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Insolvency Games

12 June, 2017Keith Pond

Game theory is used by economists (amongst others) to explain the complex behaviours in markets, especially where those markets are not competitive.  Whilst the Office of Fair Trading (2010) concluded that the market power held by a relatively small number of Insolvency Practitioners (Pond, 2017) does not work against the public interest, it did highlight just how influential lending banks can be in the insolvency process.

The Prisoners’ Dilemma

One of the classic games that summarises market behaviours and consequences is the Prisoners’ Dilemma (for a fuller explanation see: Garson, 2012).  In this “game” two thieves are arrested by the police, held in separate rooms and each is told that they face 20 years in jail.  The thieves know that without a confession the police only have enough evidence to send them to jail for 1 year.  If one thief confesses, however, then that thief is offered freedom, whilst the other thief gets 25 years in jail.

There are many “solutions” to this dilemma –silence being the favourite in many cases as this nets both thieves 1 year each.  However, individual self-interest might lead each thief to confess – at which BOTH end up in jail for 20 years.

    

This game is most likely to end in each thief adopting a strategy of silence, especially if the game is repeated as each gets to know the others’ reaction and likely response and begins to trust the other…OR each knows the violent fate that awaits them should they “rat” on their colleague.

The Bankers’ Dilemma

In a corporate insolvency the key relationship is not necessarily the one between the IP and the directors of the stricken firm but between the IP and the bank holding a debenture.  The debenture allows the bank to appoint an Administrator and it is a position that both IPs and banks find themselves in repeatedly.

The IPs know that they must not only do a job in a professional and objective way but liaise with the lender to ensure acceptance of the outcome of the insolvency.  Bankers know that they must select and monitor IPs carefully in order that the return from the insolvency is as good as it can be for their shareholders.

So, over time, the independent players in the “market” – IPs and banks, learn to trust each other, develop a relationship that gives each party some benefits.  This “trust” is supported by the twin facts that the IP’s next job is likely to come from a bank AND that, in insolvency, only licensed IPs can be appointed.

There are protections built into the Insolvency Act 1986 and its attendant regulations that allow for removal of licenses from IPs should their behaviour actually work against the interests of creditors or if they commit fraud etc.  The small number of such disqualifications should be a clear sign that high levels of honesty and integrity pervade the occupation.

Experienced bankers in “recovery” units of banks, who have the relationships with IPs, must also know their clear responsibility is to ensure that the trust they are given is not abused.  The small number of court cases involving bankers being accused of such abuse should also be a clear sign that high levels of honesty and integrity pervade the occupation.

References

Garson GD, (2012), Game Theory, Statistical Associates Publishing, available at: http://www.statisticalassociates.com/gametheory.pdf

Office of Fair Trading, 2010, The Market for Corporate Insolvency Practitioners, available at: http://webarchive.nationalarchives.gov.uk/20140402142426/http:/www.oft.gov.uk/shared_oft/reports/Insolvency/oft1245

Pond K, (2017), Put a Cork in it...The Insolvency Act 30 years on, LIBF Insights blog, available at: http://www.libf.ac.uk/news-and-insights/insights/detail/2017/05/10/put-a-cork-in-it-the-insolvency-act-30-years-on

Dr Keith Pond is part of the team leading the Masters in Banking and Finance