The collapse of the investment bank Lehman Brothers in September 2008 was perhaps the defining event of the financial crisis. Lehman’s bankruptcy, followed by the near-collapse (save for government intervention) of the insurance company AIG, greatly intensified the fear and panic in markets, bringing the financial system and the economy to the brink of the abyss.
These events, including the government’s response, remain controversial. What should not be controversial is that ordinary bankruptcy procedures were entirely inadequate for the situation. The bankruptcy judge in the Lehman case – required, by law, to focus narrowly on adjudicating creditors’ claims against the company – had neither the tools nor the mandate to try to mitigate the effects of the failure on the financial system or the economy. The Fed, FDIC, and Treasury used the powers available to them, often in ad hoc ways, to try to preserve broader stability. But these agencies likewise lacked a framework for dealing systematically with failing financial giants.
The architects of the Dodd-Frank Act, which reformed financial regulation after the crisis, recognized that – in order to make the financial system safer and eliminate future taxpayer-funded bailouts – a better approach was needed. The first two sections, or titles, of the bill aimed to do just that. Title I extended the ordinary bankruptcy framework to better accommodate the complexities of large, interconnected financial firms. It also required large bank holding companies to submit to their regulators plans for how they could be successfully resolved in a crisis (“living wills”).
The Dodd-Frank law presumed that failing financial firms would be resolved through Title I procedures if possible. But it was recognized that, during periods of high financial stress, even augmented bankruptcy procedures might not be enough to maintain a stable financial system. Accordingly, Title II of Dodd-Frank created a backup authority, called the Orderly Liquidation Authority (OLA), to be used only when the Fed, FDIC, and Treasury (in consultation with the President) declare a financial emergency. Under the OLA, the FDIC and Fed are provided tools to help resolve failing firms safely, in a way analogous to the approach that the FDIC has long used to resolve failing banks. The creation of the OLA was accompanied by the repeal of some of the powers used by the Fed, FDIC, and Treasury during the crisis (such as the Fed’s ability to make an emergency loan to a single firm that is not a bank). The logic, which I supported as chair of the Fed, was that with the new authority in place those earlier powers were no longer needed.