Derivatives Safe Harbors in Bankruptcy and Dodd-Frank: A Structural Analysis

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Derivatives Safe Harbors in Bankruptcy and Dodd-Frank: A Structural Analysis

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Title: Derivatives Safe Harbors in Bankruptcy and Dodd-Frank: A Structural Analysis
Author: Adams, Stephen D
Citation: Stephen Adams, Derivatives Safe Harbors in Bankruptcy and Dodd-Frank: A Structural Analysis (April 30, 2013).
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Abstract: The Bankruptcy Code exempts financial derivatives and repurchase agreements from key provisions, such as the automatic stay. The primary rationale for this special treatment has been the fear that the failure of an important market participant could cascade if counterparties could not immediately exit their contracts. Reflecting on the recent financial crisis and the Lehman bankruptcy, some scholars have suggested that exempting these financial contracts from bankruptcy may have exacerbated other kinds of systemic risk and contributed to the decision to bail out systemically important financial institutions (SIFIs) address this flaw by enacting a Bankruptcy alternative, Title II of the Dodd-Frank Act, instead of addressing the problems in the Bankruptcy Code safe harbors that were the source of the systemic risk. This article demonstrates that the view that Title II replaces bankruptcy reform is mistaken. Title II actually increases both the need and opportunity to reassess the proper limits of the safe harbors.
Without bankruptcy reform, the threat of irreversible damage if the SIFI files bankruptcy before intervention may force Title II to compete with bankruptcy in order to reach potential SIFIs first. However, the difficulty in evaluating whether some firm failures involve systemic risk incentivizes Title II decisionmakers to intervene in cases of doubt, leading to over-intervention, strain on resources and damage to Bankruptcy’s role as the default failure system. In addition, uncertainty over whether Title II will intervene will lead large firms to delay filing bankruptcy far past where resolution is optimal. However, with Bankruptcy reform, the Bankruptcy system would complement and mitigate weaknesses in the Title II safety net. In addition, Title II removes the primary justification for the safe harbors for financial derivatives and repurchase agreements, the fear of the consequences of the bankruptcy of a SIFI. In its wake, the safe harbors for derivative and repo creditors are at odds with powerful fairness and efficiency rationales behind default bankruptcy rules. Dodd-Frank may make Bankruptcy reform easier to achieve and more urgent.
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Citable link to this page: http://nrs.harvard.edu/urn-3:HUL.InstRepos:10985175
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