Bankruptcy-Proof Finance and the Supply of Liquidity icon.pdf E-mail

122 Yale L.J. 460 (2012).

The 2008 financial crisis has prompted widespread criticism of the bankruptcy safe harbors for repurchase agreements (repos) and derivatives, which allow a failed firm’s counterparties to enforce these contracts outside of the bankruptcy process. The emerging consensus holds that these provisions facilitated a run on the assets of troubled institutions such as Lehman Brothers, and should be curtailed to afford such firms greater protection from their counterparties.  In contrast, this Note argues that proposals to roll back the safe harbors would afford little relief to already-bankrupt firms while substantially undermining the efficiency and stability of the affected markets. Exposing these contracts to bankruptcy risk would render them unsuitable for a valuable function that they serve in the financial markets: offering institutional investors a liquid store of value akin to an insured bank deposit. And it would cause the supply of capital through these instruments to fluctuate, pro-cyclically, based on perceptions of risk to the financial system. The lessons of past crises suggest that a more promising approach would give distressed firms the emergency liquidity they need to weather a panic—not a stay on their obligations once they are already in bankruptcy.