Liquidity, systemic risk, and the bankruptcy treatment of financial contracts

Parties to repos, and to swaps and other derivatives are accorded privileged treatment under the bankruptcy laws of several dozen countries. Several key international “best practice” standards urge legislators in other jurisdictions to provide likewise. The beneficiaries of these privileges are solvent counterparties enabled, unimpeded by bankruptcy moratoria, to implement close-out netting arrangements and to dispose of collateral. The purported rationale is mitigation of systemic risk. Taking a broad international perspective, this Article explores the “domino” contagion view of distress that motivates the privileges. This view derives from the outdated “microprudential” understanding of systemic risk, and is theoretically flawed and empirically false. Drawing instead on the “macroprudential” approach, the Article argues that the elements of the broad close-out netting process—contractual termination, marked-to-market valuation, netting, and unimpeded collateral disposals—exacerbate systemic risk by increasing common exposures to risk, systemic uncertainty, procyclicality, and leverage, while reducing lending standards, collateral utilization, and regulatory capital buffers. A recent attempt to provide a new rationale for financial contract privileges highlights their contribution to the “exponentiation” of liquidity. This Article shows that the privileges diminish the liquidity of markets and financial institutions alike. What they exponentiate is “froth.” This rather unfamiliar label describes the all too familiar state in which assets are persistently and/or progressively overvalued and in which negative net-value projects obtain funding. The exponentiation of froth—the textbook recipe for systemic crises—should only be attractive to financial institution decision makers whose remuneration perversely tracks the riskiness of their institutions. The Article also throws new light on the international spread of financial contract privileges. It expands on existing literature by mapping the path-dependent ...