Size Matters: Commercial Banks and the Capital Markets

The conventional story is that the Gramm-Leach-Bliley Act broke down the Glass-Steagall Act’s wall separating commercial and investment banking in 1999, increasing risky business activities by commercial banks and precipitating the 2007 financial crisis. But the conventional story is only one-half complete. What it omits is the effect of change in commercial bank regulation on financial firms other than the commercial banks. After all, it was the failure of Lehman Brothers — an investment bank, not a commercial bank — that sparked the meltdown. This Article provides the rest of the story. The basic premise is straightforward: By 1999, the Glass-Steagall Act’s original purpose — to protect commercial banks from the capital markets — had reversed. Instead, its main function had become protecting the capital markets from new competition by commercial banks. Once the wall came down, commercial banks gained a sizeable share of the investment banking business. To offset lost revenues, investment banks pursued riskier businesses, growing their principal investments and increasing the amounts they borrowed to finance them. In effect, they assumed the features of commercial banks — a reliance on short-term borrowing to finance longer-term (and riskier) investments. For the investment banks, combining the two was lethal and eventually triggered the financial meltdown. The divide between two sets of regulators, those regulating commercial banks and those regulating investment banks, enabled the change. The need for greater regulatory coordination has grown with convergence in the financial markets. Although new regulation has addressed some of the concern, the gap between regulators continues today — raising the risk of repeating mistakes from the past. Acknowledging the role of bank regulation (and de-regulation) in reshaping the capital markets is a key step in the right direction

Creditors and Debt Governance

This chapter from the book Research Handbook on the Economics of Corporate Law (Claire Hill & Brett McDonnell, eds.), provides an introduction to the law and economic theory relating to creditors and debt governance. The chapter begins with a look at the traditional role of debt, focusing on the impact of debt on corporate governance and, in particular, the effect of an illiquid credit market on creditors’ reliance on covenants and monitoring. It then turns to changes in the private credit market and their effect on lending structure. Greater liquidity raises its own set of agency costs. In response, loans and lending relationships have adjusted to mitigate those costs, providing new means by which debt can influence corporate governance. Going forward, a firm’s decision to borrow must increasingly take account of the costs and benefits of a liquid credit market. How firms are governed is closely related to how they raise capital. Managers who maximize firm value can finance their business at lower cost than managers who pursue personal goals. Thus, actions that affect a firm’s credit quality are likely to be reflected in changes in the secondary price at which its loans and other credit instruments trade. Those changes, in turn, may affect a borrower’s cost of capital, providing managers with a real incentive to minimize risky behavior. The intuition, described at the end of the chapter, is that a liquid private credit market may begin to provide a discipline that complements the traditional protections of contract

The Goldilocks Approach: Financial Risk and Staged Regulation

Financial firms engage in a wide range of private conduct. New rules that address financial risk can regulate elements of that conduct but not all conduct or all the factors that affect conduct. There is, therefore, a real concern that new regulation will have unanticipated consequences, particularly in a system as complex as the financial markets. The result may be new risks or a shift in risk taking away from regulated conduct — responses that regulators can anticipate but may not be able to accurately predict or control. This Article cautions against the rush to adopt new financial risk regulation without first assessing its broader impact on risk taking. Attempting to do so with limited information may be difficult. For illustration, it touches on three areas where new regulation may result in new (or greater) risks: bank capital requirements, a financial transaction tax, and disclosure in the credit default swap market. A better approach may be to introduce new regulation in stages — what I refer to as the “Goldilocks approach.” Increasingly, regulators should be authorized to phase in or forego new regulation over time as it becomes clear, through experience, what the likely impact will be. At its heart, the Goldilocks approach relies on real options to develop new rules. Through staging, regulators can acquire additional information on the impact of new rules on conduct and, as necessary, adjust those rules to reflect any unanticipated consequences — perhaps a more effective approach to implementing regulation than efforts to finalize new rules from the outset

Reframing Financial Regulation

Financial regulation today is largely framed by traditional business categories. The financial markets, however, have begun to bypass those categories, principally over the last thirty years. Chief among the changes has been convergence in the products and services offered by traditional intermediaries and new market entrants, as well as a shift in capital-raising and risk-bearing from traditional intermediation to the capital markets. The result has been the reintroduction of old problems addressed by (but now beyond the reach of) current regulation, and the rise of new problems that reflect change in how capital and financial risk can now be managed and transferred. In this Article, I begin to assess the current U.S. approach to financial regulation, in light of recent changes in the financial system, and offer a tentative way forward to address gaps in proposals for regulatory reform. Regulators must focus on the principal problems that financial regulation is intended to address – relating to financial stability and risk-taking – without regard to fixed categories, intermediaries, business models, or functions. Doing so, however, requires a prospective assessment of the markets, a different approach from the reactive process that characterizes much of financial regulation today

Reframing Financial Regulation

Financial regulation today is largely framed by traditional business categories. The financial markets, however, have begun to bypass those categories, principally over the last thirty years. Chief among the changes has been convergence in the products and services offered by traditional intermediaries and new market entrants, as well as a shift in capital-raising and risk-bearing from traditional intermediation to the capital markets. The result has been the reintroduction of old problems addressed by (but now beyond the reach of) current regulation, and the rise of new problems that reflect change in how capital and financial risk can now be managed and transferred. In this Article, I begin to assess the current U.S. approach to financial regulation, in light of recent changes in the financial system, and offer a tentative way forward to address gaps in proposals for regulatory reform. Regulators must focus on the principal problems that financial regulation is intended to address – relating to financial stability and risk-taking – without regard to fixed categories, intermediaries, business models, or functions. Doing so, however, requires a prospective assessment of the markets, a different approach from the reactive process that characterizes much of financial regulation today

Sandbagging: Default Rules and Acquisition Agreements

In the M&A world, a buyer sandbags a seller when, knowing the seller has materially breached a warranty, it closes the deal and then asserts a post-closing claim. Traditionally, the buyer must have relied on the warranty, without knowledge of the breach, in order to prevail. The modern trend, with some exceptions, permits the buyer to sue without regard to knowledge. Parties, in both cases, can contract around the default rule--so that the default rule should affect how acquisition agreements are structured. Yet, a survey of publicly available deals, from July 2007 to June 2011, reveals that--regardless of default rule--roughly forty-five to fifty-five percent of contracts contain a pro-sandbagging provision,and roughly forty to fifty percent are silent. Why the similarity in contract provisions? First, the law around sandbagging is unsettled Buyers who particularly value a sandbagging right may develop standard solutions, relying on the certainty of express contractual language rather than the default rule. Second, under a pro-sandbagging standard, sellers have limited incentive to request an anti-sandbagging provision and buyers have limited incentive to agree to it. The compromise is often silence--with the right to sandbag set by the default rule rather than agreement. Thus, the claim that a buyer\u27s \u27purchase of warranties includes a sandbagging right, often used to justify a pro-sandbagging default rule, is open to question. In neither case does a pro-sandbagging default rule reflect a buyer\u27s interest in sandbagging. Rather, bargaining is more likely under an anti-sandbagging default rule, in which case those who particularly value a sandbagging right must expressly negotiate for it

Sandbagging: Default Rules and Acquisition Agreements

In the M&A world, a buyer sandbags a seller when, knowing the seller has materially breached a warranty, it closes the deal and then asserts a post-closing claim. Traditionally, the buyer must have relied on the warranty, without knowledge of the breach, in order to prevail. The modern trend, with some exceptions, permits the buyer to sue without regard to knowledge. Parties, in both cases, can contract around the default rule--so that the default rule should affect how acquisition agreements are structured. Yet, a survey of publicly available deals, from July 2007 to June 2011, reveals that--regardless of default rule--roughly forty-five to fifty-five percent of contracts contain a pro-sandbagging provision,and roughly forty to fifty percent are silent. Why the similarity in contract provisions? First, the law around sandbagging is unsettled Buyers who particularly value a sandbagging right may develop standard solutions, relying on the certainty of express contractual language rather than the default rule. Second, under a pro-sandbagging standard, sellers have limited incentive to request an anti-sandbagging provision and buyers have limited incentive to agree to it. The compromise is often silence--with the right to sandbag set by the default rule rather than agreement. Thus, the claim that a buyer\u27s \u27purchase of warranties includes a sandbagging right, often used to justify a pro-sandbagging default rule, is open to question. In neither case does a pro-sandbagging default rule reflect a buyer\u27s interest in sandbagging. Rather, bargaining is more likely under an anti-sandbagging default rule, in which case those who particularly value a sandbagging right must expressly negotiate for it