Category Archives: Financial Crisis

Structural Corporate Degradation Due to Too-Big-To-Fail Finance

Mark Roe is the David Berg Professor of Law at Harvard Law School, where he teaches bankruptcy and corporate law. Professor Roe received the European Corporate Governance Institute’s 2015 Allen & Overy Prize for best corporate governance paper. The article, Structural Corporate Degradation Due to Too-Big-To-Fail Finance, appeared in the University of Pennsylvania Law Review, and was discussed on the Forum here as a working paper. In the following summary, Mr. Roe updates the earlier post.

In Structural Corporate Degradation Due to Too-Big-to-Fail Finance, I examined how and why financial conglomerates that have grown too large to be efficient find themselves free from the standard and internal and external corporate structural pressures push to resize the firm. The too-big-to-fail funding boost—from lower financing costs because lenders know that the government is unlikely to let the biggest financial firms fail—shields the financial firm’s management from restructuring pressures. The boost’s shielding properties operate similar to “poison pills” for industrial firms, in shielding managers and boards from restructurings. But unlike the conventional pill, the impact of the too-big-to-fail funding boost reduces the incentives of insiders to restructure the firm, not just outsiders. These weakened restructuring incentives weaken both the largest financial firms and the financial system overall, making it more susceptible to crises. The article predicts that if and when too-big-to-fail subsidies diminish, the largest financial firms will face strong pressures to restructure.

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Enhancing Prudential Standards in Financial Regulations

The following post comes to us from Franklin Allen, Professor of Economics at the University of Pennsylvania and Imperial College London; Itay Goldstein, Professor of Finance at the University of Pennsylvania;
 and Julapa Jagtiani and William Lang, both of the Federal Reserve Bank of Philadelphia.

The recent financial crisis has generated fundamental reforms in the financial regulatory system in the U.S. and internationally. In our paper, Enhancing Prudential Standards in Financial Regulations, which was recently made publicly available on SSRN, we discuss academic research and expert opinions on this vital subject of financial stability and regulatory reforms.

Despite the extensive regulation and supervision of U.S. banking organizations, the U.S. and the world financial systems were shaken by the largest financial crisis since the Great Depression, largely precipitated by events within the U.S. financial system. The new “macroprudential” approach to financial regulations focuses on both the risks arising in financial markets broadly and those risks arising from financial distress at individual financial institutions.

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A Smarter Way to Tax Big Banks

Mark Roe is the David Berg Professor of Law at Harvard Law School, where he teaches bankruptcy and corporate law. This post is based on an op-ed by Professor Roe and Michael Tröge that was published today in The Wall Street Journal, which can be found here.

In conjunction with his State of the Union address, President Obama reanimated the idea of taxing big banks’ debts to help stabilize the banking industry and prevent future financial crises. The administration argues that the new tax would discourage banks from taking on too much risk by making it “more costly for the biggest financial firms to finance their activities with excessive borrowing.”

The president’s bank-tax proposal is unlikely to gain traction in the new Congress, just as similar proposals from the administration in 2010 and, last year from the now retired Rep. David Camp (R., Mich.), did not move forward. But even if it became law, it wouldn’t put a sizable dent in bank debt. The reason is simple: The existing tax system strongly encourages debt finance and the proposed new tax will not fundamentally change this.

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New Approaches to International Financial Regulation

The following post comes to us from Annelise Riles, Jack G. Clarke Professor of Far East Legal Studies and Professor of Anthropology at Cornell Law School.

International financial law scholarship is undergoing a revolution. The financial crisis of 2008 has led to a dramatic rethinking of the “givens,” and has attracted a new community of scholars to the field. Until 2008, international legal theory played only a minor role in international financial law. The implicit and taken for granted neoclassical economic theory that undergirded debates about global financial regulation was presumed to be all the theory that could or should apply, and the analysis focused rather simply and uniformly on questions of efficiency and social welfare. Since the financial crisis, however, the mainstream debate has shifted its focus to so-called “macro-prudential issues” and to an awareness of a need for some sort of global, or at least a transnationally coordinated response to systemic risk.

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A Crisis of Banks as Liquidity Providers

The following post comes to us from Nada Mora, Senior Economist at the Federal Reserve Bank of Kansas City, and Viral Acharya, Professor of Finance at NYU.

In our paper, A Crisis of Banks as Liquidity Providers, forthcoming in the Journal of Finance, we investigate whether the onset of the 2007-09 crisis was, in effect, a crisis of banks as liquidity providers, which may have led to reductions in credit and increased the fragility of the financial system. The starting point of our analysis is the widely accepted notion that banks have a natural advantage in providing liquidity to businesses through credit lines and other commitments established during normal times. By combining deposit taking and commitment lending, banks conserve on liquid asset buffers to meet both liquidity demands, provided deposit withdrawals and commitment drawdowns are not too highly correlated. Evidence from previous crises supports this view. In fact, banks experienced plenty of deposit inflows to meet the higher and synchronized drawdowns that occurred during episodes of market stress (Gatev and Strahan (2006)). The reason is that depositors sought a safe haven due to deposit insurance as well as due to the regular occurrence of crises outside the banking system (e.g., the fall of 1998 following the Russian default and LTCM hedge fund failure; the 2001 Enron accounting crisis).

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How Do Bank Regulators Determine Capital Adequacy Requirements?

The following post comes to us from Eric Posner, Kirkland & Ellis Distinguished Service Professor of Law and Aaron Director Research Scholar at the University of Chicago.

The incentive to take socially costly financial risks is inherent in banking: because of the interconnected nature of banking, one bank’s failure can increase the risk of failure of another bank even if they do not have a contractual relationship. If numerous banks collapse, the sudden withdrawal of credit from the economy hurts third parties who depend on loans to finance consumption and investment. The perverse incentive to take financial risk is further aggravated by underpriced government-supplied insurance and the government’s readiness to play the role of lender of last resort.

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Towards a “Rule of Law” Approach to Restructuring Sovereign Debt

Steven L. Schwarcz is the Stanley A. Star Professor of Law & Business at Duke University School of Law.

In a landmark vote, the United Nations General Assembly overwhelmingly decided on September 9 to begin work on a multilateral legal framework—effectively a treaty or convention—for sovereign debt restructuring, in order to improve the global financial system. The resolution was introduced by Bolivia on behalf of the “Group of 77” developing nations and China. In part, it was sparked by recent litigation in which the U.S. Supreme Court held that, to comply with a pari passu clause (imposing an equal-and-ratable repayment obligation), Argentina could not pay holders of exchanged bonds without also paying holdouts who retained the original bonds. That decision was all the more dramatic because the holdouts included hedge funds—sometimes characterized as “vulture funds”—that purchased the original bonds at a deep discount, yet sued for full payment.

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Financial Market Infrastructures

The following post comes to us from Guido A. Ferrarini, Professor of Business Law at University of Genoa, Department of Law, and Paolo Saguato at Law Department, London School of Economics.

In the paper Financial Market Infrastructures, recently made publicly available on SSRN and forthcoming as a chapter of The Oxford Handbook on Financial Regulation, edited by Eilís Ferran, Niamh Moloney, and Jennifer Payne (Oxford University Press), we study the impact of the post-crisis reforms on financial market infrastructures in the securities and derivatives markets.

The 2007-2009 financial crisis led to large-scale reforms to the regulation of securities and derivatives markets. Regulators around the world acknowledged the need for structural reforms to the financial system and to market infrastructures in particular. Due to the global dimension of the crisis and the extent to which financial markets had been revealed to be closely interconnected, national regulators moved the related policy debate to the supranational level. This approach led to the international regulatory guidelines and principles adopted by the G20 and then developed by the Financial Stability Board (FSB). The new global regulatory framework which has followed has institutionalized financial market infrastructures (FMIs) as key supports for financial stability and as cornerstones of the crisis-era regulatory reform agenda for financial markets.

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After the Deal: Fannie, Freddie and the Financial Crisis Aftermath

The following post comes to us from Steven Davidoff Solomon, Professor of Law at the University of California, Berkeley School of Law, and David T. Zaring, Associate Professor of Legal Studies and Business Ethics at the Wharton School, University of Pennsylvania.

In After the Deal: Fannie, Freddie and the Financial Crisis Aftermath, we offer a solution to the problem of what to do with the profits being made by Fannie Mae and Freddie Mac, the subject of a dispute between the government, which has declared that it will keep those profits, and the shareholders of common and preferred stock left behind after the firms were quasi-nationalized, who have sought, in court, a share of them.

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Rolling Back the Repo Safe Harbors

Mark Roe is the David Berg Professor of Law at Harvard Law School, where he teaches bankruptcy and corporate law. This post is based on an article co-authored by Professor Roe, Ed Morrison, Professor of Law at Columbia Law School, and Bankruptcy Judge Christopher Sontchi for the District of Delaware. All three are members of the Advisory Committee on Derivatives, Financial Contracts and Safe Harbors, which is working with the ABI Commission to Study the Reform of Chapter 11. The article was presented at the Federal Reserve’s recent conference on Wholesale Funding Markets.

Ed Morrison, Judge Christopher Sontchi and I recently posted to SSRN our article recommending a major narrowing of the repo safe harbors, after presenting it at the Federal Reserve’s recent conference on Wholesale Funding Markets in which the Boston Fed president warned of the dangers in the repo market. Overall, we conclude that the Bankruptcy Code has aggressively and unwisely sought to regulate market liquidity and systemic risk, with the Code’s “safe harbors” from the normal bankruptcy machinery largely backfiring during the financial crisis. The sounder policy would be to limit the repo safe harbors to U.S. Treasury repos and repos of similarly liquid government securities.

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