Tag: financial institutions

  • Bankruptcy Modification and the Emperor’s New Clothes

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    Adam Levitin

    A new argument being advanced against bankruptcy modification is that it will result in trillions of dollars of losses and the collapse of the financial system.  This is the "the sky will fall" argument.  

    Leaving aside the grossly inflated numbers, let's be really clear that these are not losses that would be caused by bankruptcy modification.  These losses exist with or without bankruptcy modification.  All bankruptcy modification does is force these losses to be recognized now, rather than at some point down the road.  Bankruptcy modification doesn't change the underlying insolvency of many financial institutions.  One way or another, there are a lot of financial institutions that have to be recapitalized. 

    Financial institutions want to delay loss recognition as long as possible.  Maybe they're hoping that the market will magically rebound.  Maybe they think that 2006 prices are the "real" prices and "2009" prices are a very short-lived aberration.  But here's the crucial point:  homeowners bear the cost of delayed loss recognition by financial institutions.  Delayed loss recognition means homeowners floundering in unrealistic repayment plans and then losing their homes in foreclosure.  Delayed loss recognition means frozen credit markets because no one trusts financial institutions' balance sheets.  Delayed loss recognition means magnifying, shifting, and socializing losses.  We only make matters worse when we try to pretend that these losses don't exist.  

    We all know the story of the Emperor's New Clothes, and how everybody plays along with the emperor's conceit until a little boy points out that the emperor is stark naked.  To suggest that widespread financial institution insolvency would be caused by bankruptcy modification is akin to blaming the little boy for the emperor's nudity. 

  • Behaviorally Informed Financial Services Regulation

    Posted by

    Adam Levitin

    A new policy paper issued by the New America Foundation and authored by Michael Barr, Sendhil Mullainathan, and Eldar Shafir argues that we need to move toward “behaviorally informed financial services regulation.” By this the authors mean that financial services regulation should incorporate the insights of behavioral economics and cognitive psychology, regarding things like default rules, framing of information, and hyperbolic discounting.

    This paper comes on the heels of Richard Thaler and Cass Sunstein’s book Nudge, the culmination of their work in developing what they call “libertarian paternalism”–a soft-form version of paternalism that instead of mandating outcomes, such as requiring retirements savings, sets default rules and menu choices in a way that encourages them, such as making workers opt-out of retirement savings plans, rather than opt-in.

    There’s much to commend about this work (Barr et al., as well as Thaler & Sunstein), and the incorporation of behavioral economics into law has been an important development in the last decade or so of legal scholarship. I do not doubt that behaviorally informed financial services regulation would be an improvement over our current model. But I am dubious about its ultimate efficacy for three reasons.

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