Two bright spots yesterday from the Office of the Comptroller of the Currency. First, the OCC announced a new policy of rotating examiners among banks. Second, this recommendation stemmed from a peer review of the OCC by international financial regulators. With multiple eyes, all bugs are shallower.
In Governor Tarullo’s closely watched speech on bank regulation (I already blogged on the idea of a sliding scale of regulation based on bank size), he also argued for ending the IRB approach to capital requirements. How does IRB translate into Plain(er) English: DIY capital requirements for big banks. Tarullo’s argument is based in part on obsolescence: all the increases to capital in Dodd-Frank and Basel III dwarfed the IRB component. But it is also based on the fact that DIY capital requirements was a spectacularly bad idea (something I wrote about back when). Big banks have built in incentives (courtesy of government guarantees, explicit and implicit) to lower their capital and increase their leverage. Tarullo’s coming to bury not praise this part of Basel II calls for revisiting some of Joe Norton’s prescient work critiquing that accord as a political economy product of lobbying by behemoth banks. If we take New Governance and its experimentalism seriously, it is vital that we look at experiments that failed.
A little over a week Governor Tarullo gave a fascinating speech that focused on creating different regulatory approaches for different sized banks. This is a must read for policymakers and scholars (and further evidence of the value of having at least one lawyer or expert in prudential regulation on the Federal Reserve Board). Tarullo advocates pushing further the approach in Dodd-Frank of having a sliding scale with different regulatory standards for different tiers of banks.
Several news outlets picked up on Tarullo’s call to reduce compliance costs for community banks. Tarullo’s welcome approach recognizes that not all banks pose the same amount or types of risk. It contrasts sharply with the views of folks like Tim Geithner, who in his Stress Test memoir, discounts reform proposals that targeted the “popular villain” of size (see pages 391-2). Oddly, Geithner’s memoir also makes the case that the government did not have enough “foam for the runway” when some of the jumboest jetliners started to plummet in the Panic of 2007-2008.
Still Geithner makes a point that serves as a mild corrective addendum for Tarullo’s sliding scale approach: many financial crises started with the risk-taking and failure of smaller institutions. Indeed, too-big-to-fail is but one problem. It should not completely overshadow the risks of herd behavior and too-correlated to fail. The collective actions of stampeding small institutions can generate big doses of systemic risk.
Tarullo’s speech implies that “macroprudential” regulation should only kick in for medium sized banks and ramp up further still for the behemoths. But the case for no macroprudential regulations for smaller firms depends on what we mean by “macroprudential.” One kind of macroprudential regulation focuses on correlated risks across financial institutions (what Claudio Borio labels the “cross-sectional” dimension). What does this mean concretely? Regulators need to worry when even small financial institutions collectively have too much risk exposure to the same types of losses (e.g. subprime residential mortgages, the Sunbelt, the energy sector, etc.). So even community banks need to come under the macroprudential umbrella.
The good news for community banks is that the monitoring cost of looking at correlated risks should (and likely has to) sit with regulators. No individual community bank would be able to assess the overlap between its risk portfolio and that of hundreds or thousands of competitors. Regulators, by contrast, are built to serve these information-gathering and coordination (or anti-coordination if you want to get technical) functions.
Regulators must also carry the burden of looking at how regulations can promote dangerous herd behavior by financial institutions and how this herd behavior can increase during bubble periods (the subject of Chapter 7 of my book). But that is a topic for another day.
Dan and Steven Schwarcz have an insightful new article, Regulating Systemic Risk in Insurance (forthcoming Univ. of Chicagao Law Review). The potential systemic risk in the insurance industry became front page news after AIG (see here for an essay questioning the AIG bailouts). It has continued to simmer; the Financial Stability Oversight Council designated both AIG and Prudential as non-bank SIFIs (systemically important financial institutions). One criticism of this desgination is that it may lead to bank-style regulations being imposed on these firms even though the risks they pose are different in kind from banks (e.g., insurance firms typically don't engage in maturity transformation).
So how might insurance firms pose systemic risk concerns? Schwarcz fils and per focus less on size and Too-big-to-fail, and more on risk correlations. This insight is welcome: the Beltway obsession with size has obscured other dangers, such as herd behavior and correlated risk exposures.
What should be done? Schwarcz and Schwarcz argue for a greater federal role in regulating insurance. Yet they chose to focus less on FSOC and more on an expansive role for one of Dodd-Frank's less well-known innovations, the Federal Insurance Office. Their abstract is after the jump...
Schwarz & Schwarcz abstract:
As exemplified by the dramatic failure of American International Group (AIG), insurance companies and their affiliates played a central role in the 2008 Global Financial Crisis. It is therefore not surprising that the Dodd-Frank Act – the United States’ primary legislative response to the crisis – contained an entire title dedicated to insurance regulation, which has traditionally been the responsibility of individual states. The most important of these insurance-focused reforms in Dodd-Frank empowered the Federal Reserve Bank to impose an additional layer of regulatory scrutiny on top of state insurance regulation for a small number of “systemically important” insurers, such as AIG. But in focusing on the risk that an individual insurer could become too big to fail, this Article argues that Dodd-Frank largely overlooked a second, and equally important, potential source of systemic risk in insurance: the prospect that correlations among individual insurance companies could contribute to or cause widespread financial instability. In fact, the Article argues that there are often substantial correlations among individual insurance companies with respect to both their interconnections with the larger financial system and their vulnerabilities to failure. As a result, the insurance industry as a whole can pose systemic risks that regulation should attempt to identify and manage. Traditional state-based insurance regulation, the Article contends, is poorly adapted at accomplishing this given the mismatch between state boundaries and systemic risks and states’ limited oversight of non-insurance financial markets. As such, the Article suggests enhancing the power of the Federal Insurance Office – a federal entity currently primarily charged with monitoring the insurance industry – to supplement or preempt state law when states have failed to satisfactorily address gaps or deficiencies in insurance regulation that could contribute to systemic risk.
A few weeks back (I am catching up on my blogging), the Economist featured a terrific essay on “A History of Finance in Five Crises.” The conclusion of the essay – “successive reforms have tended to insulate investors from risk” and “this pins risk on the public purse … [t]o solve this problem means putting risk back into the private sector” – resonates. However, the Economist makes a few surprising errors of omission in reaching this point.
First, many financial crises occurred without much of a state bailouts or safety net. The Economist starts its history with the Panic of 1792 in the United States. By that point England had already experienced a crisis in the late 1690s and the South Seas Bubble in 1720 and France had suffered through the searing Mississippi Bubble (I discuss all of these in Chapter 2 of my book). The Economist then hopscotches to the Panic of 1825. Roughly every ten years after that, Britain experienced another bubble and crash (also detailed in my book). It is less than clear how government safety nets triggered these crises.
These crises point to a second omission: each of these 19th Century British crises – the Panic of 1825, the Panic of 1837, the Crisis of 1847 (it is a mystery to me what causes some incidents to qualify as a “Panic” and others to be a “Crisis”), the Crisis of 1857, and the Overend Gurney Crisis of 1866 – was preceded by a liberalization of corporate law or an expansion of limited liability for corporate shareholders. Some scholars wax poetic about the “sine curve” of regulation without tracing that back in history. Well, British corporate law (see also Chapter 2 of my book) provides the caffeine for that coffee. This corporate law history has several important implications:
State intervention in financial markets takes other forms than deposit insurance and government bailouts. This intervention often occurs before crises. Indeed, I argue that booming markets and bubbles create strong incentives for interest groups to lobby for, and policymakers to provide, legal changes that further stimulate markets. What I call “regulatory stimulus” goes beyond “deregulation” and includes government subsidies or legal preferences (think bankruptcy exemptions for swaps) for particular markets. It also includes active government investments in markets (think all those state land and money giveaways to 19th Century railways).
Regulatory stimulus in the form of changes to corporate law has particularly powerful effects. The corporate form provides ideal for lobbying for regulatory favors: corporations solve collective action problems by centralizing decision-making and allow managers to lobby with “other people’s money.”
Moreover, as the Economist hints but doesn’t quite hammer home, limited liability can generate moral hazard, which becomes particularly vicious if risk-taking can be externalized onto financial markets and taxpayers.
The Economist’s third omission is the most amusing (at least to nerds like me). The magazine notes that after the Overend Gurney Crisis in 1866, “Britain then enjoyed 50 years of financial calm, a fact that some historians reckon was due to the prudence of a banking sector stripped of moral hazard.” Many economists reckon that these years of calm owe more to the Bank of England finally assuming the mantle of lender of last resort in a banking crisis. The intellectual godfather of this was none other than Walter Bagehot, the legendary editor of the Economist. Perhaps this failure to provide credit where it is due owes to some intellectual Oedipal issues at the journal?
The fourth omission in the essay is perhaps the most unforgivable. The Economist talks about the Great Crash of 1929 without mentioning the critique that the Federal Reserve failed to serve as lender-of-last-resort and pursued a destructive monetary policy at critical junctures. Indeed, these are state interventions that many economists advocate that central banks take in the face of a banking crisis. These state interventions also provide a government safety net that can create moral hazard.
Which leads to the most biting criticism of the Economist piece: letting the economy burn in the wake of a financial crisis is pure but risks being purely destructive. Rather than focusing on unravelling government safety nets for markets, we should be thinking about how to regulate financial firms given their inevitability.
We enjoyed a great lineup of speakers and cutting edge scholarship here in Boulder this past semester as part of CU’s Business Law Colloquium. The following papers make for excellent start-of-the-summer reading:
Dan Katz (Michigan State): Quantitative Legal Prediction – or – How I Learned to Stop Worrying and Start Preparing for the Data Driven Future of the Legal Services Industry: a provocative look at Big Data will help clients analyze everything from whether to bring or settle a lawsuit to how to hire legal counsel. Katz examines implications for legal education.
Rob Jackson (Columbia): Toward a Constitutional Review of the Poison Pill (with Lucian Bebchuk): Jackson and Bebchuk kicked a hornet’s nest with their argument that some state antitakeover statutes (and, by extension, poison pills under those statutes) may be preempted by the Williams Act. See here for the rapid fire response from Martin Lipton.
Brad Bernthal (Colorado): What the Advocate’s Playbook Reveals About FCC Institutional Tendencies in an Innovation Age: my co-teacher interviewed telecom lawyers to map out both their strategies for influencing the Federal Communications Commission and what these strategies mean for stifling innovation in that agency.
Kate Judge (Columbia): Intermediary Influence: Judge examines the mechanisms by which intermediaries – both financial and otherwise – engage in rent-seeking rather than lowering transaction costs for market participants. The paper helps explain everything from Tesla’s ongoing fight with the Great State of New Jersey to sell cars without relying on dealers to entrenchment by large financial conglomerates.
Lynn Stout (Cornell): Killing Conscience: The Unintended Behavioral Consequences of 'Pay For Performance': Stout argues that pay for performance compensation in companies undermines ethical behavior by framing choices in terms of monetary reward. This adds to the growing literature on compliance which ranges from Tom Tyler’s germinal work to Tung & Henderson, who argue for adapting pay for performance for regulators.
Steven Schwarcz (Duke): The Governance Structure of Shadow Banking: Rethinking Assumptions About Limited Liability: Schwarcz argues for imposing additional liability on the “owner-managers” of some shadow banking entities to dampen the moral hazard and excessive risk taking by these entities, which contributed to the financial crisis. This paper joins a chorus of other papers arguing to using shareholder or director & officer liability mechanisms to fight systemic risk. (See Hill & Painter; Admati, Conti-Brown, & Pfleiderer; and Armour & Gordon).
[I’ll inject myself editorially on this one paper: this is a provocative idea, but one that would make debt even cheaper relative to equity than it already is. This would encourage firms to ratchet up already high levels of leverage. I looked at the expansion of limited liability in Britain in the 18th Century in Chapter 2 of my book. The good news for Schwarcz’s proposal from this history: expansions of limited liability seem to have coincided and contributed to the booms in the cycle of financial crises in that country that occurred every 10 years in that country. The bad news: unlimited liability for shareholders does not seem to have staved off crises and likely contributed to the contagion in the Panic of 1825.]
The CU Business Law Colloquium also heard from Gordon Smith (BYU), Jim Cox (Duke), Sharon Matusik (Colorado – Business), Afra Afsharipour (UC Davis), Jesse Fried (Harvard), and Brian Broughman (Indiana). Their papers are not yet up on ssrn.
After the jump, is the program for the AALS Mid-year Meeting on Corporate and Financial Law in Washington, D.C. from June 7-9. If you register (site restricted) and attend, make sure to stay until the fireworks at the very last panel!
Saturday, June 7, 2014
4:00 - 8:00 p.m.
6:00 - 7:30 p.m.
Sunday, June 8, 2014
8:45 - 9:00 a.m.
Judith Areen, AALS Executive Director, Chief Executive Officer
Joan M. Heminway, Chair, Planning Committee for AALS Workshop on Blurring Boundaries in Financial and Corporate Law and The University of Tennessee College of Law
9:00 - 9:30 a.m.
Donald C. Langevoort, Georgetown University Law Center
9:30 a.m. - 12:00 p.m.
Sessions on Research
Recent appraisals of the state of legal education have raised questions about the value of legal scholarship. Yet, most law scholars believe that their work contributes meaningfully to important theoretical and policy-oriented discussions-including those involving financial and corporate law. What is the relevance and overall value of legal scholarship in financial and corporate law in an era of blurred and blurring boundaries? What methodologies, forms of scholarly output, and publication venues most effectively and efficiently reach the target audiences for financial and corporate law scholarship? This segment of the program focuses on these and other questions relating to research and writing in financial and corporate law as a matter of current and desired future practice.
Specifically, the segment features a two-part approach to questions involving research in the context of unclear substantive demarcations in financial and corporate law. The first part is a plenary panel discussion, and the second part is a series of small-group networking sessions. More detailed descriptions of each are set forth below.
9:30 -10:45 a.m.
Research Plenary Panel
Robert P. Bartlett, III, University of California, Berkeley School of Law
Jill E. Fisch, University of Pennsylvania Law School
Claire A. Hill, University of Minnesota Law School
The prevalence of economic analysis is one element that unites legal scholarship across the many areas of business law. Scholars in the various business law fields of endeavor (e.g., business associations, securities regulation, financial institutions, insurance) have used other disciplines and methodological approaches to a far lesser extent. Do we have the right mix of interdisciplinarity to most effectively respond to current challenges involving financial and corporate law? How, if at all, do traditional legal scholars re-tool to address any perceived need for interdisciplinary research that engages academic disciplines outside their areas of expertise (or areas of expertise in which their knowledge is superficial or outdated)?
This panel explores the capacity of a variety of methodologies and disciplines to enrich the study of financial and corporate law in an era of blurring substantive and regulatory boundaries. The panel also addresses cutting edge questions and controversies regarding blurring boundaries in particular research traditions. The panel comprises scholars who use different quantitative and qualitative analytical methods in their work. The panel is designed to allow these scholars to discuss techniques and tools they use and to yield valuable insights into questions that cut across financial and corporate law, such as the behavior of consumers, investors, financial institutions (and the individuals who work inside them), lawyers, and regulators.
10:45 - 11:00 a.m.
11:00 a.m. - 12:00 p.m.
Research Small Group /Networking Sessions
Michelle M. Harner, University of Maryland Francis King Carey School of Law
Christine Hurt, University of Illinois College of Law
Anne M. Tucker, Georgia State University College of Law
Others to be announced.
This part of the program is designed to offer participants the opportunity to share their thoughts on blurred lines in financial regulation research. Topics will vary from session to session but may include: how individual research approaches and methods have changed and are changing; how law academics keep up with emerging research approaches and methods-e.g., where research content is now found and how it is processed; whether (and, if so, how) individuals with different substantive law and research backgrounds "talk" to each other to help bridge gaps; and what optimal work product outcomes look like as substantive and regulatory lines continue to blur. Facilitators will report out the ideas from their sessions.
12:00 - 1:30 p.m.
Elizabeth Warren, U.S. Senator for Massachusetts (Invited)
1:45 - 5:00 p.m.
Associated legal and regulatory challenges and changes force us to reconsider our pedagogy and the business law curriculum in very fundamental ways. Structuring courses and choosing and employing effective teaching tools are, of course, part of the discussion. But teaching financial and corporate law in an era of blurring boundaries also engages larger issues, such as the role of different types of courses (e.g., clinics, practicums, externships, field placements, simulation courses) and pedagogies in teaching business law courses. Also important are pedagogical methods geared to develop the financial literacy, numeracy, and professional values that students concentrating in financial and corporate law should have when they graduate from law school. Finally, it seems that it would be beneficial to address the value for law students, if any, in joint degree (e.g., JD/MBA) and advanced degree (LLM, Masters in Law, Juris Masters, etc.) programs and the overall place and prominence of financial and corporate law in the current and future program of legal education in the United States. The program is designed to involve a significant amount of "show and tell," rather than predominantly focusing on traditional academic presentations.
1:45 - 3:00 p.m.
Teaching Plenary Panel
William A. Birdthistle, Chicago-Kent College of Law, Illinois Institute of Technology
James A. Fanto, Brooklyn Law School
Edward J. Janger, Brooklyn Law School
John Henry Schlegel, University at Buffalo Law School
David A. Westbrook, University at Buffalo Law School
This panel, populated with presenters culled from a call for proposals, explores the challenges and opportunities for legal educators in an era of blurring substantive and regulatory boundaries. A range of possible teaching methods and tools can assist in the task. But difficult questions exist as to how to best use these methods and tools in individual courses and across the curriculum-in and outside business law teaching. Course selection and curricular options (including those external to the standard Juris Doctor courses and curriculum) deserve important consideration at both the individual (student and faculty) and institutional levels. The panel is designed to allow academics specializing in financial and corporate law to discuss these and other issues relevant to educating business law students in light of blurring financial and corporate law boundaries.
3:00 - 3:15 p.m.
3:15 - 5:00 p.m.
Teaching Concurrent Sessions
This portion of the program features concurrent sessions on teaching led by law faculty chosen from a call for proposals. Each session has a different topical focus and is offered twice-once in each breakout period. Accordingly, each attendee has the opportunity to attend two sessions, each on a different topic. These sessions are designed to involve significant interaction between the selected discussion leader and the attendees.
3:15 - 3:45 p.m.
Consumer Protection Clinicas as a Site for Blurring Boundaries
Bryan L. Adamson, Seattle University School of Law
Teaching Banking Law
Mehrsa Baradaran, University of Georgia School of Law
A Multi-Disciplinary Approach to Real Estate Investment and Finance Law
Andrea Boyack, Washburn University School of Law
Teaching the Federal Reserve in Law School: Crossing Disciplines, Paradigms and Vantage Points
Timothy A. Canova, Nova Southeastern University, Shepard Broad Law Center
From the Balance Sheet to Beta: A Hands-On Approach to Teaching Accounting & Finance Concepts
Virginia Harper Ho, University of Kansas School of Law
3:45 - 4:15 p.m.
Repeat of Concurrent Session Presentations
4:15 - 5:00 p.m.
5:30 - 6:30 p.m.
Monday, June 9, 2014
9:00 - 10:15 a.m.
Complexity Plenary Panel
Henry T. Hu, The University of Texas School of Law
Kristin N. Johnson, Seton Hall University School of Law
Tom C.W. Lin, University of Florida Fredric G. Levin College of Law
Saule T. Omarova, University of North Carolina, School of Law
Modern financial markets, as well as the firms that operate within these markets, have become increasingly complex over the last several decades. This trend is attributable to various developments, including the accelerating sophistication of technology, the increasing size of firms, the more heterogeneous and sophisticated needs of users of financial services, and the inevitable desire of firms to seek out regulatory gaps. This ever-growing complexity creates a broad set of new challenges for law and regulation. For instance, complexity may confound the efforts of regulators to monitor financial markets for systemic risk or to erect rules to prevent or mitigate that risk. Similarly, it can frustrate the capacity of law to promote more informed consumer and investor protection tools such as disclosure or financial literacy education. Increasing complexity also raises new challenges about the optimal modes of regulation: according to some, it demands greater reliance on regulatory approaches such as self-governance or "new governance," while others argue that it may counter-intuitively necessitate simpler and blunter rules. Finally, market and firm complexity complicates the targets of regulation, which now consists not only of banks, insurers and broker-dealers, but also shadow banks, hedge funds, and participants in derivatives markets.
10:15 - 10:30 a.m.
10:30 a.m. - 12:00 p.m.
Modern Regulatory Approaches
Historically, scholars have studied law and regulation within a particular substantive area, such as banking, corporate, insurance, or securities regulation. However, modern regulatory approaches frequently require knowledge of multiple topics and raise challenges that cut across different areas of legal study. These two concurrent sessions will feature four approaches to understanding modern regulation, each led by a scholar whose work has been focused in the area.
Regulatory arbitrage and cost-benefit analysis are issues that cut across many areas of modern regulation. Many costly rules create incentives for parties to transact in ways that are economically equivalent, but lead to differential regulatory treatment. Both regulators and courts increasingly are required to, and do, use cost-benefit analysis to justify new regulation.
10:30 - 11:15 a.m.
Modern Regulatory Approaches Concurrent Session #1
Jordan M. Barry, University of San Diego School of Law (confirmed)
Modern Regulatory Approaches Concurrent Session #2
Yoon-Ho Alex Lee, University of Southern California Gould School of Law (confirmed)
11:15 a.m. - 12:00 p.m.
Modern Regulatory Approaches Concurrent Session #1
Adam J. Levitin, Georgetown University Law Center (confirmed)
Modern Regulatory Approaches Concurrent Session #2
Dana Brakman Reiser, Brooklyn Law School (confirmed)
12:00 - 1:30 p.m.
Daniel K. Tarullo, Governor, Board of Governors, Federal Reserve System, Washington, DC
1:30 - 3:00 p.m.
New Frontiers: Innovation, Competition and Collaboration in International Financial Markets
Wulf Kaal, University of St. Thomas School of Law
Eric J. Pan, Associate Director, Office of International Affairs, U.S. Securities and
Exchange Commission, Washington, DC
Roberta Romano, Yale Law School
Innovation and the mobility of capital have changed global financial markets in profound and consequential ways. Advances in technology and developments in the infrastructure of financial markets have engendered new levels of interconnectivity. The creation of new financial products, the increasing prominence of market participants such as private equity and hedge funds, and the birth of complex trading strategies (namely algorithmic and high-frequency trading); have permanently altered the landscape of financial markets. Operating in this new frontier, significant financial institutions face historically unparalleled vulnerabilities. The financial crisis of 2008 demonstrated the broad range of concerns that challenge government efforts to regulate financial markets.
Responding to the crisis, authorities propose a diverse array of regulatory reforms. For example, the U.S. Congress and regulators have adopted an aggressive and extraterritorial policy governing domestic and international over-the-counter derivatives, creating a Financial Stability Oversight Council and articulating formal processes to address the insolvency of an international financial market conglomerate. In addition, the highly debated and not-yet-finalized Volker Rule promises to reduce excessive risk taking by systemically important financial institutions and minimize the likelihood of future crises. Other countries' proposed solutions take a different tack, adopting Vickers- and Liikanen-style "ring-fencing" policies. The trend toward diversity in regulatory approaches overshadows central bankers' collaborative efforts to craft, implement and enforce the third round of Basel accords.
The debate over uniformity or diversity in regulation provides a forum for evaluating the merits of these various regulatory approaches and the domestic and international actors who inform the discussion. Questions arising from the debate explore the value of efforts to adopt uniform regulatory approaches; the contributions of international regulatory bodies and trade organizations such as the BIS, the G-20, and IOSCO; the benefits and shortcomings of microprudential policies governing banking institutions; and the limits that political accountability and legitimacy pose for each of the governments whose regulatory policies may heighten or mitigate the potential for future financial crises.
3:00 - 3:15 p.m.
3:15 - 4:45 p.m.
Political Dynamics Plenary Panel
Erik F. Gerding, University of Colorado School of Law
M. Todd Henderson, The University of Chicago, The Law School
Steven Ramirez, Loyola University Chicago School of Law
Hillary A. Sale, Washington University in St. Louis School of Law
Financial and corporate regulation no longer fits within the comfortable regulatory silos so familiar to scholars of previous decades. The efforts to design and implement new regulatory structures after the financial crisis are taking place in sometimes unfamiliar political cross-currents that reshape prior theories. This plenary panel will address the political dynamics of financial and corporate law in contexts framed by a series of important questions: Have financial and corporate law become more political (e.g. the Dodd-Frank Wall Street Reform and Consumer Protection Act and the Jumpstart Our Business Startups Act within 20 months of each other)? Have the roles of courts, legislators, the president, and independent agencies changed and what should those roles be, (with the Citizens United, Business Roundtable, and American Petroleum cases as recent relevant examples)? How has the blurred world of financial and corporate law changed? Who are the constituencies to be considered in evaluating these laws? For example, whose primacy should be our focus and is there new space for occupiers, crowds, and those pursuing social benefit enterprises? Does globalization stress our traditional reliance on state regulation and complicate our existing theories of political economy?
For your weekend reading pleasure: Thomas Hoenig, Vice Chair of the Federal Reserve, made a speech this week arguing that the living wills provisions in Title I of Dodd-Frank were critical to ending financial bailouts. He concludes:
"In theory, Title I provisions to resolve these firms make the system safer. In practice, it will be the industry and its regulators that make the law work."
Sing It loud!
But calling on industry and policymakers to make the law work points to the biggest problem with (arguably) the only really novel policy solution in post-crisis financial reform: where are the incentives for financial firms to get their living wills right? Unfortunately, we might not know if living wills work until firms actually fail. One fascinating item I learned in Mehrsa Baradaran's great forthcoming article Regulation by Hypothetical: the living wills that the largest Wall Street banks have produced appear to all have been drafted by the same team at Davis Polk. Judge for yourself how helpful these recipes will be for regulators attempting to untangle a large failed financial colossus.
Peter Conti-Brown wrote an interesting take over at Politico on the constitutional problems with so many vacancies on the Federal Reserve Board. Which leads to the question: who should fill the empty slots? What sorts of backgrounds should they have? Some in Congress have called for representation by community bankers. Recently, at the Harvard Business Review site, Justin Fox had an interesting historical take on how, over decades, economists have gradually taken over the most important spots on the Federal Reserve Board (i.e. the Chair and membership on the Open Market Committee), while the representation of lawyers has declined.
It provides food for thought. First, what value do lawyers add to the Fed leadership? I agree with the quoted remarks of Alan Blinder that it is hard to conceive of a chair without an economics PhD given the highly technical data coming from Fed staff. However, lawyers can clearly contribute mightily to the regulatory mission of the Fed, an area that critics charge was neglected under Greenspan in favor of monetary policy (see here for one critique).
One retort is that this is not the area on which the Open Market Committee focuses. Even so – I have argued (in this article and in my book) that changes in the law and financial regulation often have an enormous monetary impact. Consider how regulatory arbitrage and regulatory changes midwifed the birth of the shadow banking system, which had a profound impact on monetary policy in the years before and during the crisis. Scholars (like Margaret Blair and me) argue that the fact that monetary expansion occurred through regulatory means rather than traditional “channels” (like central banks buying and selling bonds) may have blinded many macroeconomic policymakers from realizing that a bubble was forming and what was driving it. The upshot: if legal change can have monetary impacts, then lawyers can help understand when that change is occurring. We need better coordination of prudential regulation and monetary policy-making.
Second, and more provocatively, Fox’s article points out how the real drop in representation among the Fed’s Open Market Committee comes in members without a graduate economics degree, J.D., or MBA. Others have recognized this trend before. Some, like Tim Canova, have called for a return to the Fed of the ‘30’s and ‘40’s, which they see as much more democratically accountable.
Even if you don’t agree with that position, consider the parallels to the Supreme Court, which has also been criticized for having an increasingly homogenized makeup in terms of professional background even while it has diversified in terms of gender. All the current justices studied at a very small number of law schools and have a similar mix of appellate/professorial backgrounds.
I’m sure there are other examples of powerful public bodies being homogenized professionally. This dynamic means that some courses are, and some course will not be, served at the intellectual feast.
Oops, says BofA, we messed up our capital calculations. We don't have as much money on hand for shocks or emergencies as we thought. Since that's the principal thing that banking regulators care about, you might wonder what happens to banks who do this. Perhaps it would be interesting to consider some alternatives, might offer a sense of what bank supervision does and doesn't involve these days.
- The Fed could prosecute BofA executives for fraud. Call that the securities regulator/white collar approach. One problem, fraud must be intentional, so this would have to be not an error, but at the very least some sort of reckless accounting. It punishes individuals in management who contributed to the fraud.
- The Fed/FDIC could revoke their license or pull the inspectors. This is the USDA approach. The problem is that it is too nuclear - both of those things would shut down a bank that is far too big to fail.
- The Fed could fine them. This is the money laundering approach, and those fines are often imposed not just for tolerating the laundering of money, but for having inadequate controls in place to prevent it. We may see a fine here, BofA is pretty much saying that it had inadequate controls in place by acknowledging that it did the calculations wrong to the tune of billions of dollars.
- Or the Fed could do what the Fed is, for now, doing. It is suspending any dividend increases by the bank until it submits an accurate account of the state of its capital reserves, and has that account approved by the agency as sufficient. This is a somewhat new thing in high level banking oversight - punish the shareholders, thereby encouraging them to monitor management. Does it work? It is perhaps a little untested, although suspending capital distributions has been a tool used by the FDIC on the sorts of distressed small banks that were its old stock in trade. Seeing that tool applied to Citi and now BofA, however, is a dfferent thing altogether. It will be interesting to see if this trend continues.
A friendly notice about the AALS-Mid-Year meeting on "Blurring Boundaries"...
The AALS Workshop on Blurring Boundaries of Financial and Corporate Law will be held June 7-9 in Washington, DC.
The workshop is designed to explore the various ways in which the lines separating distinct, identifiable areas of theory, policy, and doctrine in business law have begun to break down. The workshop sessions will focus on: research; teaching; complexity; modern regulatory approaches; innovation; competition; and collaboration in international financial markets; and political dynamics. A workshop objective is to bring together law faculty representing a variety of financial and corporate disciplines, scholarship traditions and pedagogical practices and perspectives.
The workshop provides a unique opportunity for faculty members to make connections between their primary fields and other fields in financial and corporate law, making it relevant to a broad spectrum of law scholars and teachers. Law faculty in all business fields should find the workshop useful to their scholarship and teaching.
- "That one million hours a year devoted to resolution planning is 500 full-time employees"
- "There are 8,000 employees 'dedicated solely to building and maintaining an industry-leading Anti-Money Laundering (AML) program.' JPMorgan employs more AML compliance officers than the Treasury and the Fed combined."
- Stress testing required 500+ FTEs
- Compliance with Basel's new securitization rules has required 35,000 hours of work (at 2000 hours per year, that's only 17.5 FTEs, so you can see why they moved to hours there).
That's a lot of compliance, and indeed, at these rates, way more people do compliance for JPMorgan than, probably, do actual investment banking. Of course, maybe we want all of this given that the firm is far too big to fail, and maybe we want to make banking burdensome and unprofitable. If so, we are on our way!
The leverage rule agreed to internationally is 3%, and you should think of a it as an alternative minimum tax. Worried that banks might be able to game capital requirements, which require them to hold funds in reserve to deal with shocks, the world's regulators also decided to forbid, on pain of cutting dividends and executive compensation, large banks froms from taking positions that would mean that more than 3% of their assets are capital. American banking regulators are going further - they are disincentivizing bigness by requiring the 8 largest banks to comply with a 5% leverage ratio. Some thoughts:
- The giveback to industry is that this rule isn't effective until 2018. Only in financial regulation do you ever see such long-dated rules.
- American banks might have to add $68 billion in capital to comply with this requirement. Would you sue to avoid that kind of a charge? Of course you would! But the banks probably won't. The Fed just doesn't face the sort of Total Litigation regulatory contest that the SEC faces.
- Ditto, you'd think that such a big deal rule would require review by OIRA. Nope!
The answer is no, it won't kill monetary policy, but here's the way it might constrain the Fed, which relies on primary dealers (that is, big banks, who would now be subject to leverage requirements) to help it set the federal funds rate. This reliance has been cited as a reason to delay the leverage rule. Felix Salmon also thinks that's no reason to delay the imposition of the rule, but here's how the argument works, in his nicely straightforward words:
The way that the Fed conducts monetary policy is by instructing the traders at the New York Fed to buy and sell certain financial instruments so that a particular interest rate — the Fed funds rate — is very close to a certain target. Through a complex series of financial interlinkages, setting the Fed funds rate at a certain level then has a knock-on effect, and ultimately helps determine every interest rate in America, from the Treasury yield curve to the amount you pay for your credit card or your mortgage.
Those interlinkages are so complex that they’re impossible to model with any particular accuracy: all the Fed can do, really, is set the Fed funds rate and then see what happens to everything else. And directionally the causality is clear: if the Fed wants rates to rise, then it pushes the Fed funds rate upwards, and if it wants rates to fall, then it brings the Fed funds rate down. That doesn’t always work at the distant end of the yield curve, but it’s still most of what monetary policy can do.
Especially early on in the chain, a lot of the interlinkages take place at the level of big banks. And so it stands to reason that if you change the leverage requirements of big banks, that might change what happens to interest rates when you move the Fed funds rate.
In my last post—also a shameless plug for my recent article, “Boilerplate Shock”—I argued that boilerplate terms governing securities could serve as a trigger that transforms an isolated credit event into the risk of a broader systemic failure. I’ll now briefly explain why I see this danger—which I call “boilerplate shock”—as a general problem in securities regulation, not just some quirky feature of Eurozone sovereign debt (the focus of the paper and post). Any market where securities are governed by uniform boilerplate terms is vulnerable to boilerplate shock.
The nature of this phenomenon—systemic risk—is of course familiar, but its source in contract language is a little unintuitive. How could private contracts unravel an entire securities market or the world economy?
Coordination around uniform standards.
In the back of our mind most of us probably still conceive of contracting as an activity that occurs among two, or perhaps a few, individuals or firms. But when standard terms are used by virtually all actors within a given market, it’s worth considering the collective impact of those terms as a distinct phenomenon.
Coordination’s benefits are well known. Consider uniform traffic signals. But coordination can also compound the effects of bad individual decisions.
As Charles Whitehead has argued, widespread “destructive coordination” among banks during the precrisis days helped generate systemic risks. When the credit markets froze, for example, firms using the same risk management formulas reacted in the same way at the same time. This helped transform isolated events into systemic ones—e.g., Lehman, the canonical example of a failure that triggered a de facto coordinated panic.
A similar risk, I argue, is present where participants in a securities market rely on the same standardized contract terms. Whether they were intended to or not, these terms will often control what happens in the event of certain legal emergencies, like a country departing the euro or Lehman declaring bankruptcy.
For example, if an effort by Greece to pay its bonds in “new drachmas” is rejected because of Boilerplate Contract Terms A and B, the market will surely be concerned that Terms A and B also govern the bonds of similarly situated borrowers, like Spain, Italy, etc. You’ll see that the borrowing premium the “peripheral” euro countries (the uppermost five lines: Ireland, Italy, Greece (biggest spike), Portugal, Spain) paid versus richer euro countries (Germany, France, the Netherlands, the three lowest lines) zoomed higher as worry over a Greece exit gripped markets in late 2011/early 2012, and again (to a lesser extent) because of Cyprus exit talk in early 2013:
Bloomberg. Click to enlarge.
Moreover, this panic occurred against a backdrop of unduly rosy assumptions (namely, that a departing euro country could convert its bonds into a new currency and thereby avoid default, a likely contagion trigger). I argue that the uniformity of boilerplate across these bonds would intensify these problems significantly since it’s likely to result in a declaration of default.
To my mind, this demonstrates that boilerplate securities contracts, in the aggregate, can be systemically significant. “Boilerplate Shock” introduces this concept and offers a modest proposal to mitigate its dangers in the Eurozone.
Beyond the euro, what about the risks of boilerplate shock in general?
Boilerplate shock is probably an inherent and permanent risk in any securities market.
Securities contracts are quintessential candidates for boilerplate. They are used by sophisticated parties for repeat or similar transactions and are drafted quickly—sometimes in three and a half minutes. The (correct) assumption is that they are more efficient for the parties that use them.
I’d like to begin thinking about how contracts can be drafted with a view to systemic risk mitigation, or at least to avoid exacerbating existing risks. But I think this is a hard problem that lacks an off-the-shelf solution:
- The nature of the risk is that it is a byproduct, not the result of intentional choices about risk allocation. This is the reason for the information-forcing default rule I propose in the Eurozone.
- The risk is also an externality: it is severe because of its collective impact. The parties do not bear the primary risk that uniform contracts will result in a meltdown, and in the unlikely event a crash happens (1) no individual party will be to blame and (2) at least one party to the initial transaction (the initial purchaser of a bond, for example) will probably no longer hold the asset, because most systemically significant securities are actively traded on the secondary market.
But banning or discouraging boilerplate is not the answer:
- The risk that a bunch of assets governed by the same terms will plummet in value is not only an externality. Risk allocation among parties might improve if scrutiny of existing securities boilerplate improves. The terms can evolve.
- A requirement to craft unique, artisanal terms—disclosures, subordination provisions ("flip clauses"), choice of governing law—for each individual securities transaction would be criminally inefficient.
- A requirement to craft unique contract terms might even be unjustified on risk-management terms alone, because it would increase drafting errors.
It's tricky to mitigate the risks of securities boilerplate.
Some options for places to start:
- Validation by third parties: perhaps issuers could use risk-rated contract templates. For example, see credit ratings…but see credit ratings.
- Culture: inculcate systemic risk mitigation as a professional norm among private sector lawyers? In principle, this could work. The number of lawyers who draft these contracts is pretty small. In practice, one could envision many complications.
- Insurance: encourage the development of derivatives to account for the possibility of boilerplate shock? Like some of the other solutions, this one presumes some agreement on what terms create the risk of boilerplate shock. It could also encourage new forms of moral hazard.
- Mandatory regulation: some public entity could be tasked with the mission of proactively identifying and combating the risk of boilerplate shock in contract practices. Arguably a natural choice given that the risk is an externality. Nevertheless, I’m a little skeptical. First of all, who would do it? A domestic regulator, like the SEC or CFTC, that might be dodged on jurisdictional grounds? An international institution, which is arguably more subject to capture? More generally, regulation seems like a heavy-handed first choice.
In sum, when standardized and aggregated, choices that determine legal risks—e.g., contract terms designating governing law, payment priority—can create the same hazards as choices about business risks. This suggests that contract terms should be taken seriously as possible sources of systemic risk alongside more familiar sources, like leverage and credit quality.
Securities contracts as a source of systemic risk—what do you think?
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