Systemic liquidity risk and bankruptcy exceptions

Abstract

A series of amendments to US and EU bankruptcy laws created in 2002 - 2005 unique bankruptcy privileges for secured financial credit and derivatives. This major legal change, though poorly understood, created super priority rights for some investors. It fed the final and most damaging stage of the securitisation wave, funded heavily with repos and hedged by CDS derivatives. Bankruptcy exceptions stride with principles of bankruptcy law aimed at orderly resolution of distress. They exempt all credit collateralized with securities and any derivative, listed or not, from the automatic stay in bankruptcy, and exempted them from rules on cross-default clauses. As a result, these investors can front run all other in case of default, as they did spectacularly upon Lehmann Brothers’ default. Ultimately, this super priority construction shifts risk to other parties and to the financial system. We propose here to target the very short-term risk by taxing the so-called bankruptcy privileges. The aim is to discourage the excessive build up of liquidity risk, and curb useless carry trades in both the banking and shadow banking sector.