Luca Enriques

Alessandro Romano

Thom Wetzer

University of Oxford and ECGI

Yale University

University of Oxford

Network-Sensitive Financial Regulation

05/08/2020

Shocks that hit part of the financial system, such as the subprime mortgage market in 2007, can propagate through a complex network of interconnections among financial and non-financial institutions. As the financial crisis of 2007-2009 has shown, the consequences for the entire economy of such systemic risk materializing can be catastrophic. Following the crisis, economists and policymakers have become increasingly aware that the structure of the financial system is a key determinant of systemic risk. A wide consensus now exists among them that network theory is the natural framework for studying systemic risk. Yet, most of the existing rules in financial regulation are still “atomistic,” in that they fail to incorporate the fact that each individual institution is part of a wider network. This article shows that policies building upon insights from network theory (network-sensitive policies) can address systemic risk more effectively than traditional atomistic policies, also in areas where an atomistic approach would seem natural, such as the corporate governance of systemically important financial institutions. In particular, we consider four prescriptions for the governance of systemically important institutions (one on directors’ liability, two on executive compensation and one on failing financial institutions’ shareholders appraisal rights in mergers) and show how making them network-sensitive would both increase their effectiveness in taming systemic risk and better calibrate their impact on individual institutions.

I. INTRODUCTION

In the wake of the 2007-09 financial crisis, economists and policymakers alike have become increasingly aware that the structure of the financial system is a key determinant of systemic risk. Shocks that hit part of the system, such as the subprime mortgage market in 2007, can propagate through a complex network of interconnections among financial and non-financial institutions and, ultimately, have a catastrophic impact on the entire economy. In the absence of this network, localized shocks hitting individual players or specific parts of a financial system would not propagate. To put it differently, systemic risk naturally presupposes the existence of a system, which consists of a network of interconnected actors. The resulting “[c]omplex links among financial market participants and institutions are a hallmark of the modern global financial system.” Given the importance of networks to understand the financial system and the systemic risk it generates, the use of network theory to inform financial regulatory policy would seem a natural approach. Yet, while leading researchers from many disciplines identify network theory as the natural framework for studying systemic risk,6 legal scholars have largely overlooked this perspective. More importantly, policymakers’ use of network theory insights to curb systemic risk has been patchy so far, despite the fact that, following the financial crisis, they have refocused their attention from regulations attempting to preserve the stability of individual banks (“microprudential” regulations or policies) to policies aimed at ensuring the stability of the system as a whole (“macroprudential” regulations or policies).

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