In a landmark vote, the United Nations General Assembly overwhelmingly decided on September 9 to begin work on a multilateral legal framework—effectively a treaty or convention—for sovereign debt restructuring, in order to improve the global financial system. The resolution was introduced by Bolivia on behalf of the “Group of 77” developing nations and China. In part, it was sparked by recent litigation in which the U.S. Supreme Court held that, to comply with a pari passu clause (imposing an equal-and-ratable repayment obligation), Argentina could not pay holders of exchanged bonds without also paying holdouts who retained the original bonds. That decision was all the more dramatic because the holdouts included hedge funds—sometimes characterized as “vulture funds”—that purchased the original bonds at a deep discount, yet sued for full payment.
Posts Tagged ‘Bailouts’
On September 29, 2014, the Financial Stability Board (the “FSB”) published a consultative document concerning cross-border recognition of resolution actions and the removal of impediments to the resolution of globally active, systemically important financial institutions (the “Consultative Document”). The Consultative Document encourages jurisdictions to include in their statutory frameworks seven elements that would enable prompt effect to be given to foreign resolution actions. In addition, due to a recognized gap between the various national legal resolution regimes that are currently in place and those recommended by the FSB, the Consultative Document sets forth two “contractual solutions”—that is, resolution-related arrangements to be implemented as a matter of contract among the private parties involved—to address two underlying substantive issues that the FSB considers critical for orderly cross-border resolution, namely:
In After the Deal: Fannie, Freddie and the Financial Crisis Aftermath, we offer a solution to the problem of what to do with the profits being made by Fannie Mae and Freddie Mac, the subject of a dispute between the government, which has declared that it will keep those profits, and the shareholders of common and preferred stock left behind after the firms were quasi-nationalized, who have sought, in court, a share of them.
A clearinghouse reduces counterparty risks by acting as the hub for trades amongst the largest financial institutions. For this reason, Dodd-Frank’s seventh title, the heart of the law’s regulation of OTC derivatives, requires that most derivatives trade through clearinghouses.
The concentration of trades into a very small number of clearinghouses or CCPs has obvious risks. To maintain the vitality of clearinghouses, Congress thus enacted the eighth title of Dodd-Frank, which allows for the regulation of key “financial system utilities.” In plain English, a financial system utility is either a payment system—like FedWire or CHIPS—or a clearinghouse.
But given the vital place of clearinghouses in Dodd-Frank, it is perhaps surprising that Dodd-Frank makes no provision for the failure of a clearinghouse. Indeed, it is arguable that the United States is not in compliance with its commitment to the G-20 on this point.
In the paper Supersize Them? Large Banks, Taxpayers and the Subsidies that Lay Between, I provide an in-depth study of the substantial, non-transparent governmental subsidies received by the biggest banks. Though some continue to deny the existence of these subsidies, I conclude that the subsidies exist and negatively impact the financial markets. The most significant implicit subsidy stems from market perception that the government will not allow the biggest banks to fail—i.e., that they are “too-big-to-fail” (TBTF)—enabling them to borrow at lower interest rates. I outline the solutions that have been proposed and/or implemented as an attempt to solve the TBTF problem, and I suggest a new user-fees framework that can be used in conjunction with other approaches to mitigate the consequences of the TBTF subsidies.
In our recent NBER working paper, Financing as a Supply Chain: The Capital Structure of Banks and Borrowers, we propose a novel framework to model joint debt decisions of banks and borrowers. Our framework combines the models used by bank regulators with the models used to explain capital structure in corporate finance. This structure can be used to explore the quantitative impact of government interventions such as deposit insurance, bailouts, and capital regulation.
Today an enormous global civilization rests upon a jury-rigged financial frame rife with moral hazards, perverse incentives, and unintended consequences. This article, SIFIs and States, forthcoming in the Texas International Law Journal, addresses one aspect of that fragile structure. It argues for basic reform in the international management of financial institutions in distress, with a special emphasis on SIFIs (Systemically Important Financial Institutions). The goal is to examine public institutional arrangements for resolution of financial institutions in the midst of a crisis, rather than the substantive rules governing the resolution process. The proposition central to this article is that the resolution of major financial institutions in serious distress will generally require substantial infusions of public money, at least temporarily. The home jurisdiction for a given financial institution must furnish the bulk of the public funds necessary for the successful resolution of its financial distress. The positive effect is that other jurisdictions may be likely to acquiesce in the leadership of the funding jurisdiction in exchange for acceptance of that financial responsibility. On the other hand, acceptance of the funding obligation would have profound consequences for the state as well as the institution, because the default of a SIFI may threaten the financial stability of that state. Until the crisis of 2007-2008, all that was implicit and unexamined in the political process; to a large extent it remains so.
One, of several, regulatory responses to the financial crisis has been to consider the extent to which bank failure can be explained by flaws in banks’ corporate governance arrangements.
In many jurisdictions this diagnosis has generated calls upon shareholders to act as effective owners and hold boards of banks to account, as well as calls to empower shareholders to enable them to do so. But what do we know about the relationship between shareholder power and bank failure? To date scholarly attention has been paid to the relationship between board independence and bank failure, but limited attention has been given to the relationship between bank failure and the core corporate governance rules that determine the ease with which shareholders can remove and replace management. In our paper, Shareholder Empowerment and Bank Bailouts, we examine the relationship between shareholder power — and, thus, managerial accountability — and the probability of bank bailouts.
In the first presidential debate, Mitt Romney identified the Dodd-Frank Act as the “biggest kiss” to Wall Street, opening a topic that has received too little attention in this election season. Supporters of the act argue that it ends bailouts, but this is true only if bailouts are defined narrowly as the use of taxpayer funds to rescue a failing financial institution. However, the source of funds for a bailout is not the real issue. The possibility of a creditor bailout creates moral hazard, no matter where the bailout funds originate, and it is moral hazard that provides the largest banks or other large financial firms with competitive advantages. The same is true of the special “stringent” regulation required by the act for banks and other firms deemed systemically important. These provisions create moral hazard by reassuring creditors that there is less risk in lending to these large firms than to small ones, and thus provide the biggest firms with a continuing competitive advantage in the form of lower funding costs. Romney is correct to see this as a subsidy to big banks and other large financial institutions. Title I invokes stringent regulation for systemically important firms, Title II provides a mechanism for bailing out creditors if a systemically important firm should fail, and Title VIII authorizes Federal Reserve funding for an unlimited number of additional financial institutions. If President Obama is re-elected, Dodd-Frank is likely to continue in its current form, adding materially to the problem of moral hazard and TBTF in the US financial system.
At its enactment, the Dodd-Frank Act (DFA) was advertised as legislation that would end financial bailouts. When signing the legislation on July 21, 2010, President Obama said, “There will be no more tax-funded bailouts—period.” But this is an accurate depiction of the act only because the president and the act’s other proponents define bailouts as the use of public funds for rescuing failing financial institutions.
From the election of a French president who has openly expressed his opposition to austerity without a greater focus on stimulating economic growth to the struggles to form a new Greek government that may or may not agree to abide by the conditions set out in the existing bailout plan, recent elections have enveloped the Eurozone in yet more uncertainty. With the desire for an alternative to a programme of strict austerity gathering increasing popular support, balancing the challenges of the Eurozone’s rapidly escalating political crisis alongside the fiscal imperatives that need to be tackled has rarely been so difficult, or the path ahead for Europe’s leaders so unclear.
In these circumstances few would dare to predict the future. But the ability to assess and anticipate potential market risks – from the impact of sovereign debt issues on an already weakened banking sector to the prospect of a country, or even countries, leaving the Eurozone – is crucial. Also crucial is the need to prepare for a variety of eventualities, whether through more stringent credit assessment, tighter documentation, careful counterparty choice or other tactics.