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Bernanke Defends Orderly Liquidation as House Weighs Dodd-Frank

Former Federal Reserve Chairman Ben Bernanke speaks at the head office of Bank of Japan in Chuo Ward, Tokyo, on May 24, 2017. (The Yomiuri Shimbun via AP Images)

WASHINGTON – Former Federal Reserve Chairman Ben Bernanke said Tuesday that bankruptcy procedures are not adequate enough to address major financial collapses, as the House considers repealing orderly liquidation options implemented by the Obama administration.

The Trump administration has voiced support for repealing orderly liquidation authority (OLA) measures and replacing them with a Chapter 14 bankruptcy option. The House considered that proposal this week when it weighed the Financial Choice Act, which would replace OLA and other key elements to the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was passed in 2010. An official vote is expected Thursday.

Title II of Dodd-Frank includes the orderly liquidation provision, an alternative to bankruptcy proceedings that provides a process for rapidly liquidating a major financial institution.

“We saw what happens without OLA,” Bernanke, who served as Fed chairman from 2006 to 2014, said at the Brookings Institution on Tuesday. “We saw it – it’s 2008. We don’t want that again.”

Bernanke admitted that OLA is not perfect, but he said he’s “absolutely confident it would have been a better strategy, a better framework, than the kinds of ad hoc and politically fraught approaches that the government was forced to use in the last crisis.”

The former chairman argued that the issue with bankruptcy is that its focus is adjudicating claims among creditors and not about protecting the financial stability of the system. David Skeel, a corporate law professor at the University of Pennsylvania Law School, agreed with Bernanke but only to an extent.

“I don’t think bankruptcy is perfect either, but I think we shouldn’t overstate the inability to take systemic considerations into account,” Skeel said. “I do think that is a limitation of bankruptcy, but it’s only a partial limitation, and bankruptcy judges are fully aware of the systemic implications.”

Bernanke also addressed a common criticism of Title II, which is that the procedure focuses on curing a disease, instead of preventing the disease in the first place. The argument is that the mere existence of a mechanism to deal with a major financial collapse allows institutions to take risks they otherwise wouldn’t. Bernanke countered that if there’s no last-resort option, then the expectation is that the political system will handle financial crises, which he argued is bad policy.

The other issue with that argument, Bernanke said, is the assumption that financial institutions are considering the impact on the overall system when making decisions. He said that a person smoking in bed is not concerned with the fire spreading to the entire neighborhood.

“I think that this Title II strategy will work, but given that we haven’t chosen that strategy, I think that we have to make sure we have a way to safely unwind a firm,” Bernanke said. “And if you want to avoid bailouts, you’ve got to eliminate the incentive for a bailout.”

When the government is faced with the options of an unpopular bailout or letting the economy crash, he added, the incentives are strong for bailouts. He suggested that the best way to avoid a bailout is to have a process in place that gives a reasonable chance of successfully unwinding institutions without the tremendous side effects experienced in 2008.

Bernanke also admitted that a major weakness for OLA is that it might not be successful in addressing failures of multiples firms at once or firms with extensive global reach.

“All those things are real problems that we need to continue addressing,” he said.