Over at DealBook, I've got something on the financial regulatory reform that Europeans, in particular, love. Give it a look. And let me know if you agree with this bit:
Can a supervisory college work in lieu of a vibrant global resolution authority regime? The problem with these colleges is not that they are implausible, but that they have not really been tried in a crisis. The best-known supervisory college outside of the European Union was created in 1987 to monitor the Luxembourg-based, but international, Bank of Credit and Commerce International. Rumors of widespread fraud in the management of the bank were plentiful, but the collegiate approach did not mean that these problems were nipped in the bud. Although coordinated supervision led regulators to close many of bank’s branches at once after the bank’s accountant resigned and its insolvency became obvious, it is not clear whether Bank of Credit and Commerce International is a college success story or cautionary tale.
There are other reasons to worry about relying on colleges. The collegiate approach is meant to encourage communication more than action. Colleges operate as peers, convened by the home banking regulator, without the sort of hierarchy of decision-making and direction that leads to coordinated action.
After the SEC settled with Citigroup over misreprsentations made about a toxic security it sold during the financial crisis for a centimillion dollar fine among other things, Judge Rakoff rejected the settlement for failing to contain "cold, hard, solid facts established either by admissions or trials." I've been pretty critical of the decision, which was always headed for reversal. Not that Judge Rakoff cares: his familiarity with the agency (he once was in it), his generally respected status as a judge, and rumblings of discontent by other courts asked to approve other settlements once he fired his shot across the SEC's bow has led to a change in approach by the agency; I talked about the new policy here.
The problem with the decision was twofold, according to the Court of Appeals, at least as I interpret it.
Problem 1: Doctrinally, a settlement decision is an exercise of enforcement discretion, and enforcement discretion is basically unreviewable because the alternative - making it reviewable - would thrust the courts into the heart of what the executive branch does. Because the SEC wanted continuing court supervision of Citigroup as a consequence of the settlement, Rakoff did, indeed, have something to do. But if the SEC had simply dismissed its suit in exchange for the payment of a fine, which is less onerous than a fine plus continuing supervision by a court, Rakoff would have had, literally, no role to play in the resolution of the case. So requiring cold, hard facts to be established as a condition of signing off on a deal was a radical increase in the oversight of the SEC by a court.
No surprise, then, that the Second Circuit said that "there is no basis in the law for the district court to require an adminision of liability as a condition for approving a settlement between the parties. The decision to require an admission of liability before entering into a consent decree rests squarely with the SEC."
Problem 2: Settlements are not about right and wrong, while admissions of guilt are. Settlements are about moving on. We don't expect private parties to establish whether management caused the bankruptcy or someone else did, whether that product really was dangerous, or was misused by consumers, or whatever. And these can be matters of great public import. So it was never clear why the government, even though, yes, it is a state actor, should be treated very differently.
No shock, then, that the Second Circuit has said that "consent decrees are primarily about pragmatism" and "normally compromises in which the parties give up something they might have won in litigation and waive their rights to litigation."
According to the appellate court, the right way to review consent decrees is for procedural clarity and, as far as the public interest is concerned, with Chevron deference to reasonable decisions by the agency. It's not totally clear what that deference means - the court faulted Rakoff for figuring out whether the public interest in the truth was served by the deal when he should have been deciding "whether the public interest would be disserved by entry of the consent decree." But there you go.
Anyway, I think this stuff is interesting, because it's a tool in the regulatory arsenal, and indeed, my first baby law professor article was on just that.
Frank Partnoy returns to the subject he wrote about early in his academic career, the role of law and regulation in financial crises, with a new book chapter on Financial Systems, Crises, and Regulation. I read Frank's earlier 1999 article avidly: this was back before the topic was fashionable. This new chapter includes a discussion of theories of the roles that information asymmetries and agency costs play in propagating crises. Later, the chapter moves on to talk about mandatory disclosure, anti-fraud enforcement, and corporate governance as crisis prevention tools. This swims against the tide of conventional wisdom which has focused more on prudential financial regulation (which Partnoy also discusses) as antidote to crisis.
Here is a critical excerpt from the chapter:
In the aftermath of the 1929 crash, regulators imposed a twin pillar regime of mandatory disclosure and anti-‐fraud enforcement. Those two pillars were the key architecture features that supported well functioning markets for decades. Both have been eroded in recent years, as disclosures became boilerplate and anti-‐fraud prosecution more limited and infrequent. The response to the Global Financial Crisis could have included architecture moves to rebuild those pillars. But instead the Dodd-‐Frank legislation focused on other priorities and architecture changes in the areas of disclosure and anti-‐fraud enforcement were minimal.
This provocative line of thought raises an important question: If disclosure and corporate governance rules are key for systemic risk too, should these rules be tailored for financial institutions? After all, Coca Cola's securities disclosure and corporate governance played no role in our latest crisis. Shouldn't we tailor securities disclosure and corporate governance reforms for banks rather than a blunderbuss approach? After all, banks (including those by any other name) are special; they play special roles in the economy and pose special risks.
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.
Collateralized Debt Obligations
USAF Tests early 1950s
JPM experiments early 1990s
Pricey Simulation of Destruction of Tokyo
Computer Special Effects
Destructive Monte Carlo Simulation for Pricing
Heating up in Asia
Europe already burned
Laser, Taser, Bomb
Too Big To
Japan, Hawaii, San Francisco, Las Vegas, in other words, comparatively limited
Scope of Devastation
Arizona, California, Florida, Nevada, European banks, worldwide financial markets
“Mmm … Calamari”
Carl Levin, Mecha-Carl Levin
Hollywood too risk averse; recycles old assets
Wall Street too risk seeking; recycles old assets
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.
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.
- "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!
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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© Disney, “Duck Tales”
I expressed concern in my last post that uniform contract terms could destabilize securities markets in unexpected ways. In a recent paper, I dub this risk “Boilerplate Shock.” The paper uses boilerplate terms in Eurozone sovereign bonds as a case study, but I argue that any market in which a lot of securities are governed by uniform contract terms is vulnerable to boilerplate shock. In this post, I will focus on the Eurozone and my proposed solution to the risk of boilerplate shock there.
One major problem is that no one really knows how to deal with sovereign debt obligations denominated in a currency that still exists but is no longer used by the debtor. A partial breakup of the European Monetary Union would trigger some question marks in commercial law and private international law (among other things).
In the Eurozone sovereign lending market, bond contracts typically contain standardized language specifying:
(a) choice of governing law (often foreign), and
(b) currency of payment (euros).
The combined effect of these clauses, I argue, is to render any country that departs the euro more likely to default on its debt. Whatever the impact of the departure itself, a forced default would make things much worse for Europe and the world economy.
Leading scholars have concluded or strongly suggested that a sovereign that changes currencies can redenominate (convert) its bonds to its new currency even where the contract is governed by foreign law (e.g., Philip Wood (p. 177), Michael Gruson (p. 456), Arthur Nussbaum (pp. 353-59), Robert Hockett (passim)). As a descriptive matter, I believe this to be a mistaken interpretation of New York (and probably English) private international law and commercial law (see “Boilerplate Shock” pp. 47-67). But normatively, I agree: a sovereign should be able to redenominate its bonds under certain circumstances. Among other things, the alternative would make currency union breakups far more dangerous than they already are.
- The prevailing consensus underestimates the risk that a departing Eurozone member’s attempt to redenominate its sovereign bonds into a new currency will be ruled a default.
- Since the bonds of other struggling euro countries are largely governed by the same boilerplate terms ((a) and (b) above), this misapprehension has the potential to be particularly damaging. In addition to surprising the market (which appears to incorporate this consensus), it is likely to spread beyond the immediate debtor to the bonds of similarly situated countries that have issued under the same terms.
- Same for CDSs (which are likewise often governed by foreign law, usually New York).
- Thus, given the widespread use of terms (a) and (b), a ruling that a departing country cannot pay its euro-denominated contracts in a new currency could cause the market to demand unsustainable premiums from other weak debtors.
- This could cause Eurozone countries to lose market access. Greece is not TBTF in any sense, but some of its neighbors are—and are also too big for the EU (including the ECB) and IMF to bail out. Italy (the world’s 9th largest economy) and Spain (13th) come to mind.
Thus, if my commercial law/private international law analysis is right, these boilerplate contracts could end up playing quite a big role in the event of any euro breakup.
To mitigate this risk of boilerplate shock, I suggest a new rule of contract interpretation. The proposal is detailed at pp. 67-71 of the article. I suggest commercially significant jurisdictions adopt it by statute. Here is a quick summary.
Any sovereign that:
- Belongs to an international monetary union, and
- Issues bonds in the currency of that monetary union subsequent to the adoption of this rule, and
- Leaves the monetary union and introduces its own currency,
shall retain the right to redenominate its bond obligations into its new currency, UNLESS the sovereign has affirmatively waived the right to redenominate its bonds.
You’ll notice this is a default rule—merely a presumption of the right to redenominate—not a mandatory rule. It is also prospective-only: it does not apply to existing issuances. It also does not protect sovereigns that issue in foreign currency (e.g., Argentina), only those that are monetary union members and issue in the common currency (e.g., France).
The reason for these limitations is to minimize unintended consequences and near-term disruption to the market, but also to embody the relatively modest objectives of the rule. It is an information-forcing default rule that is intended to facilitate better risk management by parties. It is not a “save the world” rule.
The challenge, as I’ll discuss in my next post on the paper, is not that redenomination would be ruled impermissible when it ought to be available (otherwise, that might suggest a mandatory “pro-redenomination” rule). It is that the likely effect of these boilerplate terms—to prohibit redenomination—was almost certainly not bargained for and is largely unknown to parties. This market failure has, in turn, created latent risks to the broader financial system and the existing legal tools are poorly suited to address them.
By now, the risk that a distressed European nation such as Greece might leave the Eurozone and thereby spark global economic calamity is well known. Regular readers of this blog may even privately relish the prominence of the issue. Not since the days of the gold standard has international monetary policy come so close to being a socially acceptable topic of dinner conversation.
As I noted in my first post, observers rightly perceive the Eurozone sovereign debt crisis to be driven by political and economic forces. But many consequences of a euro breakup would be determined by law, including sources of American (specifically New York) private law.
This is a complex issue. I try to address it more fully in a new article, "Boilerplate Shock," which I've just posted on SSRN.
In brief, and to continue picking on Greece, one key question in the event of a euro breakup would be: would a court recognize an attempt by Greece to convert its euro-denominated debt into its new currency, or would it instead insist that Greece pay in euros, the currency of contract? The answer is important because, as a practical matter, requiring payment in euro would be tantamount to forcing a default.
That's the familiar narrative, anyway. And I agree. But I believe that the ubiquity of boilerplate terms in these bonds—specifically, clauses selecting governing law (usually foreign) and currency of payment (euro)—is likely to make any dispute over redenomination even more damaging than this suggests.
In the article, I argue that the sparse literature on the question of redenominating sovereign bonds overlooks some sources—especially cases interpreting New York contract law and private international law—that, if extended to Eurozone sovereign bonds, could surprise the market and cause serious global repercussions. I argue that the reason for this is not only that the dominant view overlooks what are likely controlling sources of law. It is that standardization of contract terms across the Eurozone sovereign lending market makes the stakes of surprise that much higher.
If Greece's attempt to redenominate its bonds is declared a default, then the fact that the operative terms in Italian, Spanish, Irish, etc. sovereign bonds are the same or similar makes markets likely to demand unsustainable premiums from those countries. Capital and investor flight could be very rapid. We have seen several previews of this movie over the past few years in the Eurozone, and each time official-sector bailout institutions have saved the day. But the European Union/European Central Bank and IMF probably do not have the resources to stop a broad-based bank run of this nature, to say nothing of the political support necessary to attempt it.
Maybe none of that will happen. Nevertheless, the potential for uniform contract terms to create risk not just to individual third parties but to securities markets seems likely to grow at least as fast as those markets. Using Eurozone sovereign bonds as a case study, I introduce the term "boilerplate shock" to describe the potential for standardized contract terms—when they come to govern the entire market for a given security—to transform an isolated default on a single contract into a threat to the market of which it is a part, and, possibly, to the economy in general. My larger objective here is to foster a discussion of the potential for securities law and private-sector securities lawyers to manage (or alternatively, to contribute to) systemic risk.
I've posted an abstract below and will be returning to the subject. I look forward your comments.
Boilerplate Shock abstract:
No nation was spared in the recent global downturn, but several Eurozone countries arguably took the hardest punch, and they are still down. Doubts about the solvency of Greece, Spain, and some of their neighbors are making it more likely that the euro will break up. Observers fear a single departure and sovereign debt default might set off a “bank run” on the common European currency, with devastating regional and global consequences.
What mechanisms are available to address—or ideally, to prevent—such a disaster?
One unlikely candidate is boilerplate language in the contracts that govern sovereign bonds. As suggested by the term “boilerplate,” these are provisions that have not been given a great deal of thought. And yet they have the potential to be a powerful tool in confronting the threat of a global economic conflagration—or in fanning the flames.
Scholars currently believe that a country departing the Eurozone could convert its debt obligations to a new currency, thereby rendering its debt burden manageable and staving off default. However, this Article argues that these boilerplate terms—specifically, clauses specifying the law that governs the bond and the currency in which it will be paid—would likely prevent such a result. Instead, the courts most likely to interpret these terms would probably declare a departing country’s effort to repay a sovereign bond in its new currency a default.
A default would inflict damage far beyond the immediate parties. Not only would it surprise the market, it would be taken to predict the future of other struggling European countries’ debt obligations, because they are largely governed by the same boilerplate terms. The possibility of such a result therefore increases the risk that a single nation’s departure from the euro will bring down the currency and trigger a global meltdown.
To mitigate this risk, this Article proposes a new rule of contract interpretation that would allow a sovereign bond to be paid in the borrower’s new currency under certain circumstances. It also introduces the phrase “boilerplate shock” to describe the potential for standardized contract terms drafted by lawyers—when they come to dominate the entire market for a given security—to transform an isolated default on a single contract into a threat to the broader economy. Beyond the immediate crisis in the Eurozone, the Article urges scholars, policymakers, and practitioners to address the potential for boilerplate shock in securities markets to damage the global economy.
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