Recently, a new bill was introduced in the Senate to address the problem of large banks failing. It is specifically intended to replace certain parts of the Dodd-Frank Act that allowed the government to bail out unstable banks in 2007 and 2008. This act, called the Taxpayer Protection and Responsible Resolution Act, introduces a new form of bankruptcy that applies to banks.

This new type of bankruptcy, Chapter 14, is designed to handle banks that were considered ‘too big to fail’ in 2008. This act is aimed specifically at those larger banks. Similar proposals have been made several times since the 2008 bailout.

Chapter 14 Basics

Based on research by the conservative Hoover Institute, Chapter 14 would replace the Dodd-Frank Act. That act essentially had the Federal Government buying debt to keep banks solvent. It would also provide alternatives to the existing Chapter 11 bankruptcy process.

What co-sponsors Senator John Cornyn (R-Texas) and Pat Toomey (R-Pennsylvania) propose instead is a legal process that would allow banks to handle their debt without posing a threat to the banking system as a whole. In Chapter 14, systemic liabilities would be identified, and the banks assets would be spun off into a ‘bridge company.’ This company would continue making necessary payments.

The proposed law would also make owners and investors responsible for any debt, and it also makes it less likely that unsecured creditors would receive any money. Financially experienced judges would oversee the bankruptcy, and the Federal Deposit Insurance Corporation would most likely act as trustees.

Benefits of Chapter 14

Many observers, after the 2008 banking crises, were afraid that banks would continue to act irresponsibly and eventually cause another crisis. The thinking was that bankers and investors could make chancy investments confidently, with the knowledge that the Federal Government would bail them out if the bet didn’t pay off.

Chapter 14 would put a check on that kind of behavior, as the owner and investors would be directly responsible for any debt in the event of a bankruptcy. Moreover, most of a failing bank’s assets would be used by the bridge company to prevent wider problems, and thus be unavailable to the owner to pay off debts.

Rather than simply having the Federal Government pay for any debts, the proposed Chapter 14 would provide a ‘safe’ way for banks to fail. This will keep taxpayers from bearing the burden of risky banking practices.

Problems with Chapter 14

That may all sound great at first glance. However, many observers are concerned that there are a variety of problems with the Taxpayer Protection and Responsible Resolution Act.

First among the problems is the issue of how the owner of a failing bank (usually a holding company rather than an individual) would be able to pay off their debts, particularly as the bank’s assets would not be available to them. Most likely they would need to seek out financing to meet those commitments.

Critics argue that it is unlikely that financing would be available. This is particularly true of a situation where banks are failing. The amount of money necessary would probably be quite large, and require some security, which would be unavailable in Chapter 14. While these debts may not qualify as systemic liabilities, not paying them could cause wider issues.

This points to another problem. Critics contend it will be difficult to define precisely a ‘systemic liability.’ The idea is essentially that there are some debts that are so large, or important, that a failure to pay them could pose a risk to the banking system as a whole.

This may sound unlikely, but it is in fact precisely what precipitated the banking crisis in 2008. Many large banks owed debts to each other in such a complicated system that when one began to be unable to pay its debts, it had an effect on every other bank, creating a domino effect. As more banks began to have problems, the instability spread outside the banking sector to other areas of the economy.

Identifying which debts could lead to a similar instability is unlikely to be simple or straightforward. This is particularly true given the fact that banks tend to fail rapidly, in the span of weeks or days. It is unlikely anyone would be able to make that sort of assessment as quickly as is necessary. Also, the consequences of making an incorrect assessment could be quite dangerous.

While the underlying idea of providing an orderly way for banks to resolve financial difficulties is a good one, the practical difficulties may make such a method prohibitively complex. The Act, in any case, is likely to be amended as it passes through the legislative process.