Regulatory Bankruptcy: How Bank Regulation Causes [Real Estate] Firesales

Regulatory Bankruptcy: How Bank Regulation Causes [Real Estate] Firesales

It is axiomatic in American business bankruptcy practice that though they may disagree strenuously on the particulars, all parties to a Chapter 11 case are interested in the same basic goal: maximization of the debtor’s asset values.

Or are they?

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NYU Professor Sarah Woo has recently published an empirically-based analysis of this assumed common goal, and the results of that analysis are striking.  As she describes her own research (presented in an article titled “Regulatory Bankruptcy: How Bank Regulation Causes Firesales“):

This Article demonstrates empirically that this assumption is inaccurate: the actions of banks in bankruptcy proceedings are not necessarily driven by value maximization. The findings in this Article have groundbreaking implications for bankruptcy policy which focuses on the debtor and overlooks exogenous creditor-specific factors. Where banks, which extend the bulk of the outstanding credit in the United States, are driven by financial regulatory policy to over-liquidation of their own borrowers, these actions lead to fire sales which potentially amplifyliquidity shocks and systemic risk.

Ms. Woo’s working hypothesis is that changes in the banking sector over the past decade, including increased consolidation and increased leverage, eventually pushed banks to pursue higher portfolio returns.  As a result, many banks over-concentrated their portfolios in commercial real estate – a strategy which worked well during frothier times, but which proved disatrous in the aftermath of 2008’s economic collapse.

In the aftermath of the banking crisis, over-concentration by banks drew significant regulatory scrutiny – and, ultimately, significant new regulation designed to pressure banks to reduce their concentration risk.  According to Professor Woo:

As with many episodes of financial instability which can be traced to misguided attempts to use regulatory power, pervasive regulatory pressure with capital adequacy as a centerpiece affected bank behavior in bankruptcy, interfering with investment expectations and diminishing asset values. In the case of IndyMac Bank, the bank shed more than a billion dollars of construction and development loans in the first six months of 2008 under regulatory pressure, partly through liquidations in bankruptcy. The actions of bank regulators thus had unintended but dire consequences of rendering the standard assumption of value maximization in bankruptcy policy obsolete by creating a different set of incentives dependent on the bank creditor’s own health. The phenomenon of regulatory bankruptcy thus demands a comprehensive reevaluation of current bankruptcy policy which has not kept up with these developments in the banking industry.

Professor Woo’s work is important, not only for the specific question of how and why banks behave the way they do in bankruptcy, but also as an example of how industry dynamics can mold and shape the bankruptcy process – and further, how empirical data can be marshalled for the benefit of informed legislative change and judicial decision-making.

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