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Pitfalls of Global Harmonization of Systemic Risk Regulation in a World of Financial Innovation

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.

What Can We Learn from Stock Prices ? Cash Flow, Risk and Shareholder Welfare

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.

Guarantor of Last Resort

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.

Disclosure of Inside Information

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.

Governance of Financial Services Outsourcing : Managing Misconduct and Third-Party Risks

With financial institutions increasingly outsourcing their activities, they face a record number of fraud and misconduct cases arising from third-party services. We survey financial institutions to better understand which governance mechanisms may improve the monitoring and management of third-party relationships. Overall, our results suggest that there are gaps in traditional governance arrangements.
We find that financial institutions rely mainly on internal monitoring to detect fraud and that whistleblowing plays an important role in mitigating misconduct risks.

Finally, we report evidence that vendor dependency and product complexity play a pronounced role in delaying termination of agreements.

‘Dynamic Precaution’ in Maintaining Financial Stability : The Importance of FSOC

The Financial Crisis of 2007-09 has shown that financial stability is the ultimate public good: all benefit from it, it is costly to maintain, and its undersupply results in catastrophe. The threat to financial stability comes along four different avenues: first, the effort by institutions within the financial stability regime to find loopholes and other sorts of regulatory arbitrage to avoid the regime’s costs; second, the effort by institutions outside of the regime to produce financial intermediation services that are the functional equivalent of within-the-regime firms; third, “innovation,” which includes the unexpected consequence of existing rules in new application; and fourth, macroeconomic forces that magnify the threat of financial instability. The forces, separately and in combination, can reshape the financial system; these forces can move a formerly stable system into one that is systemically susceptible to either an internal or external shock.

One very important lesson of the Financial Crisis is that the maintenance of financial stability is an on-going project that requires an approach of “Dynamic Precaution.” This requires an institution such as the Financial Stability Oversight Council to monitor the financial system as it evolves, to call attention to emerging risks to financial stability, and to catalyze the necessary regulatory intervention. In developing a case for Dynamic Precaution, this chapter explains first, why financial institutions need to remain as the focus of the FSOC regime even while observation and regulation aimed at activities is also important; second, how FSOC can serve Dynamic Precaution by using its designation authority to negotiate “off ramps” from enhanced oversight for firms whose instability or failure would otherwise have systemic implications; and third, if the maintenance of financial stability is the apex goal, why cost-benefit analysis can play only a limited role in financial regulation.

Related Party Transactions in Insolvency

Transaction avoidance rules are widely considered to be an important tool for the regulation of related party transactions in insolvency. Existing ‘best practice’ guidance on the design of insolvency laws assumes that such avoidance rules are best operationalised within collective insolvency procedures. But in many jurisdictions the commencement of collective insolvency proceedings is value destructive; so much so that creditors may prefer to see firms fail outside such proceedings, even if this means foregoing opportunities to use the avoidance tools available within them. This suggests that avoidance tools may be most powerful when available outside insolvency proceedings as well as within them.

Many jurisdictions do have some such form of avoidance action, often described as the ‘actio Pauliana outside bankruptcy’, on their statute books. But these forms of action have been neglected in the literature on the control of related party transactions in insolvency, and, perhaps as a consequence, have not benefited from international initiatives to improve the operation of domestic insolvency rules in cross-border cases in the same way that transaction avoidance actions brought in connection with collective insolvency proceedings have benefited. The chapter begins by evaluating the case for approaching transaction avoidance within insolvency proceedings, before turning to consider aspects of the design of the ‘actio Pauliana outside bankruptcy’, including measures to improve its efficacy in cross-border cases.

Stock Market Short-Termism’s Impact

Stock-market-driven short-termism is crippling the American economy, according to legal, judicial, and media analyses. Firms forgo the R&D they need, cut capital spending, and buy back their own stock so feverishly that they starve themselves of cash. The stock market is the primary cause: directors and executives cannot manage for the long-term when their shareholders furiously trade their company’s stock, they cannot make long-term investments when stockholders demand to see profits on this quarter’s financial statements, they cannot even strategize about the long-term when shareholder activists demand immediate results, and they cannot keep the cash to invest in their future when stock market pressure drains away that cash in stock buybacks. This doomsday version of the stock-market-driven short-termism argument entails economy-wide predictions that have not been wellexamined for their severity and accuracy. If the scenario is correct and strong, we should first see sharp increases in stock trading in recent decades and more frequent activist interventions, and these increases should be accompanied by (1) sharply declining investment spending in the United States, where large firms depend on stock markets and where activists are important, as compared to advanced economies that do not depend as much on stock markets, (2) buybacks bleeding cash out from the corporate sector, (3) economy-wide R&D spending declining from what it should be, and (4) a stock market unwilling to support innovative, long-term, technological firms. These are the central channels from stock market-driven shorttermism to overall economic degradation. They justify corporate law policies that seek to prevent these outcomes. But these predicted economy-wide outcomes are either undemonstrated, implausible, or untrue. Corporate R&D is not declining, corporate cash is not bleeding out, and the world’s developed nations with neither American-style quarterly oriented stock markets nor aggressive activist investors are investing no more in capital equipment than the United States. The five largest American firms by stock market capitalization are tech-oriented, R&D intensive, longer-term operations. The economy-wide picture is more one of capital markets moving capital from larger, older firms to younger ones; of a post-industrial economy doing more R&D than ever; and of an economy whose investment intensity depends on overall economic activity, not stock market trading nor hedge fund activism.
True, the economy-wide data could hide stock-market hits that hold back R&D from increasing more and that weaken American capital spending more than is fitting for a post-industrial economy. But if so, these have not been shown and several seem implausible. Hence, the calamitous form of the stock-market-driven short-termist argument needs to be reconsidered, recalibrated, and, quite plausibly, rejected.

Then, last, comes the broadest question: why has a view that lacks strong economywide evidentiary support become the rare corporate governance issues that attracts attention from the media, political players, policymakers, and the public — and that is widely accepted as true? I suggest why in this paper’s final part.

Informed trading and cybersecurity breaches

Cybersecurity has become a significant concern in corporate and commercial settings, and for good reason: a threatened or realized cybersecurity breach can materially affect firm value for capital investors. This paper explores whether market arbitrageurs appear systematically to exploit advance knowledge of such vulnerabilities. We make use of a novel data set tracking cybersecurity breach announcements among public companies to study trading patterns in the derivatives market preceding the announcement of a breach. Using a matched sample of unaffected control firms, we find significant trading abnormalities for hacked targets, measured in terms of both open interest and volume. Our results are robust to several alternative matching techniques, as well as to both cross-sectional and longitudinal identification strategies. All told, our findings appear strongly consistent with the proposition that arbitrageurs can and do obtain early notice of impending breach disclosures, and that they are able to profit from such information. Normatively, we argue that the efficiency implications of cybersecurity trading are distinct—and generally more concerning—than those posed by garden-variety information trading within securities markets. Notwithstanding these idiosyncratic concerns, however, both securities fraud and computer fraud in their current form appear poorly adapted to address such concerns, and both would require nontrivial re-imagining to meet the challenge (even approximately).

Evaluating Stock-Trading Practices and Their Regulation

The social benefits of more accurate stock prices—that is, stock-market prices that more accurately reflect the future cash flows that companies are likely to produce—are well established. But it is also thought that market forces alone will lead to only a sub-optimal level of stock-price accuracy—a level that fails to obtain the maximum net social benefits, or wealth, that would result from a higher level. One of the principal aims of federal securities law has therefore been to increase the extent to which the stock prices of the most important companies in our economy (public companies) contain information about firms’ prospects so that society generates more wealth. Indeed, enhancing the accuracy of these prices in this way is perhaps the primary justification for the corporate disclosure, fraud, and insider-trading rules that make up the traditional core of federal securities law. Yet, important price-accuracy effects of a distinct area of the field (the law governing the market in which stocks are traded) have been overlooked.

This Article theorizes that a set of central, yet little-noticed, stock-market rules is resulting in society producing a lower level of stock-price accuracy than it otherwise might. The Article therefore provides examples of ways in which the laws governing stock trading can be altered to increase stock-price accuracy. And it urges regulators to consider whether such alternations might be socially desirable in one of two ways: by enhancing the current level of stock-price accuracy in a manner that results in net social benefits, or by providing society with a lower-cost means than those associated with existing disclosure, fraud, and insider-trading laws for obtaining that current level. Accordingly, the Article theorizes that regulators have a fourth main securities-law tool (stock-market law) for increasing the accuracy of public companies’ stock prices, and sets forth a cost-benefit framework to help them determine whether it can be used to achieve one of the chief goals of securities law: obtaining a socially optimal level of stock-price accuracy.


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