Schwarcz, Steven L.

English

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The Governance Structure of Shadow Banking

Duke Law Scholarship Repository

Tags: Banks, Capital markets, Financial institutions, Liability standards, Moral hazard, Shadow banking, SystemicriskMore from: Steven SchwarczEditor's Note: Steven L. Schwarcz is the Stanley A. Star Professor of Law & Business at Duke University School ofLaw.In prior articles (see, e.g., Regulating Shadows: Financial Regulation and Responsibility Failure, 70 Wash. & Lee L.Rev. 1781 (2013)), I have argued that shadow banking is so radically transforming finance that regulatory scholars needto rethink certain of  their  basic  assumptions.  In a forthcoming new article,  The Governance Structure  of  ShadowBanking: Rethinking Assumptions About Limited Liability, I argue that the governance structure of shadow bankingshould be redesigned to make certain investors financially responsible, by reason of their ownership interests, for theirfirm’s liabilities beyond the capital  they have invested. This argument challenges the longstanding assumption of theoptimality of limited liability.This article starts with a short history of how corporate limited liability became the norm and an overview of the generalacademic debate on whether it should be the norm. Historically, the legislative trend towards limited liability was heavilyinfluenced by corporate lobbying. In the United States, that trend was further influenced by fear of capital flight to otherstates. The judicial progression towards limited liability also had a “fairness” rationale: to protect innocent shareholderswho are not in a “capacity to control” or influence management decisions.The academic debate over limited liability recognizes that limited liability can create moral hazard, leading to excessivecorporate  risk-taking,  but  that  limited  liability  also  encourages  equity-capital  investment  by  addressing  investor  riskaversion. Empirically, scholars are uncertain how those factors should be balanced.My article examines limited liability in the shadow-banking context. Although limited liability has always been a potentialsource of moral hazard and externalities, I find that it is a uniquely fertile source of externalities for shadow-banking firms.That’s  because  shadow banking  is  more  likely  to  have  systemic  consequences.  Decentralization,  for  example,  canmotivate managers of limited liability shadow-banking firms to take greater risks than managers of other limited liabilityfirms. The relatively small firms, such as hedge funds, that operate in the shadow-banking system are often manageddirectly by their primary investors. Because such investor-managers typically are entitled to a significant share of theirfirm’s profits, they have strong incentives to take risks that could generate outsized profits. Yet if a risky action exposestheir firm to significant liability for externalized harm, limited liability protects those investor-managers from losing morethan their invested capital.This is radically unlike the management incentives in non-shadow banking firms, in which senior managers tend to shareonly indirectly in profits, such as through stock options. Furthermore, managers of non-shadow banking firms are oftenmore invested in maintaining their jobs and thus less motivated to take actions that risk the firm.The consequences of a shadow-banking firm’s failure are also more likely to be systemic than the consequences of anordinary firm’s failure. Like traditional banks, shadow-banking firms engage in financial intermediation on which the realeconomy is dependent. Because all financial intermediaries—including shadow-banking firms and traditional banks—tendto be highly interconnected, the failure of a shadow-banking firm could trigger the failures of other financial intermediaries.Such a chain of failures would be the epitome of a systemic event, especially if it materially reduced the availability offinancial  intermediation.  Additionally,  shadow banking’s  reliance on short-term funding of  long-term projects  not  onlyPosted by Steven L. Schwarcz, Duke University, on Thursday, February 6, 2014The Governance Structure of Shadow Banking http://corpgov.law.harvard.edu/2014/02/06/the-governance-structure-of-...1 of 2 12/11/2015 4:17 PMincreases the likelihood of a shadow-banking firm’s failure but also can increase the systemic consequences of  thatfailure. Economists have identified the failure of shadow-banking firms to roll over short-term debt as a contributing factorto the recent financial crisis.I also argue that tort law, the traditional legal mechanism for internalizing externalities, is not as effective in the shadow-banking context. To win a tort lawsuit, injured third parties normally must show their harm to be a causal and foreseeableconsequence of the firm’s actions. Third parties injured by systemic harm caused by the firm’s actions would be unlikely tobe able to show that, however. Systemic harm can affect a wide range of third parties in unpredictable ways, such as anindividual who is forced to close her family-owned restaurant during a systemically caused recession. Nor is it likely thatchanging the causation-and-foreseeability standard to enable third parties to win those lawsuits would be an efficientsolution. At the very least, courts would face a line-drawing problem and would be forced to make complicated decisionsas to what systemic externalities should (or should not) be considered compensable.Finally, I examine whether and how limited liability should be redesigned, taking into account the traditional justificationsfor limited liability. Among other things, I argue that any such redesign should ensure that any given investor’s liabilitywould be independent of the liability of other investors. Such an independent-liability redesign might, for example, includedouble liability. He also argues that imposing additional liability only on investor-managers—and perhaps only on investor-managers with the power to “control” the firm—should be more consistent with the traditional fairness justification.Regardless of how limited liability is redesigned, it still faces the dilemma that investor-managers would have relativelylittle incentive to monitor and guard against their firm’s potential to trigger systemic risk if tort law bars third parties injuredby systemic harm from recovering damages therefor. A possible solution to this dilemma would be to couple any increasein  limited liability  with  a  privatized systemic  risk  fund—which would  be  used to  mitigate  systemic harm—into  whichsystemically risky shadow-banking firms would be required to contribute. Privatizing the funding would help to reduce ashadow-banking firm’s incentive to create systemic externalities by engaging in financially risky activities; indeed, thelikelihood that firms will have to make additional contributions to the fund to replenish bailout monies should motivate themto monitor each other and help control each other’s risky behavior. Making investor-managers personally liable for all or aportion of their firm’s insufficient capital to make initial or additional fund contributions would likewise motivate them tomonitor and help control their firm’s systemically risky behavior.The full article is available for download here.The Governance Structure of Shadow Banking http://corpgov.law.harvard.edu/2014/02/06/the-governance-structure-of-...2 of 2 12/11/2015 4:17 PM

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The Governance Structure of Shadow Banking

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