Introduction

Prior to the recent financial crisis, the failure of a bank would in most countries be treated under the standard law of bankruptcy applicable to all institutions. Standard bankruptcy law is, however, best suited to those instances where the bulk of the assets are fixed, real assets, property, land and buildings, or equipment, such as railroad lines, steel furnaces, or airplanes—assets whose nature and value are not affected by the process of bankruptcy itself. Then the bankruptcy can, and does, involve a process of finding a (highest bidding) buyer for the unchanged real assets who can take them over and use them again productively. The more a business is built on such real assets, with a relatively assured and stable secondhand resale price, the more appropriate is debt finance, limited liability equity finance, and a continuing market, via takeovers, for ownership in that equity market.

Bankruptcy procedures and governance structures may need to become more complicated when the institution is primarily based on intangible capital—intellectual know-how—rather than on real tangible assets. Examples are legal and accountancy firms, advertising agencies, medical practices, universities, etc. In such cases, with no or little ability to constrain and to pre-commit the staff, who possess the human capital, by indenture or by slavery, the gone-concern value of such an institution is often a tiny fraction of its potential going-concern value. In such a condition, debt is, in general, not such an appropriate financing vehicle (on what would it be based?), a market for ownership of the institution is more problematical, and partnerships, of some form, are more suitable than a (limited liability) equity base. Normally, however, the failure of one such service provider strengthens its competitors in the market. Not only is competition for their output reduced, but they may also be able to pick up displaced and unemployed skilled staff more easily from the failing firm(s). As a generality, the failure of a service provider does not lead to contagion in that sector, whereby the failure of one firm drags others down with it.