The Future in Law and Finance

The following post comes to us from Alessio Pacces, Professor of Law and Finance at the Erasmus School of Law in Rotterdam. The post is based on Professor Pacces’ inaugural lecture for the Chair in Law and Finance at the Erasmus School of Law in Rotterdam. The full text of the lecture is available here.

Traditionally, law and finance has been concerned with investor protection. That would be enough if the future were predictable. However, because the future is in fact uncertain and unpredictable, the prices of financial assets are flawed and in the short run they may result in serious mistakes, if not widespread crises. Although these mistakes are corrected in the long run, a lot of harm may occur in the meantime. Drawing on the experience from the global financial crisis, I argue that financial law should be concerned not only with investor protection, but also with mitigating the temporary excesses of markets in allowing or restricting access to finance.

The challenge of this goal is to remedy market malfunctioning without undermining market discipline. This is possible if central banks backstop banks’ illiquidity during a crisis, provided that regulation preserves the central banks’ incentives to distinguish illiquidity from insolvency. Moreover, in order to prevent the backstop from resulting in moral hazard by financial institutions, regulation should police the incentives of both managers and shareholders. On the one hand, bank managers should not be allowed to cash in the profit of short-term success. On the other hand, corporate law should allow shareholders to commit to the long term via takeover restrictions, granting bankers private benefits of control to complement the deferral of performance pay.

Contrary to what mainstream finance assumes, the future cannot always be described by probabilities attached to some events. According to the distinction by Frank Knight, uncertainty differs from risk in that it cannot be described by probability distributions. Financial exchange does occur on the basis of risk assessment. However, as Keynes argued, risk assessment is based on conventions supporting probabilities drawn from past experience. Such conventions are fragile. When the unfolding of events no longer validates statistical models of risk assessment, uncertainty rises to the forefront and the functioning of financial markets is impaired.

Uncertainty is not sufficient for a financial crisis. Financial crises are always about debt. Because, as Hyman Minsky put it, banks are “merchants of debt,” instability ultimately stems from banking. Banking is characterized by maturity transformation: banks borrow on the short-term basis and lend on the long-term basis. The banks’ short-term liabilities are attractive because they are supposedly liquid and safe. In fact, these characteristics depend on the quality of the banks’ assets, which is assessed on the basis of statistical risk models. When these models are no longer trusted, the safety of banks’ liabilities is likewise not trusted. Following the logic of a bank run, investors will then seek to withdraw more cash than is actually available and a financial crisis will ensue.

Despite its impact on financial instability, banking is important in order to overcome uncertainty in finance. Facing uncertainty, investors seek precisely the liquidity of the typical banks’ liabilities, whereas entrepreneurs and households may need funds to be committed for a longer time. Hence, regulations setting a safety net around banking make sense. However, this safety net has not prevented the global financial crisis. Moreover, the presence of a safety net nurtures moral hazard in banking. According to the majority of commentators, financial instability depends on moral hazard, which is exacerbated by the safety net. I argue instead that moral hazard is not the principal cause of financial crises. On the contrary, excessive concerns for moral hazard may delay intervention by policymakers until this intervention is ineffective or overly expensive.

The global financial crisis was a crisis of shadow banking. Because it was out of the regulatory perimeter, shadow banking initially had no access to the safety net. Therefore, it could hardly be motivated by moral hazard. The lesson from shadow banking is twofold. Firstly, banking involves externalities. Because banks profit from maturity transformation but do not bear the full consequences of financial crises, they tend to promise more safety and liquidity than is socially optimal. Secondly, the mode of banking evolves with innovation. Hence, on the one hand, banking calls for regulation. On the other hand, ex-ante regulations are likely ineffective in the face of uncertainty and innovative ways to deal with it.

In order to cope with the inherent instability of banking, I recommend that regulation take an approach quite different from Basel III, which is too static and does not account for financial innovation. Regulation should allow central banks to play a more active role in disciplining banking through ex-post interventions. Central banks should monitor the assets against which financial institutions of any kind issue short-term liabilities. The liquidity of those assets should be guaranteed in times of crisis through temporary lending of last resort, aimed at sorting out illiquidity from insolvency. Only the former should be supported by central banks.

If central banks are vested with discretion on how and when to intervene, we should trust them to have the right incentives. Central banks normally care about their independence. It will be in their interest to distinguish illiquidity from insolvency in order to preserve this independence. However, this requires that a credible mechanism to resolve insolvent institutions be in place. Experience shows that central banks do engage in bailouts when there is arguably no other way to save the financial system they are responsible for. In this perspective, the decision by the European Union to start a Banking Union with a supervisory mechanism not accompanied by a centralized resolution mechanism is clearly incentive-incompatible.

Another problem with a backstop, however temporary, by the central banks is moral hazard: bank managers may profit from socially excessive maturity transformation hoping to be gone when the adverse consequences of this strategy materialize. Regulation on both sides of the Atlantic rightly seeks to counter this behavior by mandating the deferral of performance pay. However, this is not sufficient if managers are accountable to shareholders who may put pressure to generate short-term gains. When management is committed to the long term but shareholders are not, it becomes difficult to design an efficient compensation scheme. Shareholders should be able to commit to the long term, if that aligns incentives and saves on remuneration costs. To this purpose, shareholders should have the option to restrict takeovers and to grant the management private benefits of control. In many corporate jurisdictions outside the United States, this is not an option.

A more detailed analysis of the global financial crisis and a discussion of the policy proposals outlined in the lecture is available for download here.

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