Micro-Prudence, Macro-Risk: Where Financial Regulation Meets Bankruptcy

Abstract

Since the financial crisis began in late 2007, there has been increasing recognition that micro-prudential financial regulation must be supplemented by macro-prudential supervision in order to maintain financial stability. This Article is the first effort to examine empirical evidence showing that capital constraints, as driven by concentration risk, can significantly increase the probability that a bank will pursue a course of action culminating in foreclosure. When many banks simultaneously choose this course of action, especially when encouraged by micro-prudential policy, this creates negative externalities through increases in systemic risk. Important policy conclusions emerge. First, this furthers the understanding of the subtle effects of bank capital regulation, the regulatory responses to a banking crisis, and how these can spill over to the way banks handle the distress resolution of their debtors. Next, this problem falls squarely within the purview of the Financial Stability Oversight Council established by the recent Dodd-Frank Act. However, the Dodd-Frank Act left in its wake too much ambiguity as to how the systemic risk regulator should regulate such issues. Finally, the findings in this Article have important implications for debtor-creditor scholarship and bankruptcy policy, showing that the behavior of secured creditors in bankruptcy cases is not simply explained by the economics in the case itself, and exogenous factors originating from the bank regulatory framework can, in fact, affect bankruptcy outcomes.