It's here, and she's a tenative skeptic. I think that prop trading has often been highly profitable for banks, but she may be on to something if it is small potatoes.  And certainly the Volcker Rule doesn't forbid the existence of trading desks.  So traders may move from proprietary to elsewhere in the bank and still keep doing their thing.

Was prop trading such a minimal deal?  The argument reminds me of Jonathan Knee's memoir about his time at a bulge bracket investment bank - he worked the media group, which was very profitable, and kept its costs down... but the managers said: your group should not worry about costs and simply must make more money.  In business, small, unscalable earners often aren't worth the time.  Knee left for a botique, so there you go.

However, even though it is just journalism, here's another story suggesting that the transformation of investment banks has been substantial and arduous for the bankers.  There must be an answer to this empirical question, but my sense is that the insane profitability of prop trading desks really did contribute to bottom lines of banks - and they are contributing much less now.

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Both in the Times.  Jesse Eisinger says

bank lobbyists with complicit regulators and legislators took a simple concept and bloated [the Volcker Rule] into a 530-page monstrosity of hopeless complexity and vagueness.

But Steven Davidoff suspects that

The Volcker Rule, for all its good intentions, may perhaps unleash a burst of rapid financial innovation to do something it never intended: recreating the prefinancial crisis division between investment banks and commercial banks.

So is the Volcker Rule going to be toothless or a return to the old days of separated banking?  My money's with Davidoff.  Just because a rule is complicated doesn't mean that it won't work - look at the Clean Water Act.  And all the indicia, literally all of them - that investment banks are losing money, planning layoffs, and spinning off prop trading at the same time - suggest that regulatory reform, rather than being ignored, is substantially affecting the organization of financial intermediaries.

I know some people close to Paul Volcker himself who have despaired of the progress made in implementing the Rule.  But it seems to me that the changes in anticipation of its effect have already been substantial.  I'm not sure that the same progress will be made with derivatives regulation.  But simply adding up the word count of a regulation should be your last resort, rather than your first one.

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We'll outsource to DealBook:

The Lloyds Banking Group, partly owned by the British government after receiving a bailout, on Monday became the first bank in Britain to cut past bonuses because of losses that turned up later.

The bonus clawback of about £2 million ($3.2 million) applies to five former or current executive directors, including a former chief executive, and eight other managers. Eric Daniels, who left the bank as chief executive last year, would have to give up 40 percent of the share bonus he was awarded for 2010, or about £580,000, Lloyds said.

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The comment period just ended, and the Times has a piece on how active individual banks have been in filing their thoughts (with pictures of your favorite Davis Polk banking law celebrities, if you like that sort of thing).  Ordinarily, banks leave these sorts of things to the banking associations.  The WSJ has a piece summarizing the comments, and you can get your own taste here (SEC), here (CFTC), and here (Fed).  Perhaps most encouragingly, Kim Krawiec, already something of an expert on this sort of commenting, is on the case.  It certainly shows how financial lawyers may need to master some of the intricacies of participating in administrative rulemaking.

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The 2011 symposium edition of the Berkeley Business Law Journal on Dodd-Frank is out.  I would like to thank the editors and the Berkeley Center for Law, Business and the Economy for inviting me to a great conference.  My contribution, Credit Derivatives, Leverage, and Financial Regulation’s Missing Macroeconomic Dimension is now up on ssrn.  Here is the abstract:

Of all OTC derivatives, credit derivatives pose particular concerns because of their ability to generate leverage that can increase liquidity - or the effective money supply - throughout the financial system. Credit derivatives and the leverage they create thus do much more than increase the fragility of financial institutions and increase counterparty risk. By increasing leverage and liquidity, credit derivatives can fuel rises in asset prices and even asset price bubbles. Rising asset prices can then mask mistakes in the pricing of credit derivatives and in assessments of overall leverage in the financial system. Furthermore, the use of credit derivatives by financial institutions can contribute to a cycle of leveraging and deleveraging in the economy.

This Article argues for viewing many of the policy responses to credit derivatives, such as requirements that these derivatives be exchange traded, centrally cleared, or otherwise subject to collateral or 'margin' requirements, in a second, macroeconomic dimension. These rules have the potential to change – or at least better measure – the amount of liquidity and the supply of credit in financial markets and in the 'real' economy. By examining credit derivatives, this Article illustrates the need to see a wide array of financial regulations in a macroeconomic context. 

Understanding credit derivatives’ macroeconomic effects has implications for macroprudential regulatory design. First, regulations that address financial institution leverage offer central bankers new tools to dampen inflation in asset markets and to fight potential asset price bubbles. Second, even if these regulations are not used primarily as monetary or macroeconomic levers, changes in these regulations, including changes in the effectiveness of these regulations due to regulatory arbitrage, can have profound macroeconomic effects. Third, the macroeconomic dimension of credit derivative regulation and other financial regulation argues for greater coordination between prudential regulation and macroeconomic policy.

Comments by e-mail are always welcome.

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As the folks at Corp Counsel observe, the UK is making a big thing about reining in exeuctive pay:

As I've blogged before, the United Kingdom has been on a path to revise its executive compensation laws to rein in excessive pay. Yesterday, the UK announced a slew of proposals that would push the envelope in the executive pay area - here are the proposals (or the closest thing I could find to them), as well as British Business Secretary Vince Cable's oral statement, a summary of responses to the related discussion paper and a comparison with the High Pay Commission's report that came out a few months ago (note that the HPC is not an independent commission; it's a left wing charity). And here is a Towers Watson memo, ISS blog and NY Times article discussing these proposals.

The proposed major changes include:

- Say-on-pay votes would be binding
- Approval threshold increased to 75% from 50%
- At least two compensation committee members would have no prior board experience
- Clawbacks of bonuses if executives failed
- Enhanced disclosures

It's notable that Britain's opposition party is quoted in media reports as criticizing these proposals as not going far enough!

The Basel Committee is also worrying about executive pay in financial intermediaries.  I think this stuff is evidence of a change in the driver of the debate of executive pay regulation.  The American laissez faire perspective on pay was beginning to spread, to some consternation, to Europe and elsewhere.  But if anything, I think that the post-crisis inclination of foreign countries to point to executive compensation as part of the problem may end up constraining the old American liberality ... through vehicles like Basel.

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In the midst of repeated appeals to the merits of jail time as a post-financial crisis government strategy comes word of a new kind of reckoning.  The CEO of the Royal Bank of Scotland, who disastrously pushed his bank to go really big in the runup to the financial crisis, and received a knighthood for his efforts, is now getting stripped of it:

The British government announced Tuesday that Frederick A. Goodwin, the former chief executive of the Royal Bank of Scotland, now nationalized, would be stripped of his knighthood.

A couple of weeks ago, the country’s prime minister,David Cameron, said that he supported a review of Mr. Goodwin’s knighthood, which Mr. Goodwin received in 2004 for his service to the British banking industry.

That honor now looks woefully out of place. The bank, based in Edinburgh, is 82 percent owned by British taxpayers after receiving a multibillion-dollar bailout in 2008. Mr. Goodwin, who gained the nickname Fred the Shred for his cost-saving efforts, left the bank after the government took control of it in 2008.

Perhaps most amusingly, the stripping puts Mr. Goodwin among some pretty select company.

The removal of his knighthood places Mr. Goodwin alongside other notable individuals. Robert G. Mugabe, the president of Zimbabwe, lost his honorary knighthood in 2008 because of violence ahead of a presidential runoff. Jean Else, who helped transform a failing British school, lost her damehood last year for ignoring some standards and promoting her twin sister.

Given the track record of previous financial crises, I expected a lot more jail time in exchange for the bailouts, but perhaps the bailouts put governments in a "doing business with" rather than "being really angry at" place vis a vis the large banks.  From an American perspective, that relationship would be different from the one that developed after the S&L crisis of the 1990s.  But perhaps Britain is showing the way with regard to imposing sanctions, but not resorting to the criminal code.  If only the United States permitted titles.

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Originally, I was hoping to start this post with a link to some research a colleague and I just completed that discusses how lenders may be overestimating property values prior to foreclosure. But it has not made it through formatting and on to the web yet, so I will instead share the findings with you.

In this research we find that lenders may be overestimating property values prior to foreclosure in weak housing submarkets. (By “lender” I mean banks servicing their own loans or securitized loans.) We find evidence of overestimating values by looking at the difference between the sale price at foreclosure auction (in this case the lender’s reserve/minimum bid) and the subsequent sale price of the home out of REO in submarkets in Cuyahoga County, OH (home to Cleveland). As the housing market gets weaker, the gap between those two sale prices grows. We also find that lenders’ value estimates may be dramatically improved by incorporating a few simple factors such as the age of the home and the poverty level in the home’s census tract. So we would expect lenders to pick up on this at some point and adjust their models accordingly. But we don’t see that happening. There are three possible explanations I can think of, though I welcome others.

First, lenders may not be overestimating the value at all. The price they pay for property may represent bidding in accord with an Ohio law that automatically sets the minimum bid at the first foreclosure auction, rather than waiting for subsequent auctions when the minimum bid can be adjusted. The way Cuyahoga County interprets this law, prior to foreclosure the County pays for a drive-by or walk-around appraisal. The initial minimum bid is set at two thirds of that appraisal. (If anyone can think of a good reason for this law, please share in the comments.) If no one bids at the first auction, the lender can lower the minimum bid at subsequent auctions. Anecdotally, bankers report credit-bidding their judgment to meet the minimum bid to obtain control of, and begin marketing, the property.

Automatically placing the minimum bid may be routine for bankers, but it probably does not always payoff: we find that the worst 25% of REO property sells for less than half of its minimum bid, if it sells in the quarter it is taken into REO. If it stays in REO for four quarters, it sells for less than 10% of its minimum bid. If the property’s minimum bid was $50,000 (remember, this is the worst 25% of property taken into REO), the lender recovers $5,000 before the broker’s commission, maintenance, taxes, and transfer costs. It is unclear why lenders would be in such a rush to obtain such low-quality properties if they were valuing them correctly.

The next two explanations differ from the first, because they assume that lenders are actually bidding at or close to their estimated value of the property. The second explanation may be that the methods used to value property just don’t work well in weak submarkets, and lenders’ valuation models are not correcting for that. It is not hard to imagine that a walk-around appraisal is a reasonably accurate way to value most property in most markets. If brokers want to find non-foreclosure sales to use as comparables, they have to reach back further in time in weak markets than they do in others, so the prices they use are more likely to be stale. Walk-around appraisals may also miss interior damage(stripped copper pipe and wire, appliances, etc.) that properties are more likely to have suffered in weak markets.

The third possible explanation is that lenders are shifting accounting losses from loan portfolios to REO portfolios. This could be accomplished by using the inflated estimated value to prevent recognizing losses on the loan, and instead writing down the value in the REO portfolio. There are two potential benefits to this. The first is that capital markets tend to pay more attention to loan portfolio performance than REO portfolio performance. The second benefit is that most solvency tests for banks focus on loan portfolio performance metrics, and pay little or no attention to REO portfolio performance. So shifting these losses could potentially make lenders look healthier and more attractive than they actually are.

Any way you slice it large REO portfolios are bad for banks and communities. One way to reduce the size of these portfolios is to lower foreclosure auction reserves, increasing the chance that others will purchase the property at auction instead of it becoming REO.  If there is no market for the property, then donation to a land bank or similar entity may be the answer.

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Credit scoring has greatly reduced the cost of credit to the benefit of industry and borrowers, and has minimized concerns about intentionally discriminatory underwriting. Despite these gains, there remain questions about the integrity of the data used to determine borrowers’ scores and the fairness of the models used by credit reporting agencies (CRAs).  These concerns are amplified as credit scores take on increasingly important roles in the society.  Indeed, they have become a form of collateral.  In this post, we muse about areas in which credit scoring needs further investigation.

Credit scoring unquestionably predicts borrower creditworthiness; however, scores could be more accurate and, thus, more fair.  In particular, there is evidence that: (1) there are errors in the inputs on individual consumers; (2) some of the variables and the weights given to them are not predictive; and (3) models omit variables that would help predict borrower creditworthiness. For example, medical debt is often treated the same as credit card debt in scoring models.  As a result, borrowers with unexpected, delinquent medical debt will be “dinged” on their credit reports just as people who took on debt buying discretionary consumer goods.

The Consumer Financial Protection Bureau’s bailiwick includes the authority to write rules that would further the purposes of the Fair Credit Reporting Act. The CFPB is already collecting credit report information on 200,000 individuals from each of the three major CRAs for the purpose of analyzing variations between the scores sold to consumers and those sold to creditors (http://www.consumerfinance.gov/wp-content/uploads/2011/07/Report_20110719_CreditScores.pdf). These efforts could expand to include requiring that CRAs and entities, like FICO, that develop scoring models provide the CFPB with their algorithms, including the inputs and the weights given each variable.  This would enable the CFPB to test how well the CRAs predict default risk and the accuracy of their inputs.

The three national CRAs are not the only entities that collect and sell data on consumers.  Smaller enterprises collect discrete data on individual borrowers that are not necessarily captured in traditional credit scores.  Another role of the CFPB should be to identify these providers, evaluate their methods, and subject them to regulatory oversight.

There is a need to understand the market for the provision of accurate credit scores.  In a well-functioning market, you would expect that competition among CRAs would lead to ever more accurate credit scoring models.  However, if the marginal gains from: (1) including omitted, predictive variables, (2) insuring the accuracy of data with precision, and (3) scrutinizing weights, is small relative to the efficiency of slightly more crude scoring, CRAs and their clients might prefer the latter course.  The result would have a potentially adverse impact on borrowers who are at the cusp of creditworthiness, which would implicate fairness concerns.   

With lenders increasingly cautious about granting credit to people with less than pristine credit scores, there is a need to survey and evaluate models other than traditional scoring.  This should include approaches taken in other countries, with an emphasis on programs that help low-income borrowers build credit and demonstrate creditworthiness.

I am sure there are other areas in which more understanding is needed and hope people will comment on this post so I can expand my catalog.

Stay tuned: Suffolk Law School Law Review will have a special issue on credit scoring and reporting later this year. (http://www.law.suffolk.edu/highlights/stuorgs/lawreview/index.cfm)

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Given that there has been the creation of a Financial Stability Board, designed to bring the various financial regulatory networks together, you wouldn't think there would be a need for a Joint Forum, designed to do the same thing.

Nonetheless, the Forum exists, and perhaps in an effort to get things going in insurance, always the laggard in international regulatory harmonization, the new chair is a) an insurance supervisor, and b) an American.  Rare, but here's the news:

The Joint Forum's parent organisations, the Basel Committee on Banking Supervision (BCBS), the International Organization of Securities Commissions (IOSCO), and the International Association of Insurance Supervisors (IAIS), have announced the appointment of Dr Therese M Vaughan as Chair of the Joint Forum. This two-year appointment is effective 1 January 2012.

Therese Vaughan, who succeeds Tony D'Aloisio of the Australian Securities and Investments Commission (ASIC) in this role, is the CEO of the National Association of Insurance Commissioners (NAIC) in the United States.

The Joint Forum's parent organisations expressed their gratitude to Mr D'Aloisio for his important leadership and contributions during his time as Chair.

Therese Vaughan noted the importance of the Joint Forum's international focus on cross-sector supervisory issues: "I look forward to working with Joint Forum members and the Joint Forum's parent organisations to advance the international regulatory agenda with a focus on cross-sector issues."

The Joint Forum was established in 1996 under the aegis of the Basel Committee on Banking Supervision, IOSCO, and the IAIS to deal with issues common to the banking, securities and insurance sectors, including the supervision of financial conglomerates.

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BankAtlantic allegedly minimized the problems in its loan portfolio (strong in Florida real estate) during the financial crisis; now the SEC is suing the bank and its chairman for fraud in failing to disclose risks that the bank was worried about, privately.  Taking the complaint abstractly, I'd say that it's the kind of conduct that a large number of banks might need to worry about, meaning that perhaps indeed, we're looking at some late-breaking SEC crisis enforcement.  Here's the press release, here's last years' news that BB&T bought BankAtlantic, suggesting possible encouragement from the FDIC, though there's nothing about it in the article.  It doesn't appear to be a big case announced by the highest of higher ups at the agency, but it does bare watching.

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The debate about the legality of Richard Cordray’s appointment to head the Consumer Financial Protection Bureau is just one of many brewing power battles.  Another, and the one I am writing about today, is the Office of the Comptroller of the Currency’s preemption ruling.

The OCC has absorbed the Office of Thrift Supervision and, thus, has dramatically increased the number of institutions subject to its enforcement, supervisory and rule-writing authority, which translates into more and louder voices crying for preemption of state lending laws.  The OCC already is a poster child for regulatory capture because of its 2004 blanket preemption rule shielding national banks from state laws that were aimed at curtailing costly, unaffordable loans, and deceptive lending practices. It was in response to the OCC preemption rule (and a similar one by OTS) that the Dodd-Frank Wall Street Reform and Consumer Protection Act included provisions aimed at limiting preemption.

Dodd-Frank restricts OCC preemption to situations in which a state consumer financial law: (1) discriminates against national banks in favor of banks chartered in the state; (2) “prevents or significantly interferes with the exercise by the national bank of its power;” or (3) conflicts with federal laws that expressly preempt state laws. Dodd-Frank also requires that any preemption determinations be made case-by-case, based on substantial evidence, and on the record. http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=111_cong_public_laws&docid=f:publ203.111.

As many of you know, on July 21, 2011, the OCC revised its preemption provisions as required under Dodd-Frank. http://www.occ.treas.gov/news-issuances/news-releases/2011/nr-occ-2011-97.html.  Many features of the new OCC rule were in accord with Dodd-Frank’s mandates, but the process that the OCC employed in issuing the rule did not follow the requirements set out in Dodd-Frank.  

The OCC did not look at individual state consumer financial laws to determine whether they were preempted on the grounds that they “prevent[ed] or significantly interfere[d]” with national banks’ exercise of their power. The OCC’s position is that the process for issuing preemption rulings is only for prospective rules and that the agency had no obligation to review existing rules.  As a result, the OCC kept intact a list of preempted state laws that it had assembled under its former and broader preemption standard.  The effect boils down to continued field preemption of state consumer financial laws.

So, why should we expect a battle ahead?  When the OCC issued its proposed rule, both the Department of the Treasury—of which the OCC is an arm—and the National Association of Attorneys General opposed the proposed rule.  The OCC did not yield.  Bets are that Obama’s nominee for Comptroller of the Currency, Thomas Curry, won’t yield either. 

Whether Treasury and the CFPB, with Cordray in the driver’s seat, will try to win Curry over is hard to say.  The CFPB has its own preemption battle to contend with as consumer advocates protest its interim rule on the Alternative Mortgage Transaction Parity Act, which preempts state laws that restrict nonbank lenders from making loans with balloon payments and other “nontraditional” features. http://www.nationalmortgagenews.com/nmn_features/criticize-cfpb-preemption-1028266-1.html.

The field of play will be the courts where state Attorneys General will likely try to enforce laws that are subject to earlier OCC preemption rules. It will take years for courts to determine the legality of the OCC’s process and its 2011 rule.  While the courts sort out these issues, neither lenders nor consumers will know exactly which laws matter.

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This post is a summary of a working paper the two of us finished recently, available here.

There are numerous discussions taking place about the future of housing finance, most focusing on the secondary market.  The central themes in theses discussions have been the government's future role in secondary markets and restarting private secondary markets.  But one area that is not receiving much attention is the potential liability of either the entities that arrange securitizations or the trusts (the assignees) that end up owning loans, for unlawful acts at loan origination. 

During the housing boom, everyone seemed to think that assignees were shielded from the consequences of lenders' illegal acts.  It appears that the market assumed that the holder in due course (HDC) rule(which protects note purchasers from most defenses to non-payment on notes) and originators' loan repurchase obligations through representations and warranties would take care of assignee liability risk.  These turned out to be pretty bad assumptions.  Originator repurchase obligations are only effective if the originator is still around to repurchase loans, which has been the case less and less frequently through the crisis.

In addition, assignees are not protected from liability by the HDC rule unless the notes are negotiable instruments, and the buyers and sellers of the notes observed the formalities necessary to obtain the rules protection. As we have seen with the shoddy foreclosure documentation, the industry ignored fundamental formalities and undermined the HDC shield.

The more interesting point is that many securitization arrangers may find themselves exposed to liability for the illegal actions of originators based on theories such as joint venture.  Such claims have survived summary judgment motions when the arrangers prospectively agreed to purchase all or some of the loans originators made, and the arrangers had some knowledge of the originators' illegal acts.  Arrangers could often glean information on lenders and their loan practices through due diligence, media reports, and informal information sharing in vertically-integrated firms (the last being very difficult to prove).  Arrangers have also exposed themselves to liability by actually supplying deceptive disclosures and payment schedules to originators, who then provided the documents to borrowers.

So far, consumer claims against securitization arrangers have been rare and most have been settled, but this trend may reverse.  Now that litigators and judges better understand the organization of the private label securities markets, these claims may have sturdier footing and judges and juries may be more sympathetic to consumers.

Uncertainty is clearly the theme when it comes to both assignee and arranger liability.  This uncertainty impedes accurate pricing of MBS, especially given the potential for claims by attorneys general, large class actions, and widespread borrower rescission of loans.  Policy-makers that want to stimulate the secondary market need to address the legal complexity that causes uncertainty (among other things).  Going forward, the simplest solution is to create incentives for the market to police itself, by allowing assignee and arranger liability for originator wrongdoing.  The next step should be to set parameters for arranger and assignee liability to allow it to be quantified and priced into credit.  Together these actions will sanction future bad actors, protect consumers, and help the MBS market by making it possible to price litigation risk.

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The Section on Financial Institutions and Consumer Financial Services will have a record four events at this weekend's Association of American Law Schools Annual Meeting in Washington, DC. The theme is rethinking and reviving the field of financial institutions on the ground and in the academy. We will take stock of reforms so far and consider the impact of the crises in the United States and Europe, but also will take a long-term view of the field from diverse theoretical, policy, and methodological perspectives.

The program begins on Saturday morning (10:30 am-12:15 pm, Marriott Wardman Park, Thurgood Marshall North - Mezzanine Level) with a big-think "revival" panel featuring Jill Fisch (Penn), Howell Jackson (Harvard), Kim Krawiec (Duke), Pat McCoy (Connecticut, recently at Consumer Financial Protection Bureau), Katharina Pistor (Columbia), and Annelise Riles (Cornell).

Next we have a lunch keynote speech by Governor Sarah Bloom Raskin, introduced by Arthur Wilmarth (George Washington) (12:15-1:30 pm)

Next comes an offsite event at American University starting at 4 pm (separate registration required).  This event will include a policy roundtable on moderated by Adam Feibelman (Tulane), with regulators and policy makers from different agencies, as well as a paper presentation.

The weekend will conclude on Sunday with a panel presentation of four scholarly papers (9 - 10:45 am - Maryland Suite A, Lobby Level).  Heidi Schooner will moderate the Call for Papers panel.

Full program details are here. 

Here are links to the selected papers, authors, and commentators (as well as my prior blog posts introducing the papers):

Saturday:

Anat R. Admati, Peter Conti-Brown, & Paul Pfleiderer, Liability Holding Companies (presented by Peter Conti-Brown (Stanford), comments by Saule Omarova (North Carolina)) (my introductory blog post)

Sunday:

Eric Chaffee (Dayton) & Geoffrey C. Rapp (Toledo), Regulating On-line Peer-to-Peer Lending in the Aftermath of Dodd-Frank (comments by Andrew Verstein (Yale)) (my introductory blog post)

Stavros Gadinis (U.C. Berkeley), From Independence to Politics in Banking Regulation (comments by Shruti Rana (Maryland))(my introductory blog post)

Anita K. Krug (Univ. of Washington), Institutionalization, Investment Adviser Regulation, and the Hedge Fund Problem (comments by Kristin N. Johnson (Seton Hall)) (my introductory blog post)

Wulf A. Kaal (St. Thomas)  & Christoph Henkel (Mississippi College School of Law), Sequential Contingent Capital Triggers in Europe and the United States (comments by Mehrsa Baradaran (BYU))(my introductory blog post)

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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 Expensive, countered 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.

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