Conglomerate Blog: Business, Law, Economics & Society

February 10, 2012

Credit Derivatives, Leverage, and Financial Regulation’s Missing Macroeconomic Dimension

Posted by Erik Gerding

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.

January 22, 2012

Credit Scoring: The Next Frontier

Posted by Kathleen Engel

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)

January 16, 2012

Complexity, Complicity, and Liability up the Securitization Food Chain

Posted by Tom Fitzpatrick

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.

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 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.

January 05, 2012

Sunday Scholarship at AALS: Contingent Capital -- Harnessing Market Discipline

Posted by Erik Gerding

This is the second installment of a series of previews of the papers being presented at the AALS Financial Institutions & Consumer Financial Services Section meeting this Sunday from 9 am to 10:45 am at the Marriott Wardman Park.

If the first paper I previewed looks at the challenges of disintermediation and allocating regulatory responsibility, the second paper that will be presented looks at another fundamental question facing financial institution regulation: how can regulation harness market discipline effectively? Christoph Henkel (Mississippi College School of Law) and Wulf Kaal (Univ. of St. Thomas) take a deep, nuanced look at one approach, contingent capital requirements, in their paper Taking Contingent Capital Seriously – The Prospect of Sequential Triggers in Europe and the United States. Contingent capital describes debt instruments that would automatically convert into equity upon the occurrence of a trigger event (which might be defined in a regulation). The trigger would be set to signal the failing health of a financial institution. Contingent capital provides an additional cushion for failing firms as well as a systemic risk buffer for financial markets.

Here is Henkel and Kaal’s abstract:

Contingent capital has great potential to help make systemically important financial institutions safer and help avoid another financial crisis. United States policy makers may not have fully utilized the potential of contingent capital. A draft by the EU Commission already suggests the mandatory issuance of contingent capital securities in the resolution phase of systemically important banks in Europe. The Dodd Frank Act mandates a study on the feasibility of contingent capital. This article proposes the use of contingent capital with a sequential trigger as an early preventative tool and as a reorganization tool before liquidation and independent of protection under bankruptcy proceedings. The first preventative trigger would convert a fixed amount of debt to equity at a stage when the institution is still sound on a micro prudential basis, but shows early signs of substantial weakening. The second reorganization trigger would increase voting rights for holders of contingent capital after conversion to equity at the reorganization stage. Sequential triggers could incentivize corrective actions by bank management. The second trigger introduces a quasi preparation stage for bankruptcy, independent of management decisions or corrective action by regulators. The proposal would work seamlessly with the regulatory framework proposed by the EU Commission and could provide U.S. policy makers with a new perspective on the multiple uses of contingent capital in the context of bank restructuring.

Contingent capital has emerged as one of the most innovative potential responses to the financial crisis. A few years back, Rob Beard blogged at the Conglomerate on CoCo bonds, one version of contingent capital.

Contingent capital has a long intellectual lineage, including proposals to replace or supplement capital requirements with subordinated debt. However, the track record in Europe of bank subordinated debt serving as a buffer and early warning system during the crisis was less than stellar.

One response to this: subordinated debt instruments were poorly designed. But how should sub debt, contingent capital, or other market discipline instruments be designed? We need to move beyond the “concept car – looks sexy at the auto fair” phase to doing the safety and road testing to make sure the car doesn’t explode in a turnpike pileup. Attention to the engineering details is the real strength of the Henkel and Kaal paper.

Designing these instruments properly is a high stakes job. The challenge facing market discipline proposals is that we most need them to work when markets go haywire. This is a challenge, indeed, for all financial institution regulation.

I look forward to hearing Henkel present the paper and to the comments by discussant Mehrsa Baradan (BYU).

Sunday Scholarship at AALS: Distintermediation & Regulating P2P Lending

Posted by Erik Gerding

On Sunday, January 8th, the AALS Section on Financial Institutions and Consumer Financial Services will be holding a panel discussing featuring an impressive list of papers selected from an annual Call for Papers. The panel will take place from 9 am to 10:45 am in the Marriott Wardman Park in Maryland Suite B. It is part of a full weekend of programs by the section, including a Saturday lunch speech by Federal Reserve Governor Sarah Bloom Raskin.

In advance of that panel, let me showcase the papers one by one. (The Conglomerate is all about emphasizing the scholarly aspects of the AALS Annual Meeting.) Each of the four papers deals with a different set of foundational challenges to the regulation of financial institutions. The first paper I will preview looks at three interrelated problems:

Distintermediation;
Which regulator should be responsible for consumer/investor protection; and
How to allocate regulatory responsibility generally, when innovative financial services do not fit neatly within traditional regulatory silos.

In many ways, the first challenge – disintermediation -- is an echo (an extremely loud one) of an old problem. Starting over 30 years ago the cozy world of depository banking was rocked first by the rise of rival intermediaries – money market mutual funds, deeper bond markets and more sophisticated structured finance, as well as other elements of shadow banking.

Now scholars are looking at another competitive wave coming from radical disintermediation, in which the web facilitates direct connections between lenders and borrowers. This is the subject of the first paper, Regulating On-line Peer-to-Peer Lending in the Aftermath of Dodd-Frank, by Eric Chaffee (Univ. of Dayton School of Law) and Geoffrey C. Rapp (Univ. of Toledo College of Law). Eric will be presenting the paper, which is forthcoming in the Washington & Lee Law Review. Andrew Verstein (Yale Law School) will serve as discussant. Andrew has also written a fantastic paper on the same topic, The Misregulation of Person-to-Person Lending, which is forthcoming in the U.C. Davis Law Review.

Chaffee and Rapp outline the business model and current regulatory treatment of peer-to-peer lending, which includes platforms like Prosper Marketplace and Lending Club. They examine how securities laws govern the investment by lenders and banking law regulates the borrower end. The Dodd-Frank Act required the GAO to look at the regulation of p2p lending, and the GAO responded by formulating two alternatives. The first was continued regulation of investors on p2p sites by the SEC and regulation of borrowers by agencies responsible for consumer financial regulation (i.e. the CFPB). The second is assigning regulation to a unified consumer regulator.

In the end, Chaffee and Rapp argue that regulatory heterogeneity is not bad, but actually the way to go. They argue for an “organic” approach to regulating P2P lending, allowing different regulators to govern different aspects of the business. Here is their abstract:

The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act called for a government study of the regulatory options for on-line Peer-to-Peer lending. On-line P2P sites, most notably for-profit sites Prosper.com and LendingClub.com, offer individual “investors” the chance to lend funds to individual “borrowers.” The sites promise lower interest rates for borrowers and high rates of return for investors. In addition to the media attention such sites have generated, they also raise significant regulatory concerns on both the state and federal level. The Government Accountability Office report produced in response to the Dodd-Frank Act failed to make a strong recommendation between two primary regulatory options – a multi-faceted regulatory approach in which different federal and state agencies would exercise authority over different aspects of on-line P2P lending, or a single-regulator approach, in which a single agency (most likely the new Consumer Financial Protection Bureau) would be given total regulatory control over on-line P2P lending. After discussing the origins of on-line P2P lending, its particular risks, and its place in the broader context of non-commercial lending, this paper argues in favor of a multi-agency regulatory approach for on-line P2P that mirrors the approach used to regulate traditional lending.

Verstein comes out the other way and argues against SEC regulation of P2P lending and for unified regulation of p2p lending by the CFPB. Here is his abstract:

Amid a financial crisis and credit crunch, retail investors are lending a billion dollars over the Internet, on an unsecured basis, to total strangers. Technological and financial innovation allows person-to-person (“P2P”) lending to connect lenders and borrowers in ways never before imagined. However, all is not well with P2P lending. The SEC threatens the entire industry by asserting jurisdiction with a fundamental misunderstanding of P2P lending. This Article illustrates how the SEC has transformed this industry, making P2P lending less safe and more costly than ever, threatening its very existence. The SEC’s misregulation of P2P lending provides an opportunity to theorize about regulation in a rapidly disintermediating world. The Article then proposes a preferable regulatory scheme designed to preserve and discipline P2P lending’s innovative mix of social finance, microlending, and disintermediation. This proposal consists of regulation by the new Consumer Financial Protection Bureau.

This should be a lively discussion and of interest to our securities law junkies. Disintermediation is of course a topic a challenge for securities regulation generally, as other platforms are linking equity investors and companies seeking capital. Usha has been blogging about Sharespost and friend of the Glom Joan Heminway is working away on disintermediation too, looking at “crowdfunding” from the securities regulation angle (See her working paper here, see also, among others, Pope )

December 23, 2011

Bubbles, so the Coffee doesn't stain

Posted by Erik Gerding

Update 12/24: I wrote this post before I learned that Larry Ribstein had fallen ill two days ago. Sadly, Larry passed away early this morning, The University of Illinois press release is here.

I will always be touched by how generous Larry was as a scholar and a person. He reached out to me at a conference several years ago. I was dumbfounded that someone of his stature cared about the scholarship of someone just starting out and someone who didn't share his (occasionally strong) views. I will miss him and know my colleagues here will as well.

When the shock dulls a little, I will share more memories of Larry.

Just in time for the Holidays, the corporate law blogosphere has all lit up. The less-than-festive occasion: a draft paper by John Coffee (not on ssrrn, but I have a copy), in which Coffee, among other things, criticizes Roberta Romano, Stephen Bainbridge, and Larry Ribstein for being members of academic “Tea Party" that has opposed Sarbanes Oxley and other recent federal corporate law reforms. (Posts by Ribstein, Bainbridge, Bodie, Leiter).

Coffee usually doesn’t stain permanently, I don’t like doing laundry, and I know little about civility. So I will make a few questions and observation to switch the discussion to a more productive track. Hopefully, this might focus on some important differences in ideas among a group of scholars who I admire.

The immediate debate about Professor Coffee’s civility is obscuring a big difference between two very different scholarly approaches to the political economy of law and “bubbles.” This is a topic near and dear to me. I’ve written about it before, and am feverishly working to finish a book on the topic before Winter Break ends.

First, two introductory points: One, as I’ve written before, the greatest cost of Sarbanes Oxley and its debate was that it distracted attention from the growing storm of the financial crisis. While scholars and policymakers were debating whether or not that statute was too little, too much, or just right, financial institutions were making decisions that would do far greater and more lasting damage to the competitiveness of U.S. capital markets than anything SOX did.

Two, I have yet to be convinced that corporate governance was a first order cause of the crisis or that fixing corporate governance should be a first-order response. The crisis was about financial institutions, not corporations generally. Instead of focusing on executive pay at the Caterpillars of the corporate world or the board composition at Google, we should be worried about the leverage of the Bank of Americas and risk concentrations at the BONYs. Even if corporate governance played a role,it's financial institutions, smarty.

Now onto the main course… I do think there is an important difference in focus between Coffee on the one hand, and Romano, Bainbridge, and Ribstein on the other. The latter group has labeled SOX as an example of mis-regulation after financial crises and asset price bubbles. For example, Ribstein, in an article I enjoyed quite a bit, includes SOX in a history of “bubble laws.”

Even if you disagree with Ribstein, Romano and Bainbridge with respect to SOX, there is a long history of misguided legal responses to financial crises and bubbles. Some of this legal history is downright ugly. For example, the collapse of one of the first stock market bubbles, that of England in the 1690s, led to restriction on the number of Jewish stock brokers in the City of London. (See my article, p. 406, n. 74.) (As a footnote, the infamous “Bubble Act,” by which Parliament imposed legal restrictions on the formation of new joint stock companies, was not technically a response to a collapsed bubble. In fact, it was passed at the urging of insiders of the notorious “South Seas Company” before the collapse of the eponymous bubble. The law was an attempt to prevent competitors from entering English capital markets (see that same paper, p. 408)).

However, the focus on legal reactions in the wake of bubbles is only half the historical and political economy story. The criticism of bubble laws misses the ways in which legal change contributed to the formation of bubbles and financial crises. By legal change, I mean more than just deregulation, but also under-enforcement of laws and, in many cases, government subsidization of booming asset markets.

One way governments provide these subsidies is by granting legal monopolies to certain investment ventures. These monopolies are intended stimulate financial investment, foreign trade or the development of certain industries. In my book, I am tracing this practice from the royal charters in the South Seas and French Mississippi bubbles all the way to Freddie and Fannie in the present day. Corporate governance can and has been a part of the bubbles, just not in the way the SOX debate suggests. Indeed, it can be helpful in looking at history to see corporate law as an important tool (albeit a crude one, often used to dangerous effect) in the greater set of financial market regulations. Corporate law and corporate monopolies have been used to stimulate markets. The problem is that it is hard to pull away the punch when the party gets rockin’.

The focus on bubble laws misses the contribution of laws to bubble formation. By contrast, Coffee, in the disputed paper, provides an analysis of the political economy of financial regulation pre-crisis. However, his analysis is too spare. It focuses on Mancur Olson’s writings and leaves out the broader spectrum of theories – public choice and otherwise – that attempt to explain regulation and deregulation of financial markets and otherwise. It also misses the fact that law and regulation can stimulate markets beyond just deregulation and rollback. I argue that governments also subsidize have a history and incentive to provide excessive subsidies to particular financial markets, through corporate law and otherwise.

Coffee seems to miss the government subsidy story and the potential for misregulation. By contrast, Romano and Ribstein focus on the risk of legal overreaction to bubbles, but do not focus on the perverse political incentives to deregulate or stimulate financial markets during boom times.

I’ll save my analysis of this political economy of law and bubbles for another day. The story or regulation and bubbles I am writing doesn’t fit into neat political boxes in which de-regulation or re-regulation alone is to blame. Like cloying good cheer at this wintry time of year, there is plenty of blame to go around and provoke (if not inflame).

December 21, 2011

Who Are The G-SIFIs?

Posted by David Zaring

The FSB has designated 29 of them, and required them to hold extra capital. It means that there are too big to fail, probably, but perhaps regulators are devising careful resolution plans for them as we speak. At any rate, here's how big you have to be to be a Global Systemically Important Financial Institution:

Bank of America, Bank of China, Bank of New York Mellon, Banque Populaire CdE, Barclays, BNP Paribas, Citigroup, Commerzbank, Credit Suisse, Deutsche Bank, Dexia, Goldman Sachs Group, Crédit Agricole, HSBC, ING Bank, JP Morgan Chase, Lloyds Banking Group, Mitsubishi UFJ FG, Mizuho FG, Morgan Stanley, Nordea, Royal Bank of Scotland, Santander, Société Générale, State Street, Sumitomo Mitsui FG, UBS, Unicredit Group, Wells Fargo.

The American representatives are the not particularly huge investment banks, the really huge retail banks, and BONY and State Street, which aren't huge at all. Still, I've heard Rodgin Cohen say that the payment systems role that SS plays makes it the picture perfect definition of "too interconnected to fail," and the same probably goes for BONY. Still, they are a fraction the size of some of the Chinese banks that don't make the list, and you have to wonder if some much smaller institutions wouldn't also threaten the global financial system if they collapsed. Capital One? Allianz? The G-SIFI list hopefully won't be the only list that American regulators on the Financinal Stability Oversight Council consult when they come up with their own, domestic list.

December 19, 2011

Busy Times in International Financial Regulation

Posted by David Zaring

It would appear that yearly quotas are being met:

Perhaps most intererestingly, the Basel Committee sent out for comment "a set of requirements for banks to disclose the composition of their regulatory capital," which might be of real interest to investors, shorts, and competitors.
Much less tough, the Basel Committee, worried that arbs are forcing the prices of certain regulatorily required forms of credit protection sky hight, said that "the Committee is clarifying that supervisors will consider the cost of credit protection that has not yet been recognised in earnings when assessing whether credit protection purchased should be recognised for purposes of regulatory capital, including whether a bank meets the Basel standards for significant credit risk transference."
And Basel put out a third set of questions and answers on Basel III.
The Joint Forum (Basel plus supes of insurers and investment banks) asked for comment on its paper on "Principles For The Supervision of Financial Conglomerates.

December 16, 2011

Educating Today’s Law Students to Be Tomorrow’s Counselors and Gatekeepers

Posted by Marcia Narine

Law schools are under attack. Depending upon the source, between 20-50% of corporate counsel won’t pay for junior associate work at big firms. Practicing lawyers, academics, law students and members of the general public have weighed in publicly and vehemently about the perceived failure of America’s law schools to prepare students for the real world.

Admittedly, before I joined academia a few months ago, I held some of the same views about lack of preparedness. Having worked with law students and new graduates as outside and in house counsel, I was often unimpressed with the level of skills of these well-meaning, very bright new graduates. I didn’t expect them to know the details of every law, but I did want them to know how to research effectively, write clearly, and be able to influence the clients and me. The first two requirements aren’t too much to expect, and schools have greatly improved here. But many young attorneys still leave school without the ability to balance different points of view, articulate a position in plain English, and influence others.

To be fair, unlike MBAs, most law students don’t have a lot of work experience, and generally, very little experience in a legal environment before they graduate. Assuming they know the substantive area of the law, they don’t have any context as to what may be relevant to their clients.

How can law schools help?

First, regardless of the area in which a student believes s/he wants to specialize, schools should require them to take business associations, tax, and a basic finance or accounting course. No lawyer can be effective without understanding business, whether s/he wants to focus on mom and pop clients, estate planning, family law, nonprofit, government or corporate law. More important, students have no idea where they will end up after graduation or ten years later. Trying to learn finance when they already have a job wastes the graduate’s and the employer’s time.

Of course, many law schools already require tax and business organizations courses, but how many of those schools also show students an actual proxy statement or simulate a shareholder’s meeting to provide some real world flavor? Do students really understand what it means to be a fiducuiary?

Second and on a related point, in the core courses, students may not need to draft interrogatories in a basic civil procedure course, but they should at least read a complaint and a motion for summary judgment, and perhaps spend some time making the arguments to their brethren in the classroom on a current case on a docket. No one can learn effectively by simply reading appellate cases. Why not have students redraft contract clauses? When I co-taught professional responsibility this semester, students simulated client conversations, examined do-it-yourself legal service websites for violations of state law, and wrote client letters so that the work came alive.

When possible, schools should also re-evaluate their core requirements to see if they can add more clinicals (which are admittedly expensive) or labs for negotiation, client consultation or transactional drafting (like my employer UMKC offers). I’m not convinced that law school needs to last for three years, but I am convinced that more of the time needs to be spent marrying the doctrinal and theoretical work to practical skills into the current curriculum.

Third, schools can look to their communities. In addition to using adjuncts to bring practical experience to the classroom, schools, the public and private sector should develop partnerships where students can intern more frequently and easily for school credit in the area of their choice, including nonprofit work, local government, criminal law, in house work and of course, firm work of all sizes. Current Department of Labor rules unnecessarily complicate internship processes and those rules should change.

This broader range of opportunities will provide students with practical experience, a more realistic idea of the market, and will also help address access to justice issues affecting underserved communities, for example by allowing supervised students to draft by-laws for a 501(c)(3). I’ll leave the discussion of high student loans, misleading career statistics from law schools and the oversupply of lawyers to others who have spoken on these hot topics issues recently.

Fourth, law schools should integrate the cataclysmic changes that the legal profession is undergoing into as many classes as they can. Law professors actually need to learn this as well. How are we preparing students for the commoditization of legal services through the rise of technology, the calls for de-regulation, outsourcing, and the emerging competition from global firms who can integrate legal and other professional services in ways that the US won’t currently allow?

Finally and most important, what are we teaching students about managing and appreciating risk? While this may not be relevant in every class, it can certainly be part of the discussions in many. Perhaps students will learn more from using a combination of reading law school cases and using the business school case method.

If students don’t understand how to recognize, measure, monitor and mitigate risk, how will they advise their clients? If they plan to work in house, as I did, they serve an additional gatekeeper role and increasingly face SEC investigations and jail terms. As more general counsels start hiring people directly from law schools, junior lawyers will face these complexities even earlier in their careers. Even if they counsel external clients, understanding risk appetite is essential in an increasingly complex, litigious and regulated world.

When I teach my course on corporate governance, compliance and social responsibility next spring, my students will look at SEC comment letters, critically scrutinize corporate social responsibility reports, read blogs, draft board minutes, dissect legislation, compare international developments and role play as regulators, legislators, board members, labor organizations, NGOs and executives to understand all perspectives and practice influencing each other. Learning what Sarbanes-Oxley or Dodd-Frank says without understanding what it means in practice is useless.

The good news is that more schools are starting to look at those kinds of issues. The Carnegie Model of legal education “supports courses and curricula that integrate three sets of values or ‘apprenticeships’: knowledge, practice and professionalism.” Educating Tomorrow’s Lawyers is a growing consortium of law schools which recommends “an integrated, three-part curriculum: (1) the teaching of legal doctrine and analysis, which provides the basis for professional growth; (2) introduction to the several facets of practice included under the rubric of lawyering, leading to acting with responsibility for clients; and (3) exploration and assumption of the identity, values and dispositions consonant with the fundamental purposes of the legal profession.” The University of Miami’s innovative LawWithoutWalls program brings students, academics, entrepreneurs and practitioners from around the world together to examine the fundamental shifts in legal practice and education and develop viable solutions.

The problems facing the legal profession are huge, but not insurmountable. The question is whether more law schools and professors are able to leave their comfort zones, law students are able to think more globally and long term, and the popular press and public are willing to credit those who are already moving in the right direction. I’m no expert, but as a former consumer of these legal services, I’m ready to do my part.

December 07, 2011

From Academia To International Financial Regulation

Posted by David Zaring

Much of the interesting action in post-financial crisis regulation is occuring on the international level, through the FSB and its network affiliates. Now comes news that the SEC's international strategy is going to be coordinated by someone from academia, namely Eric Pan, from Cardozo Law School. Eric will join the SEC's office of international affairs, "where he will oversee the development of international regulatory policy," as the press release puts it.

“I am pleased to welcome Eric to the Office of International Affairs. In serving as an academic fellow this past year, Eric quickly established himself as a senior leader,” said Ethiopis Tafara, Director of the SEC’s Office of International Affairs. “Eric has tremendous intellectual skills and a remarkable ability to identify solutions to seemingly intractable issues in the regulation of cross-border activities.”

As for professors, Eric joins commissioner Troy Paredes, ex Wash U, at the agency. Somewhat rare to see an academic in a financial diplomacy job. Accordingly, we're wishing Eric the best over here at the Glom.

December 01, 2011

Requiem For A Regulator, By Dain Donelson & David Zaring

Posted by David Zaring

For a North Carolina law review symposium, Dain Donelson and I took a look at the question: did lax regulation cause the financial crisis? Of course, that's a hard question to answer, but at least we could look at how institutions that shifted in and out of the vilified and shuttered Office of Thrift Supervision did during the crisis, and consider what light was shed on the lax regulation thesis there. It's up on SSRN, do give it a look and tell us what you think:

We evaluate evidence reflecting the stability of our multi-regulator, charter-competitive system of financial regulation during the financial crisis in this symposium essay. Specifically, we compare thrifts to banks, charter-switchers to other thrifts and banks, and bailout recipients to non-bailout recipients to discover if any of these institutions did poorly when compared to their peers during the financial crisis. First, we compare publicly traded thrifts to publicly traded banks during 2008--the critical year of the crisis--and find that thrifts fared only marginally worse than banks, if at all, during that year. This result modestly suggests that the multi-regulator regime, however illogical, did not concentrate instability in a particular industry subject to a weak regulator. Second, to evaluate the impact of competition for charters, we compare thrift and bank performance to those institutions that chose to switch regulators immediately before and during the financial crisis. We find no significant differences in returns among either institutions that converted their federal bank charters to federal thrift charters, or institutions that converted federal thrift charters to bank charters, although our samples of these institutions are small. Third, we examine the bailout propensity of these charter-switchers. Our results suggest that although institutions switching to thrift charters were big enough to receive bailout money from the government, they did not. Conversely, we find that institutions switching away from thrift charters received more bailout money than their size would suggest. Our final finding may suggest some (possibly misplaced) dissatisfaction with the performance of the federal thrift regulator among federal government officials, which may have contributed to the decision to eliminate it in the Dodd-Frank Financial Reform Act passed in the wake of the crisis.

November 22, 2011

Uncertainty, Risk and Financial Law Reform

Posted by Diane Lourdes Dick

In thinking about financial law reform, several questions must loom particularly large among legal scholars: Is legal reform a source of market risk and/or uncertainty? And what are the relationships among market stability, risk and uncertainty?

I raise these questions because, as my previous post explored, the dominant judicial decision-making paradigm in finance and lending asserts that stable financial markets require an environment of legal certainty. This so-called "Certainty Imperative" ultimately constrains legal reform efforts by limiting the role of courts in shaping financial law and policy. What is more, the existing legal construct essentially assumes away these important questions, declaring legal reform as a source of uncertainty and a threat to market stability.

However, a recent book, Pandora's Risk: Uncertainty at the Core of Finance, published in July 2011 by economist Kent Osband, offers new insights as to the relationships among market stability, legal reform and certainty. These insights contradict foundational assumptions of the dominant legal paradigm.

In particular, Osband argues that markets are intrinsically uncertain environments. As Frank Knight articulated almost a century ago, risk is generally quantifiable, while uncertainty is randomness that cannot be measured. Challenging the Efficient Market Hypothesis, Osband asserts that changes in price are not caused by constantly updated (and thus highly certain) risk computations, but rather they reflect constantly shifting (and thus highly uncertain) perceptions of risk. Some perceptions of risk prove to be more accurate than other perceptions of risk, but all are inherently uncertain. Indeed, Osband alleges that our fixation with eradicating risk leads to greater market instability.

This book has caused me to further question the dominant paradigm in lending and finance. If it's true that markets are intrinsically uncertain environments, then is it appropriate to fear legal reform because it may introduce further uncertainty? And is the pervasive "Certainty Imperative" rhetoric even accurate? In other words, does the dominant paradigm simply use "legal certainty" as an umbrella term to loosely convey the absence of legal uncertainty and legal risk, or does it in fact distinguish unquantifiable "legal uncertainty" from quantifiable "legal risk"? If so, this distinction may explain why the Certainty Imperative primarily targets the judicial branch. Legal reforms that derive from the legislative and executive branches may be viewed as a lesser evil because they pose quantifiable risk to financial markets, whereas judicial reforms may be believed to introduce unquantifiable legal uncertainty.

Of course, if this is indeed the case, then the questions raised in this post are only the tip of the financial reform iceberg, and a host of normative implications also lurk below the surface. These questions and hypotheses deserve additional consideration, particularly from an interdisciplinary perspective. I welcome your insights.

November 21, 2011

The Jurisprudence of Certainty

Posted by Diane Lourdes Dick

In the wake of the recent financial crisis, I’ve been pondering the role of courts in the formation and execution of corporate financial law and policy. My focus quickly shifts to a predicate question: How do courts currently handle controversies relating to complex corporate financial arrangements? And what can we learn from judicial action and inaction in this realm?

My Article, Confronting the Certainty Imperative in Corporate Finance Jurisprudence (forthcoming in the Utah Law Review), explores the (seemingly nonexistent) role of the judiciary in shaping corporate financial law. Analyzing finance and lending jurisprudence, including cases in the related areas of consumer finance and public finance, I discover a judicial narrative of restraint, deference and abstention.

In particular, the dominant judicial decision-making paradigm in lending and finance asserts that stable financial markets require an environment of “legal certainty,” which is achieved when courts exercise considerable restraint. In disputes that stem from private financial agreements, courts show restraint by narrowly tailoring opinions to strict construction and passive enforcement of underlying contracts, and by declining to extend common law doctrines.

I call this paradigm the “Certainty Imperative.” I trace the Imperative to decisions rendered in the wake of the economic instability of the late 1970s and early 1980s, and I find that the paradigm continues to dominate finance and lending jurisprudence to this day. In fact, it has been bolstered by state and federal statutes that further constrain judicial decision-making in the corporate financing realm.

Ostensibly a creature of neoclassical economic theory, the Imperative infuses the specific goal of stability in financial markets into the broader and more deeply entrenched normative theme of legal certainty. The Imperative is rooted in the belief that financial markets are vital to the national interest, and that judges ought to decide cases in this realm in a manner that advances broad economic efficiency goals. What is more, the Imperative reflects the neoclassical conviction that markets are inherently stable in the absence of governmental intervention (including via judicial decision).

Imperative-abiding courts invoke forceful language, expressing fear that a decision might “throw credit markets into confusion and destabilize this area of law,” Smith v. Anderson, 801 F.2d 661, 665 (4th Cir. 1986), or “disrupt orderly credit markets.” Algemene Bank Nederland v. Hallwood Indus., 133 B.R. 176, 180-81 (W.D. Pa. 1991). The Fourth Circuit went so far as to suggest a slippery slope, whereby a ruling adverse to the expectations of lenders might send tremors through the industry, causing “untold and unknown consequences that cannot now be fully foreseen,” “undefinable instability” and even “widespread confusion.” Cetto v. LaSalle Bank Nat’l Ass’n, 518 F.3d 263, 277 (4th Cir. 2008). Other times, courts express this Imperative in vague terms, as if to imply some universal understanding that markets are profoundly sensitive to judicial decisions that modify existing law. For instance, courts have referred to undefined “ripple effects,” Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164, 189 (1994), and the simply-stated policy concern: “credit markets may be affected.” In re Fracasso, 210 B.R. 221, 228 (Bankr. D. Mass. 1997).

Generally focused on the needs of financial institutions rather than borrowers, the Imperative promotes bright-line rules that provide “all prospective lenders the certainty that is so important to the effective operation of markets,” In re Bulson, 327 B.R. 830, 845 (Bankr. W.D. Mich. 2005), or that deliver “guiding principle[s] for those whose daily activities must be limited and instructed” by laws governing commercial transactions. Dirks v. S.E.C., 463 U.S. 646, 664 (1983). The theme is often invoked as a rationale for maintaining the legal status quo, as courts lament a seemingly inequitable outcome under current law, but decline to engage in legal reform out of concern that any deviation from the expectations of lenders might disrupt financial markets.

When we consider this judicial narrative in its historical context, the Imperative seems not to be a reasoned legal philosophy, but rather a consequence of a shaken economy and a loose synthesis of emerging academic theories that seemed to offer new direction for maintaining financial market stability.

In my opinion, if courts are to assume a meaningful role in financial law reform, the Imperative must be confronted and overcome. The dominant paradigm heavily privileges the legal status quo, and its methodological constraints are a paralyzing force on the judiciary. The Article provides an in-depth critique of the Imperative’s strict interpretive norms, and suggests several possibilities for expanding the scope of judicial inquiries in the corporate financing realm.

I welcome your comments, questions and reactions!

November 09, 2011

Dynamite Program -- AALS Section on Financial Institutions & Consumer Financial Services

Posted by Erik Gerding

Note that the earlybird deadline for registering for the AALS Annual Meeting is coming up next week.

The AALS Section on Financial Institutions & Consumer Financial Services has put together a great program this year:

Sat. Jan. 7, 10:30 am-12:15 pm: Reviving Financial Institutions [Program # 6220]

Panelists:

Jill E. Fisch, University of Pennsylvania Law School
Howell E. Jackson, Harvard Law School
Kimberly D. Krawiec, Duke University School of Law
Patricia A. McCoy, University of Connecticut School of Law (currently on leave at the Consumer Financial Protection Bureau)
Katharina Pistor, Columbia Law School
Annelise Riles, Cornell University Law School
Peter Conti-Brown, Stanford Law School

Moderator: Anna Gelpern, American University Washington College of Law

This panel is part of a project to engage the legal academy in sustained theoretical and policy contributions to the regulation of financial institutions. We will step back from the daily news of reform to analyze the functions of today's financial institutions, revisiting the rationale for their regulation: what they do for their immediate constituents (debtors, creditors, shareholders) and for the economy as a whole (savings intermediation, liquidity, monetary policy transmission), as well as the risks they present. As we put the evolving U.S. regime in historical and comparative perspective, we will consider whether the focus on institutions detracts from regulating instruments, markets, economic functions and risks--and how to reconcile the proliferating regulatory objectives.

Sat. Jan. 7, 12:15-1:30 pm: Section Lunch [Program # 1425]

[The section has a fantastic lunch time speaker. I will announce the name in the blog as soon as I am allowed.]

Sun. Jan 8, 9:00-10:45 am: Rubber Hits Road: Implementing Dodd-Frank amid Reform Fatigue (Call for Papers) [Program # 7060]

Authors will explore the state of financial reform implementation in a still-weak national and global economy, against reform fatigue, polarization, and the risks of regulatory capture. Among other topics, the papers address the challenges inherent in moving from the legislative to the administrative realm, meshing domestic, regional, and international initiatives, and institutional design for markets and regulation. The session is an opportunity to look at specific rulemakings in detail, as well as to address larger questions about the course of reform after laws are made.

Eric Chaffee (Univ. of Dayton School of Law) & Geoffrey C. Rapp (Univ. of Toledo College of Law), Regulating On-line Peer-to-Peer Lending in the Aftermath of Dodd-Frank
- Discussant: Andrew Verstein (Yale Law School)
Stavros Gadinis (U.C. Berkeley School of Law), From Independence to Politics in Banking Regulation
- Discussant: Shruti Rana (Univ. of Maryland School of Law)
Wulf A. Kaal (Univ. of St. Thomas School of Law) & Christoph Henkel (Mississippi College School of Law), Sequential Contingent Capital Triggers in Europe and the United States
- Discussant: Mehrsa Baradaran (BYU Law School)
Anita K. Krug (Univ. of Washington School or Law), Institutionalization, Investment Adviser Regulation, and the Hedge Fund Problem
- Discussant: Kristin N. Johnson (Seton Hall Univ. School of Law)