In September 2008, the U.S. Securities and Exchange Commission (SEC) temporarily banned most short sales in nearly 1,000 financial stocks. In our paper, Shackling Short Sellers: The 2008 Shorting Ban, forthcoming in the Review of Financial Studies, we examine the ban’s effect on market quality, shorting activity, the aggressiveness of short sellers, and stock prices. For the most part, financial economists consider short sellers to be the “good guys,” unearthing overvalued companies and contributing to efficient stock prices. Even as late as the summer of 2007, regulators in the United States seemed to share this view, as they made life easier for short sellers by repealing the New York Stock Exchange’s (NYSE’s) uptick rule and other short-sale price tests that had impeded shorting activity since the Great Depression (see Boehmer, Jones, and Zhang (2009) for an analysis of this event). However, short sellers are often the scapegoats when share prices fall sharply, and regulators in the United States did a sharp U-turn in 2008, imposing tight new restrictions on short sellers as the financial crisis worsened. In September 2008, the U.S. Securities and Exchange Commission (SEC) surprised the investment community by adopting an emergency order that temporarily banned most short sales in nearly 1,000 financial stocks. In this paper, we study changes in various liquidity measures, the rate of short sales, the aggressiveness of short sellers, and in stock prices before, during, and after the shorting ban. We compare banned stocks to a control group of nonbanned stocks to identify these effects.

…continue reading: Shackling Short Sellers: The 2008 Shorting Ban

Do firm boundaries mediate the effect of shocks to the financial intermediation sector? When the functioning of the intermediation sector is impaired – as was the case in the recent financial crisis – shocks can be transmitted to the broader economy since funds may not flow to highest value use without incurring significant cost. This issue has been extensively explored in the credit channel literature (e.g., Kashyap and Stein [2000]; Bernanke and Blinder [1988; 1992], and Bernanke and Gertler [1995]). However, unlike what is assumed in this literature, firms may be able to reallocate resources internally – for instance, between divisions in different industries – to ameliorate the effect of financial shocks. If so, external credit market conditions will impact the nature of resource allocation inside firms and between industries differently than they would in an economy with no internal capital markets. Diversified firms constitute a large part of economies around the world; therefore, resource allocation within firms can be of significant importance. In this paper we propose that firms shift resources between industries in response to shocks to the financial sector. We estimate a structural model to quantify the forces driving this reallocation decision, and show that these forces dampen shocks to the financial sector in economically significant ways.

…continue reading: Resource Allocation within Firms and Financial Market Dislocation

Some 5 ½ years out from the Autumn 2008 Lehman Brothers collapse, the massive effort by the world’s leading economies to reset the regulation of the financial system is now entering its final stages. The momentum for reform remains strong, particularly with respect to shadow banking. But the main elements of the 2008-2009 G20 regulatory agenda are now in place. In the EU, for example, recent weeks have seen agreement on the Capital Requirements Directive IV, which implements the Basel III agreement and is one of the final elements of the EU’s crisis-era reform programme. Internationally, the regulatory perimeter has extended significantly, new regulatory tools and styles have been developed, and institutional structures have been reformed and replaced. The critical implementation phase is now well underway; the new EU regime has rapidly been intensified by a host of implementing rules; the behemoth US Dodd Frank Act is being subject to similar intensification. The review process is already gathering stream; the EU’s crisis-era short selling regime and its new institutional structure for financial system supervision are both to be reviewed over 2013. It is time to take stock.

In our new book, The Regulatory Aftermath of the Global Financial Crisis we (Eilís Ferran, Niamh Moloney, Jennifer Hill, and John C. Coffee Jr.) examine the forces which have shaped the international regulatory reform process and consider the likely legacy effects of the crisis-era. The book adopts a comparative approach. It examines in detail how the EU and the US – two major world economies heavily affected by the financial crisis – responded to the crisis. But it also considers the Australian experience and probes why the Australian regulatory system and economy proved resilient over the financial crisis and the reforms which it has, nonetheless, experienced. Comparison of these three major economies and how they performed over a period of extreme stress tells us much about the complex regulatory, political and economic ecosystems of which financial markets are a part.

…continue reading: The Regulatory Aftermath of the Global Financial Crisis

Mammoth bank holding companies (BHCs) have contributed to the 2008 crisis. Their “contribution” may stem from their structure.

Most BHCs are not banks but “financial malls,” of “shops” serving as brokers-dealers, underwriters, advisers (to mutual funds, trust funds, and wealthy individuals), banks proper, insurance, lending, “securitizers,” guarantors and traders for the BHCs’ own account, and more. A BHC owns the mall’s financial shops, collects their revenues, and raises funds from investors. Its management finances the shops and rewards shop managers. Managing the variety of shops that closely reflect the entire financial system is difficult. Not surprisingly, BHCs periodically produce enormous profits and bear enormous losses.

Compare BHCs structure to other malls: In business malls, mall owners serve all the shops’ needs. But these shops (pharmacies or restaurants) have different owners, customers, and regulators. Mutual fund “malls” are serviced by one adviser but owned by investors. Displeased investors can decimate their funds by redeeming their shares. Under the structure of Vanguard, the largest in the United States today, the shops—the funds (their investors) own the mall, and pay for its services. As to performance, each fund “sits on its own bottom,” judged by its shareholders, rather than by a management or a holding company’s shareholders. Yet, a fund’s failure does not shake the economy and taxpayers do not bear the cost.

The BHC structural model raises serious disadvantages for their investors, and for the financial system, against which current regulation does not effectively protect:

…continue reading: Dismantling Large Bank Holding Companies

Since the mid-1990s, and particularly since the global financial dramas of 2008-09, authorities on financial regulation have come increasingly to counsel the inclusion of macroprudential policy instruments in the standard ‘toolkit’ of finance-regulatory measures employed by financial regulators. The hallmark of this perspective is its focus not simply on the safety and soundness of individual financial institutions, as is characteristic of the traditional microprudential perspective, but also on certain structural features of financial systems that can imperil such systems as wholes. Systemic ‘financial stability’ thus comes to supplement, though not to supplant, institutional ‘safety and soundness’ as a regulatory desideratum.

Evidence of this shift from a once primarily microprudential to a now macroprudential-inclusive focus in financial oversight can be found not only in a wealth of scholarly and policy papers – including a great deal of work produced by the Bank for International Settlements (BIS), the Financial Stability Board (FSB), the International Monetary Fund (IMF, ‘Fund’), and sundry central banks worldwide over the past decade and a half – but also in many new treaty-based, statutory, and administrative provisions agreed or enacted in multiple jurisdictions over the past several years. One recent Fund paper, in fact, reports that some 50 jurisdictions, including all of the world’s most developed economies, have formally adopted one or more macroprudential finance-regulatory measures since early 2009. [1]

…continue reading: Leaning, Cleaning, and Macroprudence

In the recent NBER working paper, my co-author, Guillermo Ordoñez of the University of Pennsylvania, and I develop a model to examine the important role collateral plays in the economy. Where do safe assets come from? Empirical evidence suggests that the private sector creates more near riskless assets when the supply of government debt is low and reduces privately-created near riskless assets when the supply of government debt is high. Krishnamurthy and Vissing-Jorgensen (2012) show that the net supply of government debt is strongly negatively correlated with the net supply of private near-riskless debt.

The substitution between public and private safe debt is also shown by Krishnamurthy and Vissing-Jorgensen (2012) who document that changes in the supply of outstanding U.S. Treasuries have large effects on the yields of privately created assets. Gorton, Lewellen, and Metrick (2010) also find this relationship between government debt and privately produced substitutes. They document that the share of safe assets in the U.S. economy, including both U.S. Treasury debt and privately created near-riskless debt has remained constant as a percentage of all U.S. assets since 1952. Xie (2012) shows that the issuance of asset-backed securities tends to occur when the outstanding government debt is low and Sunderam (2012) documents the same phenomenon with respect to asset-backed commercial paper.

By “safe assets,” we mean government debt and privately created high quality debt, in particular, asset-backed securities. Such safe assets are used to collateralize repo, derivative positions, and are needed as collateral in clearing and settlement. See IMF (2012). Further, because they are ”information-insensitive” (in the nomenclature of Dang, Gorton, and Holmstrom (2012)), they are highly liquid and hence can store value without fear of capital losses in times of stress, a form of private money.

…continue reading: The Supply and Demand for Safe Assets

The book, “Corporate Law and Economic Stagnation: How Shareholder Value and Short-termism Contribute to the Decline of the Western Economies” (Eleven International Publishers, 2013), introduces three hypotheses that put corporate law on the map of the causes of the current economic crisis and introduces a normative legal concept, “Long Governance” that can help take the economy out of the slump. Overall, the author takes a post-Keynesian approach to the theory of the firm and uses political economy analysis to expose corporate law’s contribution to a stagnating economy in the West.

The breakdown of the Bretton Woods monetary order in the early 1970s triggered a chain of political, economic and legal events that incrementally brought about “the Great Reversal in Corporate Governance”, i.e. the reorientation of corporate governance from the institutional logic of “retain and invest” to the logic of “downsize and distribute”, and “the Great Reversal in Shareholdership”, i.e. the shortening of the time-horizons of shareholders.

…continue reading: Corporate Law and Economic Stagnation

As many of you know, I am now in my second term as an SEC Commissioner and this is my fifth time participating at SEC Speaks. During that time, I have served with three different SEC Chairmen, and a fourth is now in the works. It has been, and continues to be, a great privilege to serve at a time during which the SEC’s role as the capital markets regulator has never been more important. However, I must admit being frustrated that we haven’t done more to protect investors.

Clearly, my tenure as a Commissioner has been dramatically impacted by the financial crisis and the pressing need to address the many failings that were brought to light by that crisis. Throughout my tenure, I have worked to be a strong advocate for fulfilling the Commission’s mission to protect investors, facilitate capital formation, and promote a fair and orderly market. To that end, I want to talk to you today about the need to protect investors through robust and effective market oversight.

I am growing increasingly concerned about the stability of our market structure as we lurch from one crisis to another, be it the flash crash or the Knight trading fiasco. Today, I plan to focus on the dangers that investors face from a trading market structure that has shown too many signs of weakness and instability.

…continue reading: Addressing Market Instability through Informed and Smart Regulation

Introduction

As the banking industry emerges from the 2008 financial crisis, there is no question that it caused great strain on banks of all sizes. Hundreds of community banks failed, and the largest institutions were unable to continue operating without massive, unprecedented government intervention. This region in particular experienced the full impact of the crisis and the stress it placed on small institutions. A key ingredient in the market disruption was inadequate capital protection. Looking forward, it is important that the regulatory community arrive at a capital framework that is appropriate for the range and complexity of risks in today’s financial system.

As someone who served on the Treasury Department’s crisis response team in 2008, it became clear that the market was punishing firms and business models that took on too much risk without sufficient capitalization. Yet, upon returning recently to government service I have been surprised at what I see as a lack of progress towards constraining excessive leverage. Some policymakers point to advancements in the Basel III agreement, developed by the Basel Committee on Banking Supervision, which implements a global leverage ratio for the first time. However, I think that it is difficult to argue that achieving a Tier 1 leverage ratio of three percent my 2018 is significant reform, particularly as this leverage ratio requirement is not solely anchored in tangible common equity.

…continue reading: Prominent Role for Leverage Ratio in Capital Framework

The recent financial crisis and the ensuing economic slowdown have heightened the importance of better understanding the interconnectedness between the industrial and banking sectors. While several recent studies undertake this endeavor, the transmission mechanism in these studies is almost always from the banking sector to the industrial sector. In contrast, in our paper, The Effect of Industrial-Sector Transparency on Bank Risk-taking and Banking System Fragility, which was recently made publicly available on SSRN, my co-author (Sudarshan Jayaraman) and I provide evidence of the chain of causality working in the reverse direction, i.e., from the industrial sector to the banking sector. In particular, we document the important role that industrial-sector transparency plays in the efficient functioning of the banking sector. We argue that greater transparency in the industrial sector facilitates firms’ access to financing from capital markets and thus diminishes their reliance on banks. As a result, we expect banks to face increased competition in their product markets and to offset their lost rents by: (i) taking on more risk, (ii) reducing their cost structures, and (iii) increasing the intensity of intermediation.

…continue reading: Corporate Transparency on Bank Risk-Taking and Banking System Fragility