initiation stage. While the proposals might plausibly improve on the existing regime, each also raises significant concerns. Rather than opting for such an approach, Congress retained the existing framework but sought to impose much greater restrictions on regulatory discretion.In contrast to either of these approaches, I argue in this article that managers should be given the authority to initiate an insolvency proceeding. Although managers have little incentive to initiate an insolvency proceeding under existing law, lawmakers could alter this by giving them a "bonus" in connection with the initiation decision. The question how best to structure the bonus leads me to a consideration of whether lawmakers should add a reorganization option to the existing alternatives for resolving insolvent intermediaries. I conclude that reorganization is an attractive option in the insurance context, since it both would act as a bonus to managers and could be an effective disposition option. Although reorganization is less attractive for banks, I conclude that managers should be permitted to propose prepackaged purchase and assumption transactions (i.e., sales to third parties).Following my consideration of these initiation and disposition questions, I use a simple investment analysis drawn from the finance literature to assess several important priority issues. In a subsequent draft, I will conclude by briefly considering whether bank and insurance insolvency should be brought within the Bankruptcy Code, and will argue that they should not.

JEL Classifications: G21, G22, G28, G33, K22

Working Paper Series