Reform of American Business Law

In a previous session we discussed whether a change in Banking Law rules would at all be a good way of preventing systemic risk.

We kept all parameters open, assuming total freedom to write whatever we wanted in whatever Banking Law instrument we wanted. Like for the exam, total freedom. The only tricky piece, and it is not really tricky, is that you need to think of rules of Law as systems of forces or vectors: change the direction or intensity of one, and the resultant changes. So before you change a rule, you need to figure out what effect that will have on the resultant.

We discussed whether a better way to prevent systemic risk would not be to reform Bankruptcy Law appropriately. Today, we will explain what is in current Bankruptcy Law, so we can discuss what (if anything) needs to be reformed, and why.

"Chapter 11" is the codename for proceedings tending for the reorganization of the debt of an insolvent debtor, a debtor who cannot pay in full all he owes.

The objective of Chapter 11 is to avoid a "run" against the debtor, a "first-in-first-served" situation in which young fast-running students collect all the money they are owed, while the slowest running professors get nothing because there would be no money left.

Obviously, this logic is the opposite to the normal operation of a deposit bank: when a depositor wants to withdraw funds, there is no mutualization of bank insolvency risks, at least at depositor level (mutualization happens at Federal Deposit Insurance Company, or taxpayer if you wish, level).

If it weren't for this mutualization of risk, "bank run" prophecies would always self-fulfill: if you think your bank will collapse you run and try to withdraw your deposits. When others see you running, they also run and, needless to say, a "run" happens. Because depending on the "prudential regulations" Banks can have a large fraction of deposits invested, they cannot refund all depositors if all come at the same time to withdraw their deposits.

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