Epic Fail: An Institutional Analysis of Financial Distress

Abstract

This paper presents an institutional analysis of financial distress. “Institutional analysis” assesses the comparative effectiveness of large-scale social processes, such as markets, courts, and governments, at solving social problems. Although financial distress is one of our most acute problems, there has been virtually no effort to analyze it from an institutional perspective. This paper fills that gap. Institutional analysis shows that, contrary to conventional wisdom, financial distress is not a problem that courts, such as bankruptcy courts, usually solve by themselves. Instead, it is increasingly a problem that political organs (whether elected or regulatory) both create and purport to resolve. Government creates financial distress when it subsidizes private debt, through guarantees and regulatory exemptions for certain debt-like transactions, among other things. Government increasingly seeks to resolve it through laws such as Dodd-Frank, which tend to vest decision-making authority in government, not the stakeholders (e.g., creditors and debtors) involved. Institutional analysis is, in important part, about the nature and effect of stakeholder participation. On this metric, the trend is worrisome. Government tends to rob stakeholders of the participatory capacity to resolve financial distress inter se. Markets and courts, by contrast, generally create more participatory mechanisms, most commonly through the renegotiation (“work out”) of debt. To be sure, government has an important role in resolving financial distress. It is likely the best institution to prevent bank panics. But this is precisely because of the participatory failures that characterize a panic. Failing to recognize the institutional dimensions of financial distress has important implications. In the short term, laws such as Dodd-Frank codify institutional mistakes that contributed to the financial crisis. In the long term, government cannot subsidize debt as it has in recent years without creating significant problems of intergenerational equity. The paper concludes by exposing weaknesses in recent proposals to prevent future crises. I also offer an example of an institutionally-attuned solution: the strict liability claw-back for compensation received on account of government-subsidized debt.