Repeal the Safe Harbors

Abstract

The "safe harbors" excuse derivatives from much of the normal operation of the Bankruptcy Code. This exception to the normal rules is justified by fears that involvement of derivatives in the bankruptcy process will increase systemic risk. But as I and others have argued, the safe harbors themselves are likely to increase systemic risk by encouraging a "run on the bank." As Congress considers a variety of responses to the financial crisis, I argue that it is time to repeal the safe harbors. I do not advocate pulling out sections of the Bankruptcy Code and leaving the Code otherwise the same. Derivative contracts are somewhat unique. The volatility, interconnectedness and sheer magnitude of the sums of money involved make financial firms unique. As part of the repeal that I suggest, the Code would have to adapt to these realities. But the safe harbors should be repealed.

Keywords: Derivatives, chapter 11, safe harbors, ISDA, bankrupty, Lehman, AIG, systemic risk, close-out netting

JEL Classification: K22, G18, G28, G33, G38