January 06, 2012
Saturday Scholarship at AALS: Liability Holding Companies -- Reducing Bank Leverage While Having Debt Discipline
Posted by Erik Gerding

This is the fifth and final installment of a series of previews of the papers being presented at the AALS Financial Institutions & Consumer Financial Services Section events this weekend.  This final paper will be presented at a special off-site event starting at 4 pm on Saturday at American University.  (See here for details on the full weekend of Financial Institutions/Consumer Financial Services Section events).

Peter Conti-Brown (Academic Fellow, Stanford Law, Rock Center for Corporate Governance) will present, Liability Holding Companies, a paper he co-authored with Anat Admati and Paul Pfleiderer (both of Stanford’s Graduate School of Business).  To understand this paper, it helps to read an earlier, influential paper by Admati, Pfleiderer, and a number of co-authors on which it builds.  This earlier work, Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensivecountered criticisms of higher capital requirements.  That earlier paper responded to charges that higher capital requirements would impose large social costs, including reducing bank lending.

Yet in Liability Holding Companies, Conti-Brown and his co-authors admit that bank debt may have some benefits; creditors may monitor and discipline bank management.  To balance this disciplinary benefit against reducing the social costs of excessive bank leverage (financial institution fragility, systemic risk, increased risk of bailouts), Admati, Conti-Brown, and Pfleiderer propose a regulatory innovation.  Here is their abstract:      

An international debate continues to unfold in banking law, corporate governance, and finance on whether the capital structure of the world’s largest financial institutions is too heavily dependent on debt, too little on equity. Two of us, with co-authors, have argued elsewhere that there is no socially beneficial purpose for this over-reliance on debt and, indeed, that such reliance increases the likelihood of taxpayer bailouts, with their associated economic, financial, and social costs. Some academics and bankers continue to insist, however, that increased equity is costly for banks and for society. The arguments proffered in defense of these propositions contradict the most basic insights from corporate finance, and often neglect to distinguish private costs from social costs in explaining their preference for debt-heavy capital structures.

While there are overwhelming costs that excessive bank debt can have on the broader economy, some contend that there may be some benefits from debt for a firm’s corporate governance. In particular, some academics have argued that debt is useful because it “disciplines” bank management. The idea suggests that creditors with hard claims against the firm will monitor the firm to prevent bank management from misusing the free cash flows that the banks’ economic activities generate. If these benefits exist and are substantial, we may face a vexing tradeoff: too much debt creates dramatic social costs, moral hazard, and systemic risk, while too little may have negative consequences for firm governance. The challenge is to find a way of optimizing that tradeoff.

This Article engages that challenge, and introduces a new kind of financial institution – called a Liability Holding Company (LHC) – that appropriately balances the social costs of excessive private leverage with the purported benefits for corporate governance that such leverage might create. Our proposal places an increased liability version of the bank’s equity in a conjoined but separately controlled entity, the LHC, that also owns other assets to which the banks’ liabilities have recourse in the event of failure. The equity shares of the LHC—a holding company subject to a unique regulatory regime supervised by the Federal Reserve, similar to Bank Holding Companies or Financial Holding Companies—are then traded in public markets. The LHC thus aims to eliminate or at least greatly reduce the role of the government as the effective guarantor of the systemically important financial institutions (SIFIs), thus reducing the distortions that current implicit governmental guarantees create. It additionally allows banks the benefits of two boards: an advising board, that the bank managers may appoint, and the monitoring board housed at the LHC, appointed by the LHC’s own public shareholders. This dual board structure resolves some important issues raised in the long-standing debate about the role corporate boards should play. We discuss in detail how this proposal would function within the present legal and regulatory environment—particularly within the contexts of bank regulation, corporate governance, and Dodd-Frank—and address counter-arguments and alternative proposals.

 Saule Omarova (North Carolina) will serve as discussant for the paper.

 

AALS, Corporate Governance, Finance, Financial Crisis, Financial Institutions, Legal Scholarship | Bookmark

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