Too Important to Fail: Bankruptcy versus Bailout of Socially Important Non-Financial Institutions

Abstract

Systemically important financial institutions are broadly considered to impose a risk to the entire economy upon failure; thus taxpayers act upon their failure, providing them with an implied insurance policy for ongoing liquidity. Yet taxpayers frequently provide de-facto liquidity insurance for non-financial institutions as well. For example, recently in the U.K., hospital trusts were sharing millions in bailouts. A decade earlier, a federal court approved California's multibillion-dollar bailout of Pacific Gas & Electric Corporation. The Russian government continuously subsidizes corporations exclusively providing employment and social amenities in Monotowns. After 9/11, the U.S. Congress passed the Air Transportation Safety and System Stabilization Act, which provided the airline industry with financial aid. In all of these cases, taxpayer money was used to rescue non-financial organizations. The article defines a new category of socially important non-financial institutions (SINFIs) and proposes a method for their ex-ante identification. SINFIs are corporations exclusively providing an essential social function, and the article offers guidelines for defining essential industries and essential social functions as well as for assessing the monopolistic position assumed by the SINFI for provision of the essential service or social function.The case for bailouts of socially important non-financial institutions is discussed. Liquidity distress for a SINFI is unlikely to be resolved efficiently through bankruptcy, as the risk of an operating default for the socially important institution imposes an immediate crisis of confidence. The provision of service by a socially important institution imposes positive externalities on the general public, rendering the main features of bankruptcy, namely, debtor-in-possession rules and the ability to sell assets free and clear of all liens, sub-optimally efficient. Private investors are unlikely to capture the full value of their investment in the socially important firm on the edge of illiquidity. Thus, in a financially distressed SINFI, both the likelihood of new investment opportunities and their potential terms are expected to be suboptimal, and public finance is likely to be required: socially-important non-financial institutions are too important to fail. The article further analyses the structural characteristics and distorted corporate governance of socially important non-financial institutions. The elevated probability of rescue in case of failure makes the socially important non-financial institution prone to unwarranted expansion, and distorts its corporate governance well before failure occurs. The resulting moral hazard creates both enhanced incentives for excessive leverage and risk-taking, and elevated incentives for empire building due to the weaker corporate governance mechanisms available.