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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Greetings, Glommers! (and hello, Janet and Mario*!)
It’s an honor to join this extremely sharp and thoughtful community of corporate and commercial law scholars for the next two weeks. The Conglomerate has long been one of my favorite law blogs and it’s truly a privilege to walk among these folks for a time (if a bit daunting to follow not just them but Urska Velikonja and her excellent guest posts). Thanks to Gordon, David, and their Glom partners for inviting me to contribute.
By way of biographical introduction, I’m currently a Visiting Assistant Professor at the University of Denver Sturm College of Law, where I teach International Business Transactions and International Commercial Arbitration. Last year, I did a VAP at Hofstra Law School (and taught Bus Orgs and Contracts). I am on the tenure-track market this year.
In the next few weeks, I’ll be exploring a number of issues related to law and global finance. I have a particular interest in currencies and monetary law, or the law governing monetary policy. Two of my current projects (on which more soon) address legal aspects of critical macroeconomic policy questions that have emerged since 2008: U.S. monetary policy and the Eurozone sovereign debt crisis.
Without further ado, I will take a page from Urska and kick off my residency here with a somewhat meta question: should scholars refrain from writing about legal issues in macroeconomics, specifically monetary policy?
One thinks of monetary policy decisions—whether or not to raise interest rates, purchase billions of dollars of securities on the secondary market ("quantitative easing"), devalue or change a currency—as fundamentally driven by political and economic factors, not law. And of course they are. But the law has a lot to say about them and their consequences, and legal scholarship has been pretty quiet on this.
Some concrete examples of the types of questions I’m talking about would be:
- Pursuant to its dual mandate (to maintain price stability and full employment), what kinds of measures can the Federal Reserve legally undertake for the purpose of promoting full employment? More generally, what are the Fed’s legal constraints?
- What recognition should American courts extend to an attempt by a departing Eurozone member state to redenominate its sovereign debt into a new currency?
When it comes to issues like these, it is probably even more true than usual that law defines the boundaries of policy. Legal constraints in the context of U.S. monetary policy appear fairly robust even in times of crisis. For example, policymakers themselves often cite law as a major constraint when speaking of the tools available to the Federal Reserve in combating unemployment and deflation post-2008. Leading economics commentators do too. Yet commentary on “Fed law” is grossly underdeveloped. With the exception of a handful of impressive works (e.g., by Colleen Baker and Peter Conti-Brown), legal academics have largely left commentary on the Fed and macroeconomics to the econ crowd.
A different sort of abstention characterizes legal scholarship on the euro crisis. Unlike the question of Fed power, there is a burgeoning literature on various “what-if” euro break-up scenarios. But this writing tends to focus on the impact on individual debtors and creditors, not on the cumulative impact on the global financial system. Again, the macro element is missing.
It is curious that so many legal scholars would voluntarily absent themselves from monetary policy debates. The subtext is that monetary policy questions are either normatively or descriptively beyond the realm of law. If that is scholars’ actual view, I think it is misguided. But maybe the silence is not as revealing as all that.
- One issue is sources. You will not find a lot of useful caselaw on the Fed’s mandate or the Federal Reserve Act of 1913, and the relevant statutes and regulations are not very illuminating. Further, it’s a secretive institution and that makes any research (legal or otherwise) on its inner workings challenging.
- Another issue is focus. Arguably the natural home of legal scholarship on domestic monetary issues, for example, should be administrative law. But the admin scholarly gestalt is not generally as econ-centric as, say, securities law. Meanwhile, securities scholars tend to focus on microeconomic issues like management-shareholder dynamics.
- A final possibility, at least in the international realm, is historical. After World War II, Bretton Woods established a legal framework intended to minimize the chance that monetary policy would again be used as a weapon of war. The Bretton Woods system collapsed over forty years ago, the giants of international monetary law (Frederick Mann, Arthur Nussbaum) wrote (and died) during the twentieth century, and now even some of the leading scholars who followed in their footsteps have passed away. At the same time, capital now flows freely across borders and global financial regulation has become less legalized in general. These factors plus the decline of exchange-rate regulations (most countries let their currencies float) may have undermined scholars’ interest in monetary law. But as the ongoing euro saga demonstrates, international monetary law and institutions remain as critical as ever.
These are some possible explanations for why legal scholars have largely neglected questions of monetary law, but I’m sure I’ve overlooked others. What do you think?
*Pictured are Janet Yellen and Mario Draghi, chiefs, respectively, of the Federal Reserve and the European Central Bank.
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Last week witnessed two very different views of how faculties can and should evaluate junior scholars for hiring and tenure. Compare this academic study (with the catchy title Moneyball for Academics ) with KerryAnn O’Meara’s essay in Slate on countering implicit bias in tenure reviews.
Both works leave a lot of questions unanswered. Even if the Moneyball approach one day delivers on its promise – to use network analysis of citations to predict the success of junior academics – it would also prove less than satisfying. Scholars who start out at citation hubs and collaborate with other scholars at those hubs – may be more likely to be cited going forward. But does that make their work more valuable? If financial markets are marked by fads, fashions, herding, and information cascades, the “market for ideas” (whatever that means) is even more susceptible to these dynamics. At least financial markets have arbitrageurs. (If only Socrates was able to ride out his short sale of Athenian democracy a little bit longer.)
The Slate article lies at the opposite end of the spectrum of Moneyball. O’Meara is critical of excessive reliance of quantitative factors –including citation counts – in evaluating scholarship. She argues that, to address problems of implicit bias, faculties should take a broader view of what constitutes scholarly contributions than traditional measures, including the use of external reviewers. But what does that look like in practice? If there is an inescapable level of subjectivity to any evaluation of scholarship, what standards should apply?
After over four years of work, my book Law, Bubbles, and Financial Regulation came out at the end of 2013. You can read a longer description of the book at the Harvard Corporate Governance blog. Blurbs from Liaquat Ahamed, Michael Barr, Margaret Blair, Frank Partnoy, and Nouriel Roubini are on the Routledge’s web site and the book's Amazon page. The introductory chapter is available for free on ssrn.
Look for a Conglomerate book club on the book on the first week of February!
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Just before Christmas the Washington Law Review published a symposium issue honoring Larry Cunningham's new book, Contracts in the Real World. The issue is a good read for Contracts teachers. You can read my contribution, "Contracts as Pattern Language" here. The abstract for this essay is below:
Christopher Alexander’s architectural theory of a "pattern language" influenced the development of object-oriented computer programming. This pattern language framework also explains the design of legal contracts. Moreover, the pattern language rubric explains how legal agreements interlock to create complex transactions and how transactions interconnect to create markets. This pattern language framework helps account for evidence, including from the global financial crisis, of failures in modern contract design.
A pattern represents an encapsulated conceptual solution to a recurring design problem. Patterns save architects and designers from having to reinvent the wheel; they can use solutions that evolved over time to address similar problems. Contract patterns represent encapsulated solutions within a legal agreement (or set of agreements) to a specific legal problem. This problem might consist of a need to match the particular objectives of counterparties in a discrete part of a bargain or to address certain legal rules. A contract pattern interlocks, nests, and works together with other contract patterns to solve more complex problems and create more elaborate bargains. Interlocking patterns enable scalability. Just as Alexander’s architectural patterns for rooms create patterns for buildings, which create patterns for neighborhoods and cities, patterns of individual contract provisions form legal agreement patterns, which interlock to create patterns for transactions, which, mesh to create patterns for markets. For example, contract patterns help lawyers draft real estate contracts. These contracts interlock in sophisticated real estate transactions, which mesh with other contract patterns to form securitization transactions. Securitization patterns create markets for asset-backed securities, which, form part of the larger shadow banking system.
This scalability differentiates contract patterns from boilerplate. However, legal scholarship on boilerplate – including Henry Smith’s work on the modularity of contract boilerplate – patterns allow certain debt contracts to become what Gary Gorton calls "informationally insensitive" and to enjoy many of the economic features of money.
The pattern language framework explains not only how sophisticated contracts function, but also how they fail. The pattern language framework provides a lens for examining recent contracts law scholarship on the failures of sophisticated contract design, including "sticky" contract provisions in sovereign bond agreements, "Frankenstein" contracts in mortgage-backed securitizations, and the "flash crash." If modularity and contract design patterns foster the development of new financial instruments and markets, then their features can also contribute to the unraveling of these markets. For example, by restricting the information content of contracts, patterns and modularity not only midwifed the creation of liquid markets for those contracts, they also played a role in "shadow bank runs" and the catastrophic freezing of these markets. The failure of contracts can have systemic effects for entire markets when a particular contract enjoys widespread use or when it is so connected to other critical contracts that cascading failures occur.
This essay was a contribution to a symposium for Larry Cunningham’s book, Contracts in the Real World.
We like the developing Harvard Business Law Review, and we are very proud that our own Gordon Smith has penned the third most cited article in the Journal of Corporation Law's history. But how big a hit is a hit in one of these journals? Herewith, the number of citations to the most cited articles in five of them:
248 - Business Lawyer (2002)
200 - Journal of Corporation Law (2002)
124 - Delaware Journal of Corporate Law (2007)
95 - American Business Law Journal (2000)
43 - Berkeley Journal of Business Law (2007)
The dates are the dates of those most cited articles; it is worth noting that The Business Lawyer has been around for a long time, and has published lots of things, making it quite the tournament to finish top of (so congratulations, John Coffee!), while the Berkeley Business Law Journal is still in volume single digits. Still, credit to JCL, which has really occupied a niche.
By way of comparison, William Cary's Yale Law Journal piece "Reflections on Delaware" has been ctied 985 times.
Here is Vic Fleischer's DealBook column on what the Seton Hall layoffs of untenured faculty means for academic freedom: Link
The budget situation of law schools is likely going to lead to other pressure on academic freedom. Don't be surprised if the search for new revenue pushes many schools into an eat-what-you-kill focus on faculty funding much of their salaries through grants. That might work well in the natural sciences (assuming that you have a funder like the NIH or NSF that has plenty of resources and solid academic peer review). But much of law school research is normative. Just try to present a purely descriptive paper at a workshop. Who would fund research into financial regulation without placing strings attached? The government of Iceland, NASDAQ, some industry trade group, an investment bank?
Moreover, many important fields in the legal academy might not receive any grants at all. The marketplace for ideas is not the same thing as the marketplace for grants.
A small sampling of recent legal scholarship on "shadow banking" (a topic of I've written about myself):
- Chrystin Ondersma (Rutgers Newark): Shadow Banking and Financial Distress: The Treatment of 'Money-Claims' in Bankruptcy; and
- Ed Greene & Elizabeth Broomfield (both, Cleary Gottlieb): Promoting Risk Mitigation, not Migration: a Comparative Analysis of Shadow Banking Reforms by the FSB, USA and EU (in the Capital Markets Law Journal)
Steve Schwarcz of Duke also produced a bevy of articles on the topic at the end of last year.
Richard Pildes (NYU) recently posted on ssrn a thoughtful book chapter that confronts law professors with a series of tough questions about the trade-offs of becoming engaged in the policy process, which ranges from co-authoring an amicus brief to serving in a President’s Administration or even running for office. (The abstract is at the end of this post).
Pildes intentionally seeks to raise more questions than answers. Although much of his essay may not strike the reader as new, it renders an invaluable service nonetheless by renewing the call for legal academics to reflect on the inherent conflicts between critiquing the law and helping interpret, apply, or construct it. This is itself a variation of the ancient tension between describing how the law is and how it ought to be.
Pildes sees a generational divide among legal scholars. On one side, he places the generation of scholars like Bruce Ackerman, with a legendary disdain for engaging the political process. On the other side, Pildes claims younger scholars are more likely to write to shape policy and to be active in litigation, consulting, and government service.
I’m not so sure this is factually correct. (I can think of numerous older and mid-career professors on the Harvard faculty when I was a student who served in Presidential Administrations, worked on law reform, or argued before the Supreme Court). Perhaps the trend is cyclical. Pildes surmises that the generational shift he sees may stem from two Democratic Administrations in the past two decades. The existence of this generational shift seems like an area ripe for empirical study.
Pildes follows a provocative essay by Richard Fallon (Harvard) two years ago critiquing the standards for law professors co-signing or authoring amicus briefs (here are both a draft and final version). Fallon’s essay generated both NY Times coverage as well as equally incisive replies (e.g., Amanda Frost’s (American) essay).
The Fallon debate yielded a particularly useful harvest. It prompted many academics to articulate their standards for writing or co-signing amicus briefs. The academy needs a similar debate to offer guidance to professors (particularly, but not exclusively, junior professors) on other aspects of policy engagement. What should professors consider in testifying before Congress or an agency? When to take on consulting or litigation work?
The questions Pildes raises assume a greater urgency because of institutional pressures he does not address in the essay. Budgetary pressures will undoubtedly pressure law schools and professors to seek more soft money grants and big hard money donations to fund programs and professorships. To what extent will this put pressure on the valuable role of academic dissent that Pildes rightly cherishes? This institutuional economic pressure may present more of a challenge to dissent than revived questions about academic tenure.
It is, however, by no means a new challenge. Bruce Ackerman, for example, holds the Sterling Professorship at Yale, which was funded by John William Sterling, founder of Shearman & Sterling and counsel to Standard Oil, Henry Ford, and Jay Gould. But institutional pressures on law schools and professors merit re-examining again and again with fresh eyes.
Here is the abstract for Pildes' chapter (after the jump):
This essay is meant to prompt professional self-reflection
for academics, particularly legal academics, on the appropriate relationship
between the pursuit of knowledge and the pursuit of power.
Academic institutions, in theory, should be among the most robust sites in which dissent against conventional or widely-shared views of policy and law ought to find easy expression. That has long been part of the justification for the general principle of institutional academic freedom, as well as for specific organizational features of the academy, such as tenure.
Yet the legal academy risks being more compromised, and increasingly so, in its ability to play this role than is often recognized. The reason is the paradox of the relationship of legal academics to actual political power. Legal academics are not just independent scholars of public policy, law, legal or political institutions. They are also often direct participants in the systems of public and private power they study. Unlike academics in most other disciplines (except, perhaps, economics), legal academics have greater opportunity for effective influence over policy, law, and politics. The various forms of practical engagement which legal scholars undertake -- consulting, litigating, testifying to Congress or courts, service in government -- have significant benefits, both in the classroom and in scholarship. But they also come with significant risks, including risk to the ability to play an essential role that justifies academic institutions, the role of being able to stand apart from existing constellations of power or interest or conventional wisdom on issues of moment.
This essay identifies the various ways in which the paradoxical position of the legal academic and the temptations of access to political and legal power threaten the ability of the legal academy to be a source of dissent. The essay then explores how legal academics ought to think about the benefits and risks of the unique position of academics closely connected to the institutions and actors who wield actual political and legal power. I emphasize that the foundation for considering the role of legal academics as potentially important sources of dissent must be a belief in the existence and importance to collective decision making of expert knowledge about the kinds of questions legal academics teach, research, and write about. This premise needs emphasis because many forces press against it. American democracy since the Jacksonian era has always contained a strong strand of anti-elitism capable of being mobilized by political actors against various claims to specialized knowledge and expertise.
In my view, Intellectual independence, and the capacity to dissent from various orthodoxies and structures of power is more difficult to attain and maintain than academics often recognize. That is so even though academics are institutionally and structurally situated to be in most able to resist the political or ideological conventions of the moment. As one example, I discuss the political scientist Arthur Schlesinger Jr.’s distortion of history in his public attempt to legitimate President Truman’s unilateral decision, without congressional authorization, to commit massive military force to defend South Korea against North Korea’s attack in the 1950s. The unauthorized Korean War was a turning point in American political practice regarding unilateral presidential commitments of military force. Twenty years later, during the Vietnam War, Schlesinger publicly recanted and acknowledged that he had distorted the history to support Truman’s war.
This necessarily brief essay is meant mainly to raise and provoke further discussion of these issues, rather than to offer a comprehensive analysis. It is not offered as a moralistic exercise, and I have engaged in many of the practical activities I describe. But power -- political, financial, and other -- is seductive, and the tensions between it and intellectual independence are central to the modern legal academy and warrant fuller discussion.
A message for those business law scholars and practitioners seeking a well respected, peer-reviewed home for their scholarship:
The Editorial Board of The Business Lawyer is soliciting submission of articles and essays for Volumes 68 and 69. TBL is the flagship scholarly journal of the American Bar Association Section of Business Law. It reaches 41,000 readers on a quarterly basis. Authors must submit exclusively to the journal and submissions are peer-reviewed. We generally give authors a response in about two weeks. TBL provides a good forum to reframe scholarly articles published elsewhere for an audience of judges and practitioners. Past authors include Bernie Black, Henry Wu, Lucian Bebchuk, Joe Grundfest, Guhan Subramanian, Vice Chancellor Leo Strine, former Chief Justice of the Delaware Supreme Court Norman Veasey, Larry Hamermesh, Starvros Gadinis, Roberta Karmel, Jonathan Lipson, and Barbara Black.
Articles should be submitted to Diane Babal, Production Manager, at email@example.com. Questions about submissions can be addressed to Associate Editor-in-Chief, Professor Gregory Duhl, at firstname.lastname@example.org.
Is market discipline dead? Market discipline as a means to check the systemic risk posed by financial institutions was very much in vogue in financial institution scholarship until the financial crisis. Not any more. There are certainly calls for restraining government bailouts and some interesting work on contingent convertible capital requirements. But, by and large, this pillar seems to have been moved to the back of the financial regulation temple.
Kate Judge (Columbia) has a new paper (forthcoming in the UCLA Law Review) that cuts against this contemporary conventional wisdom. She argues for revisiting and rethinking the idea of interbank discipline – that is the incentives and capacities of large, complex banks to monitor and check the risk-taking of their counterparties. Here is her abstract:
As banking has evolved over the last three decades, banks have be-come increasingly interconnected. This Article draws attention to an effect of this development that has important policy ramifications yet remains largely unexamined—a dramatic rise in interbank discipline. The Article demonstrates that today’s large, complex banks have financial incentives to monitor risk-taking at other banks, the infrastructure, competence and information to be fairly effective monitors, and mechanisms through which they can respond when a bank changes its risk profile.
The rise of interbank discipline has both positive and negative ramifications from a social welfare perspective. The good news is that self-interested banks may be expected to penalize a bank when it takes excessive risks, thereby deterring such risk taking. The bad news is that the interests of banks and society are not always so well aligned. Other banks, for example, may be expected to reward a bank when it changes its risk profile in a way that increases the probability that the government would bail the bank out rather than allowing it to fail. This is because a bailout protects a bank’s creditors, even though it is socially costly. Interbank discipline may thus encourage banks to alter their activities in ways that increase systemic fragility.
In drawing attention to the powerful yet mixed effects of interbank discipline on bank activity, this Article contributes to a new generation of scholarship on market discipline. Its aim is not to question whether we need regulation, but to address the pressing issue of how we should allocate inherently finite regulatory resources. It suggests that by reducing the regulatory resources devoted to activities that other banks are performing relatively well, increasing the resources devoted to activities that regulators are uniquely situated or incentivized to address, and seeking to counteract the adverse effects of interbank discipline, bank oversight could be redesigned to more effectively promote the stability of the financial system.
The paper is a valuable springboard for talking about the flip side of bank “interconnectedness” – not merely as transmission lines for contagion, but as a crucial feature of market and regulatory architecture.
I just returned from speaking at a panel at the Clearing House’s Annual Meeting in New York that focused on the regulation of shadow banking. My fellow panelists included Amias Gerety (Deputy Assistant Secretary for Financial Stability, U.S. Dept. of Treasury), Ed Greene (Senior Counsel, Cleary Gottlieb), Sandy Krieger (Executive Vice President, FRBNY), and Barney Reynolds (Moderator, Shearman & Sterling).
Our first bone of contention was whether shadow banking is actually a useful concept for financial regulation. I think it is, as I have written elsewhere. Shadow banking describes how a series of financial instruments, markets, and institutions came to perform the same economic functions as banks:
- credit intermediation/credit risk transfer,
- maturity transformation, and
- liquidity transformation (i.e. creating money-like instruments that have theoretically high liquidity and low credit risk) (see Morgan Ricks).
We discussed several of these instruments and institutions at the panel including: securitization, money market funds, repos, and prime brokerage. These markets not only performed similar economic functions as banks, in the Panic of 2007-08, they also suffered runs and solvency crises just like banks.
In response, the federal government refashioned some of the same conceptual tools historically used to address banking crisis to staunch a shadow banking crisis. What, after all, was TARP and the alphabet soup of Federal Reserve liquidity facilities other than the government:
- acting as lender-of-last resort,
- providing deposit insurance to investors in shadow banking markets, and
- resolving institutions that failed because of shadow banking investments (albeit resolution without wiping out existing shareholders).
So if it quacks like a bank, suffers runs like a bank, and is saved like a bank, it needs to be regulated like a bank.
The difficulty is how to narrowly tailor bank-like regulations (from capital requirements to liquidity regulations) to address the specific forms of risk posed by each kind of shadow market. As I put it, you don’t regulate a turkey the same as a duck or a chicken. This turducken problem led some of my co-panelists to believe a bottom-up approach to regulation (one that focuses on market failures of individual instruments) makes more sense than a top-down approach (starting with the conceptual problems of shadow banking and then figuring out how to tailor policy approaches to particular contexts).
I continue to think a top-down approach helps focus on what are the big picture market failures and systemic risks that we should care about – bank runs and liquidity crises; high leverage; and correlated risk-taking and herd behavior by financial institutions.
Here were my takeaway points from a great panel discussion:
- Size matters, but it ain’t the only thing: the Too-Big-To-Fail problem has obscured the dangers of many smaller financial institutions moving as a herd.
- The FSOC’s power to designate certain institutions as systemically significant, however has asset size as a threshold. It cannot subject an entire class of institutions or instruments to systemic regulation by the Fed.
- This means that FSOC must deal with the danger of herd behavior or the systemic risk posed by smaller institutions through its recommendation power. The FSOC’s recent proposed proposals on money market reform will provide a test of this power.
- One oft-overlooked problem is how securitization did not effectively transfer risk, because the financial institutions that securitized assets also purchased asset-backed securities. This daisy chain meant that much risk stayed within the regulated banking system.
- Why did so much risk stay within the system? In part, this occurred because shadow banking instruments (particularly securitization, asset-backed commercial paper, and repos) were increasingly used not to transfer credit risk but to game bank capital requirements (aka “regulatory capital arbitrage”).
The bottom-up approach may also obscure a couple of key problems, including:
- These markets – from securitization to repos to money market funds – have been tightly connected. For example, asset-backed securities often “collateralized” repo loans. Money market funds invested in asset-backed commercial paper and repo markets. A focus on instruments means less attention is given to the network as a whole.
- If you want to regulate a network, you focus on the hubs. Who were at the hubs of the shadow banking network? Investment banks! They have their finger in every shadow banking pot, including via:
- Securitizing assets off their own balance sheet;
- Sponsoring securitizations and underwriting asset-backed securities;
- Purchasing asset-backed securities;
- Borrowing through repos...
I could go on – the whole business of investment banks is to “make markets” and serve as the intermediary of a web of transactions. Focusing exclusively on instruments means we may overlook the role of critical institutions in making the plumbing of shadow banking work.
- Perhaps the greatest myth of the shadow banking system is that only unregulated entities were involved. In fact, regulated entities were deeply involved. Banks securitized assets off their balance sheets. Banks, investment banks, insurance companies, and a host of other institutional investors purchased asset-backed securities. They also issued securities that were bought by money-market funds, which, in turn, are regulated by the SEC.
- Indeed, the real sweet spot of the crisis, came not with heavily regulated institutions or unregulated institutions (like hedge funds), but less regulated affiliates of heavily regulated entities. Think AIG’s London affiliate that wrote all those credit derivatives or Bear Stearns’ hedge funds. These examples indicate that conglomerates were playing games to transfer the benefits of government guarantees (explicit or implicit) and other subsidies from regulated to less-regulated affiliates.
- In many cases, it was not a lack of regulation that caused shadow banking to flourish, but the presence of regulation. In other words, Congress and regulators often granted preferences that allowed the markets for various shadow banking instruments to flourish. For example, Congress exempted repos (and later swaps) from various bankruptcy rules. (see Roe) Or, to pick a hot topic, consider the 1983 SEC rule change that allowed money market funds to price their shares at a fixed Net Asset Value, which made these investments appear more safe and bank-deposit-like. (see Birdthistle).
Shadow banking provides a vital conceptual framework to remind policymakers why and what they should regulate. It also provides a field guide to studying new financial instruments. When new financial innovations arise, when should financial regulators take heed and what should they watch for.
David and I presented at a great financial regulation workshop at Brooklyn Law School on Friday. Many thanks to Claire Kelly and Roberta Karmel for putting together a great program (particulary during a few extraordinary weeks in Brooklyn).
Among the doom and gloom at the conference: banks are taking on unknown amounts of commodities risk, coco bonds and TRUPs aren’t all they are cracked up to be, and auditors make lousy agents for financial regulators.
Among the bright spots: there may be better ways to fix the tax incentives for financial institution leverage, and the Volcker Rule may offer opportunities to address the market structure for OTC swaps markets.
Illuminated: why EU counties and other went gaga over collective action clauses in sovereign debt, what international financial regulation can teach international public law, and new insights into the corporate governance role of credit derivatives.
With the earlybird registration deadline for the AALS Annual Meeting in New Orleans two days away, here are two events to put on your calendar:
Friday, January 4th: Joint Program of the Securities Regulation and FInancial Institutions/Consumer Financial Services Section [AALS Code 4160]
The Securities Regulation and Financial Institutions & Consumer Financial Services sections have joined forces to put together a Joint Program on the “The Regulation of Financial Market Intermediaries: The Making and Un-Making of Markets” on Friday, January 4th from 2 pm to 5 pm.
The program will give us a chance to look at the intersection of capital markets and financial institution regulation, a sweet spot that was overlooked until the global financial crisis hit. The program will include a panel of scholars who have been looking at this intersection for quite a while, including, Onnig Dombalagian (Tulane), Claire Hill (Minnesota), Tamar Frankel (Boston University), Donald Langevoort(Georgetown), Geoffrey Miller (NYU), David Zaring (Univ. of Pennsylvania – Wharton School of Business),David Min (UC Irvine and author of How Government Guarantees in Housing Finance Promote Stability) and Kimberly Krawiec (Duke) (Moderator).
The program will also include the following four papers picked from a large response to our Call for Papers:
- “The Federal Reserve’s Use of International Swap Lines,” Colleen M. Baker (Notre Dame);
- “Investment Company as Instrument: The Limitations of the Corporate Governance Regulatory Paradigm,” Anita K. Krug (Univ. of Washington); and
- “The Case for Decentralizing Financial Oversight: A Strategy for Overseeing the Derivatives Industry,” Jeffrey Manns (George Washington Univ.).
Saule Omarova (North Carolina) will moderate the call for papers panel.
Saturday, January 5th: Financial Institutions/Consumer Financial Services Lunch [AALS Code 1413]
Our keynote speaker will be Michael Barr of the University of Michigan Law School. Professor Barr returned to Michigan after serving as Assistant Secretary for Financial Institutions at the U.S. Department of Treasury in the Obama Administration. Professor Barr was one of the architects of the Dodd-Frank Act. Anna Gelpern (American Univ.) will introduce Professor Barr.
On Thursday, I travelled to Houston and gave a statement before the Public Company Accounting Oversight Board in a roundtable hearing, as the PCAOB considers whether to impose a mandatory auditor rotation rule. In using its new inspection powers, the PCAOB has found worrying evidence of auditors compromising their independence, objectivity, and professional skepticism (see the PCAOB’s concept release soliciting public feedback).
This problem and whether mandatory auditor rotation is an appropriate solution present a bramble bush of questions that have solicited a great deal of comments (you can see the statements at the Houston roundtable (including my own) here); the PCAOB also held roundtables previously in Washington, D.C. and San Francisco).
For me, the roundtable represented an opportunity to revisit some of the legal scholarship on audit failure that deserves renewed attention, even as public attention has shifted from Enron/SOX to “Subprime”/Dodd-Frank. Let me highlight the works of two scholars in particular.
First, Sean O’Connor (Univ. of Washington) authored a great series of articles that examined “the creation” of the problem of auditor independence. In one work, O’Connor looks at how certain accountants pushed for, and Congress created, requirements for mandatory “independent” auditing of issuer financial statements in public offerings (the ’33 Act) and in periodic reporting (the ’34 Act). Professor O’Connor looks at how the New Deal Congress imported much of these requirements from provisions in Britain’s Companies Act but without considering key differences in status and governance between chartered accountants in Britain versus the accounting industry in the United States. Moreover, Congress failed to spell out what makes auditors “independent.” This omission left the job to the SEC and resulted in Boards and not shareholders selecting and paying auditors. In a later work, O’Connor looks at how these legal requirements and the “issuer pays” model mean that true auditor independence will always be elusive. His work parallels work in other scholarship on gatekeepers (for example, Frank Partnoy’s theory of how “regulatory licenses” endow credit rating agencies with government-granted oligopoly power that undermines their effective gatekeeping). O’Connor presents a fairly radical set of solutions, including ending the ’34 Act (but not the ’33 Act) statutory requirements for independent audits and giving shareholders control of auditor selection.
Bill Bratton (Penn) had a second and different spin on the problem of auditor independence. He agrees that the issuer-pays model fundamentally compromises auditor independence. But, he argues that making auditors responsive to shareholders is problematic, as different groups of shareholders have radically different investing interests and time horizons. This article represents part of a series of articles by Bratton on the “dark side” of shareholder value and the downsides of shareholder primacy. Instead of making auditors beholden to shareholder, Bratton recommends strengthening the fidelity of auditors to accounting rules. Less radical than O’Connor’s suggestions, Bratton’s proposal raises a number of questions, including whether fidelity to rules can provide adequate discipline of audit firms without a third-party strenuously enforcing those rules on behalf of shareholders, whether professional and social norms provide a meaningful disciplining device for auditors, and, most vexing, how effective can rules be when industry wields a powerful hand in writing them.
Both sets of works deserve renewed scrutiny as the problems of auditor independence persist.