The incentive to take socially costly financial risks is inherent in banking: because of the interconnected nature of banking, one bank’s failure can increase the risk of failure of another bank even if they do not have a contractual relationship. If numerous banks collapse, the sudden withdrawal of credit from the economy hurts third parties who depend on loans to finance consumption and investment. The perverse incentive to take financial risk is further aggravated by underpriced government-supplied insurance and the government’s readiness to play the role of lender of last resort.
Posts Tagged ‘Eric Posner’
Nearly all U.S. regulatory agencies use benefit-cost analysis (BCA) to evaluate proposed regulations. The EPA, for example, uses BCA to evaluate regulations that require factories to reduce emissions. OSHA uses BCA to evaluate regulations that require workplaces to install safety devices for workers. NHTSA uses BCA to evaluate fuel economy standards. Yet a striking exception to this pattern occurs in the area of financial regulation. The major agencies with jurisdiction over financial activities—including the SEC, the CFTC, and the Fed—have almost never used formal BCA to evaluate financial regulations.
Yet there is no reason to believe that BCA would be appropriate for environmental or workplace regulation and not for financial regulation. Indeed, BCA would seem more appropriate for financial regulation where data are better and more reliable, and where regulators do not confront ideologically charged valuation problems like those concerning mortality risk and environmental harm. The benefits and costs of financial regulation are commensurable monetary gains and losses, and so can be easily compared.
Chapter 11 bankruptcy is a dizzyingly complex and inefficient process. Voting on potential reorganization plans take place by class, rules are based on achieving majorities and super-majorities by different standards, and a judge must evaluate the plan to ensure it respects pre-bankruptcy entitlements appropriately. Plan proponents can gerrymander plans in order to isolate creditors; hedge funds can buy positions that pay off if plans fail while allowing them to exert influence over the negotiation process; and judges are often unable to stop such gaming. To cut through this morass, lawyers and economists have proposed reforms, such as holding an auction for the firm or offering options to junior creditors that enable them to buy out senior creditors.
While these reforms could make important steps towards improving Chapter 11, they neglect a crucial problem the current system is designed to address: that of collective action. The current owners of various claims on the firm are usually well-suited to play the particular roles they are playing within the capital structure. Because of sunk investments in learning about the firm or their risk-preferences they are the most valuable investors to hold the assets they hold. A reorganized firm that does not have their appropriate participation may not be nearly as valuable as one that does. In fact, it may be better to liquidate the firm, even if reorganization could be efficient, than to reorganize it with the wrong owners.
Imagine that a corporation holds a shareholder vote on a project like a merger, and, under the corporation’s bylaws, each shareholder can cast a number of votes equal to the square root of the number of shares that he holds. This might seem like a gimmick, but it actually provides a natural, smooth form of minority shareholder protection without the external intervention of the courts. In fact, under reasonable conditions square root voting (SRV) ensures that the project is approved if and only if it maximizes the value of the firm and thus achieves the efficiency goals of minority shareholder protection without the messy legal procedures that usually accompany them.
To see why, suppose that a corporation proposes a merger. An investor believes that the merger will increase the value of the corporation by $1000 per share, and that a vote in favor of the merger increases the probability of approval by 0.01. Thus, the marginal benefit from buying a share is $10. The investor can buy shares of the corporation at an opportunity cost of $1 (in the sense that she would rather use her money in another way and she incurs brokerage fees, but can otherwise sell the share for net expected profit of $0 if the merger is not approved). Because of the square-root rule, however, she must buy the square of the number of shares for every vote she casts. Thus, if she wants to cast 1 vote, she must buy 1 share at a cost of $1; if she wants to cast 2 votes, she must buy 2 shares at a cost of $4; if she wants to buy 3 shares, she must pay $9; and so on.
In the past few years, several important financial regulations have been struck down by the D.C. Circuit Court of Appeals because the regulatory agency failed to prove that the benefits of those regulations exceeded the costs. There is no current explicit legal requirement for financial agencies to conduct cost-benefit analyses, but given vagaries in the underlying statutes, the Court has felt that it has the authority to insist on a greater degree of economic rigor than agencies often display. In a parallel development, Senator Shelby has introduced a bill that would explicitly require financial agencies to perform cost-benefit analyses. If the bill is enacted, we will see even greater bloodshed in the courts.