No-fault Default, Chapter 11 Bankruptcy, and Financial Institutions

35 Pages Posted: 29 Jan 2021 Last revised: 29 Sep 2021

See all articles by Robert C. Merton

Robert C. Merton

Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER); Harvard Business School - Finance Unit

Richard T. Thakor

University of Minnesota - Carlson School of Management; Massachusetts Institute of Technology (MIT) - Laboratory for Financial Engineering

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Date Written: December 27, 2020

Abstract

This paper analyzes the costs and benefits of a no-fault-default debt structure as an alternative to the typical bankruptcy process. We show that the deadweight costs of bankruptcy can be avoided or substantially reduced through no-fault-default debt, which permits a relatively seamless transfer of ownership from shareholders to bondholders in certain states of the world. We show that potential costs introduced by this scheme due to risk shifting can be attenuated via convertible debt, and we discuss the relationship of this to bail-in debt and contingent convertible (CoCo) debt for financial institutions. We then explore how, despite the advantages of no-fault-default debt, there may still be a functional role for the bankruptcy process to efficiently allow the renegotiation of labor contracts in certain cases. In sharp contrast to the human-capital-based theories of optimal capital structure in which the renegotiation of labor contract in bankruptcy is a cost associated with leverage, we show that it is a benefit. The normative implication of our analysis is that no-fault-default debt, when combined with specific features of the bankruptcy process, may reduce the deadweight costs associated with bankruptcy. We discuss how an orderly process for transfer of control and a predetermined admissibility of renegotiation of labor contracts can be a useful tool for resolving financial institution failure without harming financial stability.

Keywords: Bankruptcy, Default, Chapter 11, Capital Structure, Labor Contracts, Human Capital, Financial Institutions

JEL Classification: D21, G21, G23, G32, G33, G38, K12, L22

Suggested Citation

Merton, Robert C. and Thakor, Richard T., No-fault Default, Chapter 11 Bankruptcy, and Financial Institutions (December 27, 2020). Journal of Banking and Finance, Forthcoming, MIT Sloan Research Paper No. 6382-20, Available at SSRN: https://ssrn.com/abstract=3756037 or http://dx.doi.org/10.2139/ssrn.3756037

Robert C. Merton

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Richard T. Thakor (Contact Author)

University of Minnesota - Carlson School of Management ( email )

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Massachusetts Institute of Technology (MIT) - Laboratory for Financial Engineering ( email )

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