American Enterprise Institute think tank scholar Peter Wallison published a compelling essay yesterday relating to firm resolution. Since the financial crisis, determining how to quickly and effectively manage the failure of a large firm has been an important goal of financial reform. Bankruptcy is a notoriously messy and drawn out legal process. Wallison offers a suggestion to make things a little easier: allow firms to choose the legal system of their resolution ahead of time.

In a perfect world, every country would have identical bankruptcy laws. Then, the process would contain little uncertainty and great clarity. But the world we live in is more complicated. In this quickly developing global market, jurisdictional disputes over which nation's rules ought to apply could increase the time it takes for resolution. While that's less than ideal in any situation, it's particularly dangerous with the failure of a large firm, where a slower process will could create uncertainty that could lead to market instability.

Although Wallison wishes all countries could agree on universal bankruptcy rules, he knows that's not realistic. So he suggests what he calls "Debtor Selection," which would allow whatever firm is issuing debt to choose which nation's bankruptcy rules will be followed in a failure event. It would kind of be like how U.S. firms choose their state of incorporation. The idea has quite a few very attractive characteristics, but one concern sticks out.

Eliminates Uncertainty

The first nice aspect of this idea is that it immediately eliminates a great deal of uncertainty that would otherwise cloud the bankruptcy process. The laws that must be followed are clear, based on whatever nation's rules the firm decides to adhere to. This is especially good for investors, who can take this new variable into account when determining which firm's debt is most attractive at a given yield.

It's Fast

That clarity provides something extremely important for economic stability: speed. Without different countries bickering over which laws should be followed, proceedings should occur much more quickly. The market can then interpret the implications of the firm's bankruptcy faster and more forward.

Fits With Current Reform Plans

In fact, the debtor selection concept could also fit in well with Washington's work thus far on attempting to create a non-bank resolution authority. Doing so would include firms developing failure plans to facilitate the bankruptcy process. Wallison explains that a part of that plan should include which nation's laws a firm's resolution should follow:

In addition, if financial institutions are ultimately required to prepare some form of living will--a description of how they will be resolved in the event of insolvency--certainty about the applicable bankruptcy regime would be of great assistance in determining in advance how a resolution would proceed.

This matters a lot, because there's some worry that big firms will have a great deal of trouble determining how to fail if being pulled in different directions by conflicting bankruptcy laws from the different nations where it does business.

The Market Mostly Regulates Itself

One criticism of debtor selection might be that firms could intentionally choose rules with some end in mind, like preserving more power for management instead of creditors in bankruptcy. Yet, so long as creditors are aware of the debtor's selection, why would that matter? They can build that into the price they demand to purchase the firm's debt. Less favorable terms for creditors will require firms to pay up for their borrowing.

The same applies to the resolution authority's fund used to wind down firms. If the rules a firm wants to follow during failure would result in a more costly process, then the assessments on that firm would be greater than on a firm that chooses a less costly regime.

Should Apply to All -- Not Just Large -- Firms

Wallison makes an important point arguing that this proposal should apply to all firms:

A key question is whether the system should be limited to financial firms that are "systemically important." There is no need for this limitation. Indeed, no one has any idea when a company is systemically important or what factors might make it so.

Whether large firms would derive some competitive advantage from living under a different set of resolution rules than smaller firms has been discussed here. Wallison's point is even more general -- it's probably impossible to determine which firms are going to turn out to be systemically significant anyway. We might as well have the same rules across-the-board.

One Major Concern

Wallison's debtor selection could allow firms to opt-out of a local resolution authority's jurisdiction, through international treaties. That might create a problematic moral hazard. Big firms could just choose to live within the resolution regime of a nation with no regulator charged with conducting the orderly wind down of failing firms. Then, if a large firm fails, the nation in which it is headquartered -- which may not be where the firm selected to be resolved -- could be on the hook for a bailout if that its bankruptcy will result in a systemic threat.

Wallison responded to this criticism via e-mail:

It's exactly the opposite. Choosing a regime that does not have a resolution authority reduces moral hazard. Moral hazard arises from the possibility that the govt will rescue the creditors.

He says the Dodd proposal would create such a bankruptcy regime. But a resolution authority doesn't necessarily need ability to provide bailouts. Indeed, one shouldn't be allowed do so. One could, instead, only have the power to wind down firms more efficiently and quickly, while taking measures to minimize market disruption by covering certain necessary costs involved in bankruptcy through a pre-paid resolution fund. The FDIC works in this way to resolve smaller banks.

The mere existence of one set of clear bankruptcy laws to be followed doesn't eliminate the possibility that a firm's failure could destabilize the economy. For example, even if AIG had chosen, say, Mexico as its resolution jurisdiction, the U.S. might have still felt the need to bail out the firm. There's no guaranteeing the process would have happened quickly and cleanly enough under Mexico's resolution regime to ensure economic stability without a bailout.

Unfortunately, the market wouldn't punish such behavior: it would reward it. Investors would find value in the possibility of an implicit government guarantee due to a big firm choosing a bankruptcy regime with a weak bankruptcy regulator in place, incapable of conducting a quick, tidy resolution. Instead, it might be more reasonable to allow firms to choose any nation's bankruptcy rules, but rely on a resolution authority where it is headquartered to actually conduct the bankruptcy process under those chosen laws.

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