Bank Regulation: Will Regulators Catch Up with the Market?

Legislation on financial services modernization has taken on special urgency since the banking industry is transforming itself through mergers stretching across financial services and across countries. Phil Gramm (R-Tex.), the new chairman of the Senate Banking Committee, has made bank regulatory reform his "number-one priority." A review of historical and contemporary evidence shows how market forces can address concerns about consumer protection and the soundness of the financial system. The financial services modernization legislation thus should repeal the 1933 Glass-Steagall Act and reform the 1956 Bank Holding Company Act,allow banks to structure their new activities through operating subsidiaries or affiliates,reduce the "moral hazard" of federal deposit insurance by mimicking private bond covenants, andnot raise any new regulatory barriers

The Essential Role of Securities Regulation

This Article posits that the essential role of securities regulation is to create a competitive market for sophisticated professional investors and analysts (information traders). The Article advances two related theses-one descriptive and the other normative. Descriptively, the Article demonstrates that securities regulation is specifically designed to facilitate and protect the work of information traders. Securities regulation may be divided into three broad categories: (i) disclosure duties; (ii) restrictions on fraud and manipulation; and (iii) restrictions on insider trading-each of which contributes to the creation of a vibrant market for information traders. Disclosure duties reduce information traders\u27 costs of searching and gathering information. Restrictions on fraud and manipulation lower information traders\u27 cost of verifying the credibility of information, and thus enhance information traders\u27 ability to make accurate predictions. Finally, restrictions on insider trading protect information traders from competition from insiders that would undermine information traders\u27 ability to recoup their investment in information. Normatively, the Article shows that information traders can best underwrite efficient and liquid capital markets, and, hence, it is this group that securities regulation should strive to protect. Our account has important implications for several policy debates. First, our account supports the system of mandatory disclosure. We show that, although market forces may provide management with an adequate incentive to disclose at the initial public offering (IPO) stage, they cannot be relied on to effect optimal disclosure thereafter. Second, our analysis categorically rejects calls to limit disclosure duties to hard information and self-dealing by management. Third, our analysis supports the use of the fraud-on-the-market presumption in all fraud cases even when markets are inefficient. Fourth, our analysis suggests that in cases involving corporate misstatements, the appropriate standard of care should, in principle, be negligence, not fraud

The Essential Role of Securities Regulation

This Article posits that the essential role of securities regulation is to create a competitive market for sophisticated professional investors and analysts (information traders). The Article advances two related theses-one descriptive and the other normative. Descriptively, the Article demonstrates that securities regulation is specifically designed to facilitate and protect the work of information traders. Securities regulation may be divided into three broad categories: (i) disclosure duties; (ii) restrictions on fraud and manipulation; and (iii) restrictions on insider trading-each of which contributes to the creation of a vibrant market for information traders. Disclosure duties reduce information traders\u27 costs of searching and gathering information. Restrictions on fraud and manipulation lower information traders\u27 cost of verifying the credibility of information, and thus enhance information traders\u27 ability to make accurate predictions. Finally, restrictions on insider trading protect information traders from competition from insiders that would undermine information traders\u27 ability to recoup their investment in information. Normatively, the Article shows that information traders can best underwrite efficient and liquid capital markets, and, hence, it is this group that securities regulation should strive to protect. Our account has important implications for several policy debates. First, our account supports the system of mandatory disclosure. We show that, although market forces may provide management with an adequate incentive to disclose at the initial public offering (IPO) stage, they cannot be relied on to effect optimal disclosure thereafter. Second, our analysis categorically rejects calls to limit disclosure duties to hard information and self-dealing by management. Third, our analysis supports the use of the fraud-on-the-market presumption in all fraud cases even when markets are inefficient. Fourth, our analysis suggests that in cases involving corporate misstatements, the appropriate standard of care should, in principle, be negligence, not fraud

Bank Recapitalizations: A Comparative Perspective

We have been here before. No matter how different the latest financial frenzy or crisis always appears, there are usually remarkable similarities with past experience from other countries and from history

Crisis Governance in the Administrative State: 9/11 and the Financial Meltdown of 2008

This essay compares crisis governance and emergency lawmaking after 9/11 and the financial meltdown of 2008. We argue that the two episodes were broadly similar in outline, but importantly different in detail, and we attempt to explain both the similarities and differences. First, broad political processes and constraints operated in both episodes to create a similar pattern of crisis governance, in which Congress delegated large new powers to the executive. We argue that this pattern is best explained by reference to the account of lawmaking in the administrative state offered by Carl Schmitt, as opposed to the standard Madisonian view. Second, within the broad constraints of crisis politics, the Bush administration asserted its authority more aggressively after 9/11 than in the financial crisis. Rejecting competing explanations based on legal differences, the nature of the threat, or other factors, we attribute the difference to the Bush administration's loss of popularity and credibility over the period between 2001 and 2008 and to the more salient and divisive distributive effects of financial management

Why Supervise Banks? The Foundations of the American Monetary Settlement

Administrative agencies are generally designed to operate at arm’s length, making rules and adjudicating cases. But the banking agencies are different: they are designed to supervise. They work cooperatively with banks and their remedial powers are so extensive they rarely use them. Oversight proceeds through informal, confidential dialogue. Today, supervision is under threat: banks oppose it, the banking agencies restrict it, and scholars misconstrue it. Recently, the critique has turned legal. Supervision’s skeptics draw on a uniform, flattened view of administrative law to argue that supervision is inconsistent with norms of due process and transparency. These arguments erode the intellectual and political foundations of supervision. They also obscure its distinguished past and deny its continued necessity. This Article rescues supervision and recovers its historical pedigree. It argues that our current understanding of supervision is both historically and conceptually blinkered. Understanding supervision requires understanding the theory of banking motivating it and revealing the broader institutional order that depends on it. This Article terms that order the “American Monetary Settlement” (“AMS”). The AMS is designed to solve an extremely difficult governance problem—creating an elastic money supply. It uses specially chartered banks to create money and supervisors to act as outsourcers, overseeing the managers who operate banks. Supervision is now under increasing pressure due to fundamental changes in the political economy of finance. Beginning in the 1950s, the government started to allow nonbanks to expand the money supply, devaluing the banking franchise. Then, the government weakened the link between supervision and money creation by permitting banks to engage in unrelated business activities. This transformation undermined the normative foundations of supervisory governance, fueling today’s desupervisory movement. Desupervision, in turn, cedes public power to private actors and risks endemic economic instability

Split Derivatives: Inside the World\u27s Most Misunderstood Contract

Derivatives are the bad boys of modern finance: exciting, dangerous, and fundamentally misunderstood. These misunderstandings stem from the failure of scholars and policymakers to fully appreciate the unique legal and economic structure of derivative contracts, along with the important differences between these contracts and conventional equity and debt securities. This Article seeks to correct these misunderstandings by splitting derivative contracts open, identifying their constituent elements, and observing how these elements interact with one another. These elements include some of the world\u27s most sophisticated state-contingent contracting, the allocation of property and decision-making rights, and relational mechanisms such as reputation and the expectation of future dealings. The resulting hybridity essentially splits every derivative into two separate contracts: one that governs under normal market conditions, and another that governs under conditions of fundamental uncertainty. In good times, derivative contracts contemplate the almost automatic determination and performance of each counterparty\u27s obligations. In bad times, these contracts include various mechanisms designed to provide counterparties with the flexibility to incorporate new information, fill contractual gaps, and promote efficient renegotiation. The process of splitting derivative contracts open yields a number of important policy insights. First, the bundling of contract, property, decision-making rights, and relational mechanisms makes derivatives look far more like commercial loans than publicly traded shares or bonds. The regulatory treatment of derivatives as securities and the resulting emphasis on market transparency is thus somewhat misguided and serves to distract attention from the significant prudential risks posed by the widespread use of derivatives. Second, the flexibility associated with the relational mechanisms embedded within many derivative contracts can play a useful role in promoting both institutional and broader financial stability. This has important implications in terms of the desirability of the recent push toward mandatory central clearing of derivative contracts. It also exposes the potential perils of recent proposals to use distributed ledger technology and smart contracts to execute, clear, and settle these contracts. By the same token, the widespread breakdown of these relational mechanisms can be a source of financial instability. This provides a compelling rationale for authorizing central banks to act as dealers of last resort during periods of fundamental uncertainty

Split Derivatives: Inside the World\u27s Most Misunderstood Contract

Derivatives are the “bad boys” of modern finance: exciting, dangerous, and fundamentally misunderstood. These misunderstandings stem from the failure of scholars and policymakers to fully appreciate the unique legal and economic structure of derivative contracts, along with the important differences between these contracts and conventional equity and debt securities. This Article seeks to correct these misunderstandings by splitting derivative contracts open, identifying their constituent elements, and observing how these elements interact with one another. These elements include some of the world’s most sophisticated state-contingent contracting, the allocation of property and decision-making rights, and relational mechanisms such as reputation and the expectation of future dealings. The resulting hybridity essentially splits every derivative into two separate contracts: one that governs under normal market conditions, and another that governs under conditions of fundamental uncertainty. In good times, derivative contracts contemplate the almost automatic determination and performance of each counterparty’s obligations. In bad times, these contracts include various mechanisms designed to provide counterparties with the flexibility to incorporate new information, fill contractual gaps, and promote efficient renegotiation. The process of splitting derivative contracts open yields a number of important policy insights. First, the bundling of contract, property, decision-making rights, and relational mechanisms makes derivatives look far more like commercial loans than publicly traded shares or bonds. The regulatory treatment of derivatives as “securities”—and the resulting emphasis on market transparency—is thus somewhat misguided and serves to distract attention from the significant prudential risks posed by the widespread use of derivatives. Second, the flexibility associated with the relational mechanisms embedded within many derivative contracts can play a useful role in promoting both institutional and broader financial stability. This has important implications in terms of the desirability of the recent push toward mandatory central clearing of derivative contracts. It also exposes the potential perils of recent proposals to use distributed ledger technology and smart contracts to execute, clear, and settle these contracts. By the same token, the widespread breakdown of these relational mechanisms can be a source of financial instability. This provides a compelling rationale for authorizing central banks to act as “dealers of last resort” during periods of fundamental uncertainty