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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.
For almost every type of company, the United States has just one body of securities regulation. Pet stores, hospitals, for-profit universities, and iron mines all have to comply with the same securities laws in basically the same way. There is, however, one important exception: investment funds. Mutual funds, closed-end funds, exchange-traded funds, hedge funds, private equity funds, and venture capital funds have their own special body of securities regulation that applies in place of or in addition to the regular securities laws that apply to other types of companies. Why? This 7,000-word essay, prepared for publication in the Research Handbook of Mutual funds, contemplates a number of possible answers and concludes that the most distinctive and legally salient feature of an investment fund is its structure. Investment funds divide their assets from their managements in much more radical ways than other types of companies. The surprising implication is that for purposes of regulation, an investment fund’s investments are much less important than its pattern of organization.
This Article analyzes the functioning of the European regulatory approach to the crisis of credit institutions, in the framework of EU banking supervision and in light of its early applications, with a special focus on bail-in. We investigate how the new resolution mechanisms — rooted in the principle of private sector involvement in banking restructurings — have inter-played with legal and institutional contexts still characterized by an attitude to bail-out rescues and by non-harmonized national insolvency rules. We show how and well-experimented restructuring tools have influenced the application of the new ones and, in many cases, have emphasized the defects, pitfalls and inconsistencies of the new regime, suggesting paths for reform.
The Article is organized as follows. Part II sets out a summary of the common regime applicable to credit institutions within the EU, based on harmonized requirements for capital and liquidity. Part III focuses on the pre-crisis and crisis tools, as spelled out in the Bank Recovery and Resolution Directive (“BRRD”), in coordination with bordering regulatory areas, such as the regimes applicable to the liquidation of insolvent banks and State aids in the context of banking rescues.
After a brief comparison with the US system (Part IV), we dwell, in Part V, on the practice of restructurings, before and after the BRRD. We specifically discuss two cases (the resolution of Banco Popular Español and the liquidation of Italian “Banche Venete”) that, in our view, illustrate very well the pros and cons of the new regime. Part VI concludes offering some suggestions for possible reform.
The Data Standardization Challenge: Forthcoming in Systemic Risk in the Financial Sector : Ten Years After the Great Crash
Data standardization offers significant benefits for industry and regulators alike, suggesting that it should be easy. In practice, however, the process has been difficult and slow moving. Moving from an abstract incentive-based analysis to one focused on institutional detail reveals myriad frictions favoring the status quo despite foregone gains. This paper explores the benefits of and challenges confronting standardization, why it should be a top regulatory priority, and how to overcome some of the obstacles to implementation. The paper also uses data standardization as a lens into the challenges that impede optimal financial regulation. Alongside capture and other common explanations for regulatory failures, this paper suggests that coordination problems, delayed benefits, and other banal, but perhaps no less intractable, challenges are often the real impediments to better financial regulation.
This paper investigates what we can learn from the financial crisis about the link between accounting and financial stability. The picture that emerges ten years after the crisis is substantially different from the picture that dominated the accounting debate during and shortly after the crisis. Widespread claims about the role of fair-value (or mark-to-market) accounting in the crisis have been debunked.
However, we identify several other core issues for the link between accounting and financial stability. Our analysis suggests that, going into the financial crisis, banks’ disclosures about relevant risk exposures were relatively sparse. Such disclosures came later after major concerns about banks’ exposures had arisen in markets. Similarly, banks delayed the recognition of loan losses. Banks’ incentives seem to drive this evidence, suggesting that reporting discretion and enforcement deserve careful consideration. In addition, bank regulation through its interlinkage with financial accounting may have dampened banks’ incentives for corrective actions. Our analysis illustrates that a number of serious challenges remain if accounting and financial reporting are to contribute to financial stability.
In France, the regulation of related party transactions (RPTs) involves three steps following the notification to the board of an RPT. First, the board gives its prior authorisation to the transaction. Those who are self-interested do not take part in the vote. Secondly, auditors prepare a report on RPTs. Thirdly, a general meeting of shareholders approves or rejects it. If the shareholders do not endorse the transaction, any adverse consequences will be borne by the interested insiders. The RPT can only be avoided if it was not approved by the board and is harmful to the company. This longstanding procedure has been designed to prevent company officers and substantial shareholders from using their power to influence a contract with the company on terms less advantageous than those that the company would have obtained from a third party in a fair and balanced negotiation. This rather burdensome procedure often proved artificial and ineffective. Anti-tunnelling laws may have been unproductive because demand for them and shareholder protection more generally had traditionally been low in a culture where top management was a closed club. However, the addition of AMF recommendations in 2012 and legislative modifications in 2014 have increased the quality and quantity of information passed on to auditors and shareholders.
The implementation of the 2017 Directive on Shareholders’ Rights may be the occasion to introduce further useful adjustments, such as a legislative clarification of the scope of French RPT law.
The working hypothesis of international financial regulation is that it should be globally harmonized. This paper contends, to the contrary, that we should be wary about the efficacy of global harmonization, and in particular, harmonization of systemic risk measurement and regulation. The thesis is informed by what I consider two key lessons from the recent global financial crisis. The first lesson is that, when business strategies that internationally-harmonized regulation induces banks to follow go seriously awry, the adverse consequences will spread globally and not be limited to one regulator’s domain. The second lesson is that, innovations in financial technology that have been engines of prosperity across the globe also may contain the seeds of financial calamity with imprudent use and regulatory inattention. In addition, three kinds of uncertainty operate in this context: i) uncertainty regarding how best to define and measure systemic risk; (ii), dynamic uncertainty, that financial institutions respond to regulation in unpredictable ways that tend to undermine regulatory effectiveness; and (iii) radical uncertainty, that we do not know all possible future states of the financial system and therefore cannot compute the probabilities of outcomes that would be necessary for informing rules regarding systemic risk measures. The uncertainty in the regulatory context, in conjunction with the lessons from the crisis, suggest that a value-added international regulatory strategy would foster at least a modicum of diversity across national regulatory regimes, along with periodic updating of global standards. At the national level, they suggest adopting a dual-pronged regulatory approach that focuses regulators’ attention on monitoring developments in short-term debt markets, leverage levels, and the impact of new financial products and services, as well as on promoting experimentation, to better inform regulatory decisionmaking.
Price is expected cash flows discounted at the risk-free rate and a discount for risk exposure. Price-equivalency does not always imply welfare-equivalency: shareholders are not necessarily indifferent between a price increase of $1 from higher cash flows and the same $1 increase from lower risk exposure. Even in complete markets, if managers enjoy private benefits of control, the social planner may prefer lower risk exposure to a price-equivalent increase in firm value from greater investor protection.
This has implications for event studies, the tradeoff between principal costs and agency costs, and the link between macroeconomic risk and corporate governance.
The optimal response to a financial crisis entails addressing two, often conflicting, demands: stopping the panic and starting the clock.
When short-term depositors flee, banks can be forced to sell assets at fire-sale prices, causing credit to contract and real economic activity to decline. To reduce these adverse spillover effects, policymakers routinely intervene to stop systemic runs. All too often, however, policymakers deploy stopgap measures that allow the underlying problems to fester. To promote long-term economic health, they must also ferret out the underlying problems and allocate the losses that cannot be avoided. A well-designed guarantor of last resort can help address these conflicting demands. Just-in-time guarantees keep private capital in the system, providing policymakers the time that they need to develop a viable plan to address deficiencies. A strict time limit on those guarantees ensures that policymakers and market participants remain motivated to devise such a plan, avoiding the alternative pitfall of excessive forbearance.
The disclosure of inside information is a core component of EU capital market regulation. It underpins the market abuse regime, providing information to investors, and robbing it of its “inside” quality. Different regimes tackle the issue of inside information disclosure in distinct ways. The EU regime of continuous disclosure stands in sharp contrast to the approach adopted in the US and this paper considers the pros and cons of the EU’s approach. This paper argues that the EU provisions are preferable, and are more likely to promote market efficiency, but the EU regime also creates potential dangers and disadvantages for companies who are the subject of the disclosure obligations. Sufficient flexibility is therefore needed to capture the benefits of continuous disclosure without imposing undue burdens on issuers in the process.