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  • 2021
  • Working Paper

No-fault Default, Chapter 11 Bankruptcy, and Financial Institutions

By: Robert C. Merton and Richard T. Thakor
  • Format:Print
  • | Language:English
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Abstract

This paper analyzes the costs and benefits of a no-fault-default debt structure as an alternative to the typical bankruptcy process. We show that the deadweight costs of bankruptcy can be avoided or substantially reduced through no-fault-default debt, which permits a relatively seamless transfer of ownership from shareholders to bondholders in certain states of the world. We show that potential costs introduced by this scheme due to risk shifting can be attenuated via convertible debt, and we discuss the relationship of this to bail-in debt and contingent convertible (CoCo) debt for financial institutions. We then explore how, despite the advantages of no-fault-default debt, there may still be a functional role for the bankruptcy process to efficiently allow the renegotiation of labor contracts in certain cases. In sharp contrast to the human-capital-based theories of optimal capital structure in which the renegotiation of labor contract in bankruptcy is a cost associated with leverage, we show that it is a benefit. The normative implication of our analysis is that no-fault-default debt, when combined with specific features of the bankruptcy process, may reduce the deadweight costs associated with bankruptcy. We discuss how an orderly process for transfer of control and a predetermined admissibility of renegotiation of labor contracts can be a useful tool for resolving financial institution failure without harming financial stability.

Keywords

No-fault Default; Chapter 11; Insolvency and Bankruptcy; Borrowing and Debt; Governing Rules, Regulations, and Reforms; Financial Institutions; Contracts

Citation

Merton, Robert C., and Richard T. Thakor. "No-fault Default, Chapter 11 Bankruptcy, and Financial Institutions." NBER Working Paper Series, No. 28341, January 2021.
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About The Author

Robert C. Merton

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More from the Authors

    • 2015
    • Faculty Research

    Customers and Investors: A Framework for Understanding Financial Institutions

    By: Robert C. Merton and Robert T. Thakor
    • July–August 2014
    • Harvard Business Review

    The Crisis in Retirement Planning

    By: Robert C. Merton
    • Journal of Portfolio Management

    Tribute to Paul A. Samuelson

    By: Robert C. Merton
More from the Authors
  • Customers and Investors: A Framework for Understanding Financial Institutions By: Robert C. Merton and Robert T. Thakor
  • The Crisis in Retirement Planning By: Robert C. Merton
  • Tribute to Paul A. Samuelson By: Robert C. Merton
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