How a GOP bill could cause the next financial crisis – Bruce Grohsgal and Simon Johnson

MIT Sloan Professor Simon Johnson

From Politico

Wall Street’s gambles and risky borrowing directly led to the financial crisis, causing the collapse and near-collapse of megabanks and greatly harming millions of Americans. But thanks to government bailouts, those megabanks recovered quickly and top executives lost little.

In response, Congress passed the Dodd-Frank regulatory law to ensure thatno failing bank ever receive such special treatment again. But legislation that favors very large banks

Professor Bruce Grohsgal

and undermines those reforms is in the works again. The bill is called the Financial Institution Bankruptcy Act, or FIBA. The measure already has been passed by the House, and the Senate may take it up soon.

In theory, the bill attempts to solve a major issue in the Bankruptcy Code that prevents failing megabanks from restructuring through traditional Chapter 11 bankruptcy protection. In effect, though, FIBA offers banks an escape route, creating a subchapter in the Bankruptcy Code through which the Wall Street players who enter into these risky transactions will get paid in full while ordinary investors are on the hook for billions of losses. Not only is that deeply unfair, but it will encourage Wall Street to gamble on the very same risky financial instruments that caused the recent crisis.

Under Chapter 11, a failing company can get a reorganization plan approved to keep its business operating while paying its creditors over time. It then can emerge from bankruptcy as a viable business. During Chapter 11 bankruptcy protection, creditors are prohibited from suing the debtor to collect on their debt, a key provision that ensures all creditors are treated fairly and enables the business to reorganize. This is known as an “automatic stay.”

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