Regulatory Bankruptcy: How Bank Regulation Causes Firesales
65 Pages Posted: 29 Mar 2011
Date Written: March 25, 2011
Bankruptcy policy has long been founded upon the assumption that creditors seek to maximize the value of their assets. The radical changes that have swept over the banking sector over the last two decades, however, have rendered this assumption unreliable. Banks, which are responsible for the majority of the outstanding credit in the United States, are no longer necessarily driven by the goal of value-maximization. Instead, their behavior is increasingly influenced by financial regulation and regulatory policy in ways that lead them to drive their own borrowers into liquidation - a phenomenon that richly deserves to be called regulatory bankruptcy.
This Article offers the first-ever empirical account of regulatory bankruptcy - the ultimate result of pervasive regulatory pressure on issues of concentration risk and capital adequacy at banks during the recent financial crisis, which in turn induced banks to press excessively for liquidation of commercial real estate in bankruptcy proceedings. The analysis of an original dataset that encompasses bankruptcy filings as well as bank portfolio data confirms the significant relationship between a bank’s concentration risk and its choice to pursue liquidation. This bias toward over-liquidation engendered by micro-prudential financial regulatory policy was a source of unnecessary downward pressure on the value of assets throughout the banking system, leading to potentially catastrophic increases in systemic risk and financial contagion.
Proposed and recently instituted legal reforms in the financial regulatory framework such as the Dodd-Frank Act need to recognize the existence of regulatory bankruptcy and its serious externalities. Although this Article also argues that bankruptcy contagion can be contained, specifically in commercial real estate cases, by re-examining provisions relating to Single Asset Real Estate in the Bankruptcy Code, a general response from the direction of systemic risk regulation is required to deal with the source of systemic risk emerging from regulatory bankruptcy.
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