The basic argument about the procyclical effects of bank capital requirements is well-known. In recessions, losses erode banks’ capital, while risk-based capital requirements, such as those in Basel II, become higher. If banks cannot quickly raise sufficient new capital, their lending capacity falls and a credit crunch may follow. Yet, correcting the potential contractionary effect on credit supply by relaxing capital requirements in bad times may increase bank failure probabilities precisely when, because of high loan defaults, they are largest. Given the conflicting goals at stake, some observers think that procyclicality is a necessary evil, whereas others think that procyclicality should be explicitly corrected. Basel III is a compromise between these two views. It reinforces the quality and quantity of the minimum capital required to banks, but also establishes that part of the increased requirements be in terms of mandatory buffers—a capital preservation buffer and a countercyclical buffer—that are intended to be built up in good times and released in bad times.

In our paper, The Procyclical Effects of Bank Capital Regulation, forthcoming in the Review of Financial Studies, we develop a model that captures the key trade-offs in the debate. The model is constructed to highlight the primary microprudential role of capital requirements (containing banks’ risk of failure and, thus, deposit insurance payouts and other social costs due to bank failures) as well as their potential procyclical effect on the supply of bank credit.

…continue reading: The Procyclical Effects of Bank Capital Regulation

How can governments limit excessive and unstable credit growth? Should they raise capital requirements for banks? In our recent NBER working paper, Does Macropru Leak? Evidence from a UK Policy Experiment, we address these questions using evidence from a policy experiment in the UK. The minimum capital ratio requirements that national regulatory authorities impose on banks have two sets of objectives: (i) so-called ‘micro-prudential’ motives, to ensure the safety and soundness of individual banks; and (ii) ‘macro-prudential’ goals, especially to influence the aggregate supply of credit. Micro-prudential regulation has a long pedigree, but the focus on macro-prudential regulation has increased sharply in the wake of the global financial crisis. This sharpened focus underlies recent changes in the international regulatory regime for banks. Basel III, as the new regime is called, establishes a “countercyclical capital buffer”, under which national regulators would vary banks’ required capital-to-risk-weighted assets ratio over time, thereby helping smooth the credit cycle. For variation in minimum capital requirements to be effective in regulating the aggregate supply of credit, three conditions must be satisfied:

…continue reading: Does Macropru Leak? Evidence from a UK Policy Experiment

How important is the role of credit availability in inflating asset prices? And what are the consequences of past greater credit availability when perceived fundamentals turn? In our recent NBER paper, The Anatomy of a Credit Crisis: The Boom and Bust in Farm Land Prices in the United States in the 1920s, my co-author, Rodney Ramcharan, and I broach answers to these questions by examining the rise (and fall) of farm land prices in the United States in the early twentieth century, attempting to identify the separate effects of changes in fundamentals and changes in the availability of credit on land prices. This period allows us to use the exogenous boom and bust in world commodity prices, inflated by World War I and the Russian Revolution and then unexpectedly deflated by the rapid recovery of European agricultural production, to identify an exogenous shock to local agricultural fundamentals. The ban on interstate banking and the cross-state variation in deposit insurance and ceilings on interest rates are important regulatory features of the time that allow us to identify the effects of credit availability that we incorporate in the empirical strategy.

…continue reading: The Anatomy of a Credit Crisis

In the paper Derivatives and the Legal Origin of the 2008 Credit Crisis (published in the inaugural issue of the Harvard Business Law Review), I argue that the credit crisis of 2008 can be traced first and foremost to a little-known statute Congress passed in 2000 called the Commodities Futures Modernization Act (CFMA). In particular, the crisis was the direct and foreseeable (and in fact foreseen, by myself and others) consequence of the CFMA’s sudden and wholesale removal of centuries-old legal constraints on speculative trading in over-the-counter (OTC) derivatives.

Derivatives contracts are probabilistic bets on future events that can be used to hedge (which reduces risk) but also provide attractive vehicles for speculation on disagreement (which can increase risk). The common law recognized the differing welfare consequences of hedging and speculative trading in derivatives by applying a doctrine called “the rule against difference contracts” to discourage derivatives that did not serve a hedging purpose by treating them as unenforceable wagers. Speculators responded by shifting their trading onto organized exchanges that provided private enforcement mechanisms, in particular clearinghouses through which exchange members guaranteed contract performance. The clearinghouses effectively cabined and limited the social cost of derivatives speculation risk. In the twentieth century, the common law rule was replaced by the federal Commodity Exchange Act (CEA). Like the common law, the CEA confined speculative derivatives trading to the organized (and now-regulated) exchanges. This regulatory system also for many decades also kept derivatives speculation from posing significant problems for the larger economy.

…continue reading: Derivatives and the Legal Origin of the 2008 Credit Crisis

In our forthcoming Journal of Finance paper, Did Structured Credit Fuel the LBO Boom? we study how large shifts in the availability of credit affected the corporate use of leverage by examining LBO transactions that rely heavily on debt financing. We argue that developments that led to the growth of structured credit contributed to increased credit supply that at least partially fueled the recent LBO boom. Our evidence highlights important linkages between structured credit, the dual role of banks in the structured credit markets as loan originators and underwriters, and the corporate use of leverage.

…continue reading: Did Structured Credit Fuel the LBO Boom?

In the aftermath of the recent financial crisis, bank remuneration remains a critically sensitive issue – for shareholders, creditors, regulators, governments and the general public. This is particularly the case for those systemically important financial institutions that received government bailouts. While many of these institutions are beginning to recover, the negative effects of increased debt taken on at the public sector level to protect the financial system have resulted in serious and lingering economic problems in many countries, including the UK and the US. Indeed, the impact of public sector balance sheets absorbing losses of the banking sector has had the after-effect of contributing to sovereign debt crises in several smaller European jurisdictions — which continue to plague investors, taxpayers and the wider economy.

…continue reading: Credit Quality as a Bonus Underpin

In the paper, Leverage, Moral Hazard, and Liquidity, forthcoming in the Journal of Finance (February 2011), the authors argue that the buildup of leverage in the financial sector in good economic times helps explain why adverse asset shocks in such times are associated with a severe drying-up of liquidity and deep discounts in asset prices. We illustrate that while the incidence of financial crises is lower when expectations of fundamentals are good, their severity can in fact be greater in such times due to greater system-wide leverage.

The core foundation of their theoretical model lies in the idea that when adverse asset shocks wipe out capital base of financial intermediaries, their short-term debt cannot be rolled over due to attendant agency problems, in particular, due to the problem that intermediaries may gamble excessively if leverage is not reduced. They tie this problem of rollover risk with the following facts: (i) the prominence of short-term rollover debt in the capital structure of financial firms, and (ii) the low cost of rollover debt in good economic times, which leads to the entry of highly leveraged firms in the financial sector. All of these factors played an important role in the financial crisis of 2007 to 2009 and the period preceding it.

…continue reading: Leverage, Moral Hazard, and Liquidity

In the paper, Cyclicality of Credit Supply: Firm Level Evidence, which was recently made publicly available on SSRN, we study bank loan supply through the business cycle using firm level data from 1990 to 2009. It is well known that lending is cyclical. The contribution of our paper is to address two of the main empirical challenges in identifying whether this reflects the effects of bank credit supply. First, we focus on firms’ choice between two close forms of external debt financing: bank debt and public bonds. By conditioning the sample on firms raising new debt, we can rule out a demand explanation for the drop in bank borrowing which coincides with downturns. Second, by doing the analysis at the firm level, we can directly address how the composition of firms raising finance varies through time. This allows us to rule out compositional changes in the pool of firms seeking debt finance as an explanation of our findings.

…continue reading: Cyclicality of Credit Supply

(Editor’s Note: This post comes to us from Vikrant Vig of London Business School, Rainer Haselmann of the University of Mainz, and Katharina Pistor of Columbia University School of Law.)

In our paper, How Law Affects Lending, which was recently accepted for publication in the Review of Financial Studies, we exploit variation in legal institutions of twelve transition economies to investigate the effect of legal change on the supply of credit.

Our study focuses on twelve Central Eastern European (CEE) transition economies. We assemble a unique matched database comprising bank-level information, ownership information, and time series information of legal changes for these countries. There are several advantages of using this set of countries as a laboratory: (i) these countries have undergone major legal reforms in the 1990s; (ii) these countries form a fairly homogeneous group; (iii) there is a considerable inter-temporal variation in the timing of these reforms; (iv) the reforms are motivated by pressures from outside governing bodies such as the European Union (EU), European Bank for Reconstruction and Development (EBRD), and USAID; and (v) these are all bank-based economies; therefore, creditor rights should play an important role in these countries.

We find that banks increase the supply of credit subsequent to legal change. The economic impact of a legal change on bank lending is considerable; an improvement of our legal indicator by one implies an increase in loan supply by 13.66%. Further, we differentiate between legal rules designed to protect individual creditors’ claims outside bankruptcy (Collateral) and the collective enforcement regime bankruptcy establishes (Bankruptcy). We find Collateral to be more important than Bankruptcy. This result is in contrast to previous articles, in which measures related to collective enforcement/reorganization (LLSV index) were used to proxy for creditor rights. Further, the effectiveness of a bankruptcy regime is conditional on the existing collateral regime, i.e., the existence of a strong collateral regime is critical for the efficacy of the bankruptcy regime.

Finally, our data suggest that entrants to the market, and in particular foreign banks, respond more strongly to legal change than incumbents by increasing their lending volume. The same is true when comparing greenfield banks with incumbents. We also find that improvements in collateral law result in an increase in individual and household lending, while lending to the government remains unaffected. Finally, legal improvements also affect firms’ level of external debt and their capital structure.

The full paper is available for download here.

(Editor’s Note: This post by John G. Finley is based on a Simpson Thacher & Bartlett memorandum, which first appeared as an article in the New York Law Journal.)

This post was written together with Simpson Thacher & Bartlett associate Salvatore Gagliardi.

While the pace of M&A activity has been subdued, the significance of contractual developments in dealmaking has been pronounced. Over the past year, the difficulty of the credit markets has resulted in significant developments in how practitioners draft cash acquisition agreements for strategic buyers (e.g., corporate buyers seeking to further their strategic objectives). These developments have resulted in such buyers having greater flexibility in deciding not to close, particularly if the reason is financing related. These changes have been especially pronounced in multi-billion dollar transactions where the buyer is dependent on third party financing to effect the proposed transaction. This trend began with strategic buyers utilizing the termination provisions used in private equity deals under which a seller’s only remedy if a buyer were to fail to close were a fixed fee from the buyer (i.e., a reverse break fee). In such cases, this reverse break fee structure was analogized to an option or referred to as providing the buyer with “optionality.” The practice has, however, now developed beyond the use of the reverse break fee model as utilized in private equity deals. Although there are variations in the benefits of these provisions to prospective buyers, a common element is that they mitigate the risk to a buyer from failing to close due to a financing failure.

Private Equity Precedent

The optionality used in recent strategic deals was based on a structure used in private equity deals that developed after 2005. Prior to 2005, private equity transactions were structured with the private equity firm forming a shell company that entered into the acquisition agreement and undertook the obligations contained therein. There was no risk to the private equity firm, as distinguished from the shell company, other than reputational risk and the theoretical possibility of piercing the corporate veil (i.e., disregarding the corporate entity and treating obligations of the shell company as obligations of shareholder/owner). Further, the acquisition agreement was typically conditioned on the availability of financing (although the shell company often agreed to be subject to the remedy of specific performance pursuant to which it could be required to use its reasonable best efforts to obtain financing). Given that the shell company was without resources, sellers were put in the position of relying on the reputational risk to the private equity firm if its wholly owned shell company breached its obligations as well as the possibility of veil piercing. This latter risk was viewed as remote but the consequences were grave if realized.

Beginning in 2005, the private equity structure utilizing financing conditions as described above was superseded by a reverse break fee structure. This structure arose out of a desire by sellers to eliminate the financing condition and reduce the reliance on the reputational risk to the buyer arising from a breach. Under this structure, a break fee of roughly 3 percent was payable by the shell company for a failure to close, which fee was guaranteed by the private equity firm. This created significant optionality for the private equity firm as it guaranteed the payment of a fixed fee, but the firm was no longer subject to the in terrorem risk of veil piercing or any other liability. Moreover, although there were exceptions, the norm that developed was that even the shell company was not subject to specific performance. This meant that there was no risk that the shell company would sue the private equity firm under the equity commitments or lenders under the debt commitments. Some deals sought to increase the cost to the buyer of failing to close by providing that the private equity firm could be subject to, in addition to the reverse break fee, the payment of damages in excess of a break fee for a willful breach. Those deals were, however, a small minority.

…continue reading: Impact of the Credit Crunch on Acquisition Agreements