Complexity, Innovation, and the Regulation of Modern Financial Markets
The intellectual origins of the global financial crisis (GFC) can be traced back to blind spots emanating from within conventional financial theory. These blind spots are distorted reflections of the perfect market assumptions underpinning the canonical theories of financial economics: modern portfolio theory, the Modigliani and Miller capital structure irrelevancy principle, the capital asset pricing model and, perhaps most importantly, the efficient market hypothesis. In the decades leading up to the GFC, these assumptions were transformed from empirically (con)testable propositions into the central articles of faith of the ideology of modern finance: the foundations of a widely held belief in the self-correcting nature of markets and their consequent optimality as mechanisms for the allocation of society’s resources. This ideology, in turn, exerted a profound influence on how we regulate financial markets and institutions. The GFC has exposed the folly of this market fundamentalism as a driver of public policy. It has also exposed conventional financial theory as fundamentally incomplete. Perhaps most glaringly, conventional financial theory failed to adequately account for the complexity of modern financial markets and the nature and pace of financial innovation. Utilizing three case studies drawn from the world of over-the-counter (OTC) derivatives—securitization, synthetic exchange-traded funds and collateral swaps—the objective of this paper is thus to start us down the path toward a more robust understanding of complexity, financial innovation, and the regulatory challenges flowing from the interaction of these powerful market dynamics. This paper argues that while the embryonic post-crisis regulatory regimes governing OTC derivatives markets in the U.S. and Europe go some distance toward addressing the regulatory challenges stemming from complexity, they effectively disregard those generated by financial innovation.
Managing Disputes Through Contract: Evidence from M&A
An important set of contract terms manages potential disputes. In a detailed, hand-coded sample of mergers and acquisition (M&A) contracts from 2007 and 2008, dispute management provisions correlate strongly with target ownership, state of incorporation, and industry, and with the experience of the parties’ law firms. For Delaware, there is good and bad news. Delaware dominates choice for forum, whereas outside of Delaware, publicly held targets’ states of incorporation are no more likely to be designated for forum than any other court. However, Delaware’s dominance is limited to deals for publicly held targets incorporated in Delaware, Delaware courts are chosen only 20% of the time in deals for private targets incorporated in Delaware, and they are never chosen for private targets incorporated elsewhere, or in asset purchases. A forum goes unspecified in deals involving less experienced law firms. Whole contract arbitration is limited to private targets, is absent only in the largest deals, and is more common in cross-border deals. More focused arbitration––covering price-adjustment clauses––is common even in the largest private target bids. Specific performance clauses––prominently featured in recent high-profile M&A litigation––are less common when inexperienced M&A lawyers involved. These findings suggest (a) Delaware courts’ strengths are unique in, but limited to, corporate law, even in the “corporate” context of M&A contracts; (b) the use of arbitration turns as much on the value of appeals, trust in courts, and value-at-risk as litigation costs; and (c) the quality of lawyering varies significantly, even on the most “legal” aspects of an M&A contract.
Dynamic Resolution of Large Financial Institutions
One of the more important issues emerging out of the 2008 financial crisis concerns the proper resolution of a systemically important financial institution. In response to this, Title II of Dodd-Frank created the Orderly Liquidation Authority, or OLA, which is designed to create a resolution framework for systemically important financial institutions that is based on the resolution authority that the FDIC has held over commercial bank failures. In this Article, we consider the various alternatives for resolving systemically important institutions. Among these alternatives, we discuss OLA, a European-style bail-in process, and coerced mergers, while also extensively focusing on the bankruptcy code. We argue that implementing several discrete modifications to Dodd-Frank, as well adopting an ambitious Chapter 14 proposal written by a working group at the Hoover Institution is the best way forward for establishing a strong resolution framework.
Complexity, Complicity, and Liability up the Securitization Food Chain: Investor and Arranger Exposure to Consumer Claims
The financial crisis has revealed the complexity of mortgage financing. In a matter of a few years, a multitude of actors have replaced loan officers at local banks. Now, brokers, lenders, and Wall Street arrangers mediate between borrowers and investors. Most home loans are owned by securitization trusts and investors receive a stream of income from loan payments. The law, which was designed for more deliberative and less complex transactions, did not change with the new structures. Old laws and complex, innovative finance do not make good partners, particularly in the area of consumer law. Today, tremendous uncertainty exists about the extent to which consumers might have claims against arrangers and investment trusts based on misdeeds at the origination of their loans. For financial services firms, the uncertainty impedes their ability to calculate potential legal liabilities, which in turn makes it difficult to accurately price credit and securities backed by loans. Regulators, who are charged with assuring the safety and soundness of banks and thrifts, likewise, cannot readily determine the dent consumer claims might make in banks’ balance sheets.
The laws governing consumer lending were a challenge to parse even before home loan financing moved from Main Street to Wall Street. Credit raters, lawyers, and others issued countless reports and white papers during the subprime boom speculating about consumer claims and who might be liable for what types of wrongdoing. Those questions were never resolved, and there was little incentive to resolve them. Originators, servicers, arrangers, and investors were all making substantial short-term profits. Borrowers in default rarely brought claims against anyone in the securitization chain because it was easier and far less expensive to refinance than find and engage an attorney to determine the existence of claims and pursue them against defendants with much deeper pockets. But this situation has changed: the availability of mortgage credit has fallen sharply, borrowers are challenging foreclosures in court, and borrowers and states are bringing actions against parties in the securitization chain based on alleged unlawful origination practices. This paper is the first to assess consumer claims against arrangers and investment trusts since the securitization of home loans took off and Wall Street firms became key players in the housing market. Our analysis is critical because the government is embarking on plans for a new system for housing finance, which we contend must clarify the liability of participants in the securitization food chain so that the market can accurately price securities and loans up-front.Equally important, we need better incentives to discourage unfair and risky lending. We contend that enabling borrowers to pursue claims against all the entities responsible for making and financing unlawful loans is a solution that would both provide relief to borrowers and encourage the creation of effective compliance programs.
The Need for Special Resolution Regimes for Financial Institutions—The Case of the European Union
The global financial crisis has demonstrated weaknesses in resolution regimes for financial institutions around the globe, including in the European Union (EU). This paper considers the principles underlying resolution regimes for financial institutions, and draws out how a well-designed resolution regime can expand the toolset available for crisis management. Introducing, or in some cases expanding the scope, of these regimes is pressing to achieve more effective responses to ongoing financial sector weaknesses across the EU.
Quixotic Regulation: Section 23A of the Federal Reserve Act and Containment of the Federal Safety Net Subsidy
Section 23A of the Federal Reserve Act imposes quantitative and qualitative limits on certain transactions between depository institutions and their non-depository affiliates. The Board of Governors of the Federal Reserve states that a purpose of Section 23A, along with Section 23B of the Federal Reserve Act, which mandates that depositories conduct affiliate transactions on arm’s length terms, is to prevent any subsidy given to depositories by the federal safety net from leaking to their non-depository affiliates. Yet Section 23A does not stop subsidy from leaking to non-depository affiliates through mispriced transactions; Section 23B does this by mandating that depositories receive adequate compensation in affiliate transactions. Most importantly, neither Section 23A nor Section 23B can prevent subsidy from leaking through dividend transactions to non-depository affiliates or to shareholders. Thus, in this Note, I question the usefulness of restrictions on affiliate transactions and of restrictions on affiliations generally, concluding that the goal of containing subsidy should take a backseat to the goal of preventing subsidy from accruing to depository institutions in the first place.