This paper aims to describe a resolution process for faltering financial firms that quickly allocates losses to bondholders and transfers ownership of the firm to them. This process overcomes the most serious flaws in resolution plans submitted by banks under Dodd–Frank Title I and in the Federal Deposit Insurance Corporation (FDIC) receivership procedure in Dodd–Frank Title II by restoring the balance sheet of a failing financial institution and immediately replacing the management and board of directors who allowed its demise.
Feasibility of the proposed resolution procedure is assessed by comparing long-term bonds outstanding for the largest American banks just before the 2008 crisis to the capital needed by these banks to restore their balance sheets after their losses prior to and during the crisis.
In almost all bank failures, this process would eliminate the need for government involvement beyond court certification of the reorganization. The procedure overcomes the serious incentive distortions and inefficiencies created by bailouts, and avoids the destruction of value and financial market turmoil that would result from the bankruptcies and liquidations that Dodd–Frank requires for distressed and failing banks.
Title II of the Dodd–Frank Act would require liquidation of any banks that enter into its resolution process. The case of Lehman Brothers indicates the severity of losses to investors that liquidation imposes and the disruption to financial markets and the economy. The procedure developed in this paper would avoid the disruptions that Dodd–Frank requires, preserving core functions of faltering financial firms and maintaining them as going concerns, even in a severe financial crisis.
