Equity Suppliers in Bank Regulation

Yesha Yadav is Professor of Law at Vanderbilt Law School. This post is based on a recent paper by Professor Yadav.

Post-Financial Crisis regulatory reform requires banks to fund themselves more fully through common equity. By maintaining deeper equity buffers, banks are better positioned to absorb losses and to prevent the spread of contagion through the financial sector. [1] Under the Dodd-Frank Act’s Orderly Liquidation Authority, shareholders of a failing bank must pay for its risk-taking by seeing the value of their equity be extinguished to meet the bank’s obligations to short-term and secured creditors. [2] In this way, equity reserves can help stem the spread of losses.

My paper shows that the practical realization of this policy objective faces serious challenges when viewed from the standpoint of who actually supplies equity capital to banks. Surveying the 2016 proxy statements of the 25 publicly traded, U.S. bank and financial holding companies subject to the Federal Reserve’s stress tests, [3] I find that a handful of top asset managers—the Vanguard Group, BlackRock, Fidelity Investments, State Street Global Advisors and T. Rowe Price—are blockholders at multiple banks, meaning that each owns more than 5% of common equity across different firms. In 2015/6, for example, Vanguard and BlackRock were both blockholders at 22 out of these 25 banks, with BlackRock funds holding blockholder positions at 23 of these 25 banks and Vanguard funds at 22 of these 25 banks. This pattern of ownership showcases a marked percentage increase over the last five years. According to the 2011 proxy statements of these same banks, BlackRock was a blockholder at 10 out of (then) 24 banks; [4] and Vanguard was a blockholder at a single bank out of these 24 firms in 2010/11.

So, what does this mean for post-Crisis capital regulation? With sizable equity investments at the largest U.S. financial institutions, a cohort of asset managers (meaning, the retirement and other savings funds they manage), have assumed the residual default risk of a swath of the financial sector. To the extent that asset managers like BlackRock and Vanguard represent the savings of American (and global) homes and businesses, this investment in the financial sector directly ties Main Street wealth to the fate of Wall Street firms. In some respects, this observation should come as unsurprising. Asset managers like BlackRock and Vanguard direct trillions of dollars of capital into securities markets and banks have eagerly been seeking out equity funding as they endeavor to overcome the Financial Crisis and comply with more demanding capital standards. [5] Moreover, where asset managers control funds that are indexed to a diversified portfolio of S&P companies, one should expect to see a proportionate representation of large banking firms. Nevertheless, as regulation looks to equity to safeguard markets against crises and to support the operations of leveraged, interconnected, banking firms, it is important to identify those that have come to hold meaningful default risk in this design. [6]

The paper examines how effectively asset managers—as influential shareholder-monitors—can protect fund-holders from suffering damaging, possibly correlated losses from systemic bank failure. This paper makes three arguments. At first glance, asset managers might seem like a source of high risk for bank regulators. Theory posits that bank shareholders tend to be risk-seeking, primed to push for gains on the back of the cheap leverage and state-support that banks enjoy. [7] If asset managers like BlackRock direct sizable equity investments at multiple banks, then perhaps they will be especially susceptible to these problematic incentives.

However, I suggest that asset managers, as bank shareholders, may defy this conventional view. Corporate law scholars generally view the large mutual and savings fund providers as passive investors. This passive approach to governance makes sense given that they compete with one another to charge low fees from users and also do not invest their own wealth, rather putting the money of their savers on the line. [8] In bank governance, then, without their own money invested and also constrained by low fees, asset managers might be less likely to fall prey to the risk-seeking tendencies of the usual bank shareholder. In other words, this passive posture might prove a boon for bank regulators to the extent that asset managers—looking after others’ money and unable to charge users to pursue aggressive action—may be less motivated to advocate for overly risky strategies. Still, this passivity itself can be problematic. Asset managers may give managers or more aggressive shareholders too wide a berth to take outsize risks and potentially place the banking system at risk.

Bank regulation can thus benefit by incentivizing the large asset managers to take a more active, monitoring role in bank governance—to protect fund-holders from large losses and also to provide a kind of systemic oversight of the financial system. Asset managers now possess unique informational advantages by virtue of their multiple investments in the banking sector that can help defray the high costs of performing bank oversight. Banks tend to be informationally opaque and difficult to value, particularly as their asset bases grow. [9] With the largest U.S. banks increasing the size of their balance sheets over the past few years, even sophisticated asset managers are likely to confront high transaction costs in understanding the fuller credit risk of banking firms. [10] Nevertheless, with their funds holding the equity of several banks, asset managers are well positioned to be efficient monitors. They can apply the insights they gather to monitor their many investments across the banking sector, thereby also providing a systemic lens to support existing public supervision of the financial system.

On a concluding note, it is important to highlight the growing literature in antitrust economics relating to widespread equity ownership of U.S. companies by the same small cohort of asset managers comprising BlackRock, Vanguard, State Street Global Advisors and T. Rowe Price. [11] Scholars in law and economics have examined the impact of this “common ownership” on competition, suggesting that common owners may tolerate (even promote) anti-competitive behavior in the form of higher prices and poorer service outcomes for customers. Their writings have set off a lively, contentious and significant debate in antitrust regulation.

This paper does not deal with antitrust concerns nor enter into existing debates in that literature on common ownership. My goal here is only to examine the question of who owns the bank equity from the point of view of financial stability and capital regulation. While I do not engage with the antitrust literature on this issue, policy prescriptions in this paper are likely to be considered unpalatable by antitrust scholars. For example, I suggest that asset managers—as bank shareholders at multiple banks—can usefully provide a form of “systemic” oversight across the financial sector, supplementing public monitoring of banks. Carrots to encourage such system-wide supervision by asset managers reflect a focus on financial stability as the driving policy objective, though such solutions will doubtless raise red flags for antitrust scholars. This paper constitutes a first in a series of works examining bank capital structure to identify those that hold the real-world default risk of the equity, debt as well as convertible securities issued by banks. This research agenda seeks to understand how effectively bank regulation might work in practice to fulfill the public policy goals governing financial regulation. In the context of the present Article, widespread equity investment by key asset managers in the banking sector begs the obvious question: will regulators be willing to trigger processes that extinguish the value of bank equity where much of it is ultimately held by ordinary Main Street savers and businesses?

The complete paper is available here.

Endnotes:

1The Dodd Frank Wall Street Reform and Consumer Protection Act Pub. L. 111–203 H.R. 4173 §171 (“Dodd-Frank Act”); Federal Reserve Board of Governors, Basel III Implementation, http://www.federalreserve.gov/bankinforeg/basel/USImplementation.htm.(go back)

2See e.g., Dodd-Frank Act § 212(a).(go back)

3Board of Governors of the Federal reserve, Comprehensive Capital Analysis and Review 2016: Assessment Framework and Results (June 2016).(go back)

4Notably, Citizens Financial was then primarily owned by the U.K.’s Royal Bank of Scotland.(go back)

5See e.g., Sarah Krouse, Vanguard Reaches $4 Trillion for First Time, Wall St. J., Feb. 10, 2017; Economist, BlackRock, The Monolith and the Markets, Dec. 13, 2013.(go back)

6On bank runs, see, for example, Douglas W. Diamond & Phillip H. Dybvig, Bank Runs, Deposit Insurance, and Liquidity, 91 J. Pol. Econ. 401 (1983).(go back)

7Richard Squire, Shareholder Opportunism in a World of Risky Debt, 123 Harv. L. Rev. 1151, 1182-1185 (2010)(go back)

8Ronald J. Gilson & Jeffrey N. Gordon, The Agency Costs of Agency Capitalism, 113 Colum. L. Rev. 863, 874 (2013)(go back)

9See e.g., Donald Morgan, Judging the Risks of Banks: What Makes Banks Opaque, Federal Reserve Bank of New York Staff Report 98-04 (1998).(go back)

10Steve Schaefer, Five Biggest U.S. Banks Control Nearly Half Industry’s $15 Trillion in Assets, Forbes, Dec 3, 2014.(go back)

11Jose Azar, Martin C. Schmalz & Isabel Tecu, Jose Azar, Martin C. Schmalz & Isabel Tecu, Anti-Competitive Effects of Common Ownership, Ross School of Business Working Paper Number 1235 (July 2016), 1-4; Einer Elhauge, Horizontal Shareholding, 129 Harv. L. Rev. 1267(2016); Eric A. Posner, Fiona M. Scott Morton & E. Glen Weyl, A Proposal to Limit the Anti-Competitive Power of Institutional Investors, Antitrust L. J. 84 (forthcoming). For a critical perspective, Edward B. Rock & Daniel L. Rubinfeld, Defusing the Antitrust Threat to Institutional Investor Involvement in Corporate Governance, NYU Law and Economics Research Paper No. 17-05 (Mar. 2017); Matt Levine, Index-Fund Bans and Hedge-Fund Data, Bloomberg, https://www.bloomberg.com/view/articles/2016-11-22/index-fund-bans-and-hedge-fund-data.(go back)

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