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«2011-2012 IT’S ALL SHADOW BANKING, ACTUALLY 593 IT’S ALL SHADOW BANKING, ACTUALLY JONATHAN MACEY* Introduction “Shadow banking” is a great term. ...»

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2011-2012 IT’S ALL SHADOW BANKING, ACTUALLY 611 to low-cost, contractual, private ordering solutions;51 (2) the asymmetric information – “lemon” – problems and signaling problems that impede firms from raising money;52 and (3) the various market and regulatory impediments to asset sales.53 Debt overhang refers to the problem, first identified by Stewart Myers,54 that sometimes arises when over-leveraged companies find themselves in financial distress. In such situations, recapitalizing the firm by issuing new equity may serve the interests of both equity holders and debt holders. When the distressed firm has so much debt that nobody will consider making an equity investment in it because the proceeds of such investment simply will go to repay creditors, the company has “debt overhang.” Also, earnings generated by new projects funded with new equity will go to creditors if debt overhang exists. Shareholders also may not want to issue new equity in cases of extreme debt overhang because doing so would dilute their existing equity claims. Debt overhang can be removed as an obstacle to a pareto-superior restructuring (i.e. a restructuring that makes shareholders, creditors and other corporate constituencies, such as local communities and workers, better off) if low transaction cost (Coasean) bargaining exists. Sadly, this generally is not the case. Transaction costs are high, particularly in large, complex financial institutions for two reasons: (a) there often are many claimants, like repo counterparties and depositors, who must agree to any proposed restructuring; and (b) such institutions have highly complex capital structures with many sorts of financial claims and financial contracts that must be evaluated and renegotiated. The only solution to the lack of a Coasean bargaining environment is bankruptcy, which of course is notoriously costly and inefficient.

Another barrier to raising capital that companies (including, but not limited to banks and shadow banks) have when they are in financial distress (or even if it merely is perceived that they might be in financial distress) is the lemons problem identified by George Akerlof.55 Lemons markets emerge because of the acute asymmetry


For an in-depth discussion of these social costs, see generally Ronald Coase, The Problem of Social Cost, 3 J.L. & ECON. 1 (1960).

Duffie, supra note 7, at 45.

See id. at 44-45 (describing the difficulties with asset sales).

See generally Stewart Myers, The Capital Structure Puzzle, 39 J. FIN.575 (1977).

See generally George Akerlof, The Market for Lemons: Quality, 612 REVIEW OF BANKING & FINANCIAL LAW Vol. 31   of information that exists between potential new investors in a company and the incumbent managers and investor who are trying to access the capital markets.56 The incumbents, who are aspiring to sell equity to raise capital, have more information about the current status and the future prospects of the company. The incumbents know this, and, unfortunately, the universe of potential investors also is acutely aware of its informational disadvantage. Investors are reluctant to invest in the face of this information problem, known in finance and banking as the adverse selection problem. If they can be persuaded to invest, it may well be at a price that is so discounted to offset this risk that the company is unwilling to sell because equity sales at discounted prices dilute the value of the current investors’ holdings.

Regulatory failure also impedes the prompt, efficient identification of distressed financial institutions and leads to the reluctance to confront, or even to acknowledge, their financial problems. In particular, bank regulators, including the Federal Reserve, the FDIC and the Comptroller of the Currency, generally are evaluated by their Congressional overseers on the basis of the number of institutional failures that occur during a particular period.

Frequent questions asked of bank regulators in congressional hearings are “how many bank failures did we experience in this quarter?,” “how many bank failures did we experience in my congressional district or state this quarter?” and “how much money do we have in the FDIC insurance fund this year as opposed to last year?” These are not merely questions. More significantly, these questions reflect the criteria used by Congress and the media to evaluate the health of the financial system in general and the adequacy of the performance of financial regulators in particular.

The inappropriate but politically salient criteria just described lead directly to the severe regulatory failures that we have observed in recent years in the field of financial regulation. This is because regulators have strong incentives to show that they are performing effectively. These incentives motivate regulators to refrain from recognizing the financial distress of financial institutions, to diminish the severity of such distress when it occurs, and to delay addressing the problems of distressed financial institutions. When regulators fail to recognize or to respond to distressed financial companies, the problems in such companies tend to metastasize quickly and widely because bank managers, in order


Uncertainty and the Market Mechanism, 84 Q. J. ECON.488 (1970).

Id., at 490.

2011-2012 IT’S ALL SHADOW BANKING, ACTUALLY 613 to dig themselves out of the holes in which they find themselves, face powerful incentives to engage in higher and higher levels of risk taking to stave off financial ruin. In particular, as the assets of a distressed firm decline in value, equity owners have less and less at stake because the value of their equity claims declines in lock-step with the decline in the value of their companies’ assets. And, as the so-called equity cushion (the difference between the value of a companies’ assets and the value of its liabilities) declines, shareholders have less “money on the table” (colloquially referred to as “skin in the game”) and their incentives to engage in excessive risk-taking worsens.

V. Solutions

From the point of view of the “equivalency” theory propounded in this paper (that shadow banking and traditional banking are functional equivalents), the various solutions to the problems just described are no different than the solutions that have been propounded for years for conventional banks.

These solutions tend to include the introduction of distresscontingent convertible debt and mandatory rights offerings.57 These are well-known contractual alternatives, available to any firm, which have come in and out of fashion over time. The idea is that companies will be required to issue debt that automatically converts to equity if the institution’s financial condition deteriorates. In my view, this sort of proposal does not comport with practical realities.

While financial institutions or any other firm may issue such securities, in practice, they do not, which suggests something about the cost of issuing these sorts of securities. Issuing such securities should count as equity for purposes of satisfying regulatory capital requirements, and any regulations inhibiting such treatment should be changed. Ultimately, however, companies should not be forced to issue this sort of security instead of equity.

It sometimes is argued that distress-contingent convertible debt is superior to equity because it creates a class of claimants (i.e., the holders of the distress-contingent convertible debt), who have strong incentives to monitor against excessive risk-taking and other


See, e.g., Squam Lake Working Grp. on Fin. Regulation, Improving Resolution Options for Systemically Relevant Financial Institutions 6 (Oct.

2009) (unpublished manuscript), available at http://icfr.org/content/ publications/attachments/Squam_lake_Working_Paper7.pdf.

614 REVIEW OF BANKING & FINANCIAL LAW Vol. 31   sorts of moral hazard on the part of the companies from whom they purchased contingent convertible debt. Old-fashioned convertible bonds, however, are an even more powerful tool for the mitigation of moral hazard. Perhaps this is why straight convertible debt is used in the real world and distress-contingent convertible debt is not.

Convertible bonds mitigate moral hazard by exerting two constraints on current equity claimants. First, if equity claimants take big risks and those risks pay off, then, by hypothesis, the value of the company’s equity will rise. When this happens, the holders of the convertible debt can profit by converting their shares to preferred stock and selling those shares at a premium generated by the shareholders’ previous gambles. Such conversions will dilute the claims of the current equity holders, thereby reducing the expected returns from risk-taking. On the other hand, if the equity claimants take risks and those risks do not pay off, and the value of the equity declines or the company finds itself in financial distress, then the holders of the convertible bonds will not exercise their option to convert their claims. By remaining creditors with fixed claims rather than shareholders with residual claims, these creditors protect themselves against post-investment opportunism in the form of excessive risk-taking because they retain their bankruptcy priority over the residual claimants.

Other time-tested solutions for improving the current situation, such as “stronger liquidity standards” for the financial institutions involved in shadow banking and improving the clearing process for over-the-counter derivatives, are modest and reasonable.58 But these approaches merely reinforce the point that, as a matter of economic substance, shadow banks have no problems that are unique to them because they themselves are not unique. They are no different in substance from traditional banks. This is why the solutions imagined for dealing with the problem of shadow bank failure are identical to the solutions identified for ordinary bank failures.

In particular, those who write about the major participants in the shadow banking industry, just like those who write about traditional banking, assert that “improved failure resolution” could be an effective mechanism for mitigating the negative externalities associated with the potential failure of shadow banks.59 The ultimate


See DUFFIE, supra note 7, at 53-59 (discussing stronger liquidity standards for dealer banks).

See, e.g., id. at 59-61 (discussing an “improved failure resolution”).

2011-2012 IT’S ALL SHADOW BANKING, ACTUALLY 615 way to improve the resolution of distressed financial institutions is through early closure. This is true for two reasons. First, the moral hazard problem gets worse as banks get deeper into trouble because their balance sheets deteriorate as their financial condition weakens.

Thus, the value of their equity declines, creating an incentive to engage in increased risk-taking. This is a core attribute of moral hazard in the context of corporate finance. At the limit of the analysis, if a company’s equity declines to zero, then the shareholders have nothing to lose by taking huge risks because they have already lost their entire investments. But if they take big risks and, improbably, realize large enough returns, then the value of the firm’s equity will be restored.

The second reason why early closure reduces moral hazard is that the general quality of the asset side of the balance sheets of financially distressed companies experience significant deterioration.

This is so because the assets purchased during times of distress are riskier and far more likely to deteriorate over time than the assets acquired by financial institutions that are well-capitalized.

In theory at least, the ideal bank failure resolution policy would be to close distressed financial institutions before they are actually insolvent, even before the market value of their assets declines to a value that is less than the market value of their liabilities. Specifically, if financial companies can be merged or liquidated at or prior to the time when the value of their assets equals the value of their liabilities plus the administrative costs of the merger or liquidation, then no creditor will suffer. And this includes entities like the government who are creditors by virtue of their implicit or explicit guarantees of all or part of the liability side of the financial company’s balance sheet.

Unfortunately, while the public’s interests are best served by assiduously closing distressed financial institutions very promptly at or prior to the moment when they become insolvent, elected officials and regulators have the opposite incentive structure. Politicians and regulators have strong incentives to delay closure rather than to practice a closure policy because they can maximize their political support by delaying closure and by failing to recognize insolvency.

This is because the success of the financial oversight system appears to be evaluated by the public and the government on the basis of metrics such as the size of the balance in the FDIC’s insurance fund and the number of bank “failures” during a particular period.

616 REVIEW OF BANKING & FINANCIAL LAW Vol. 31   Conclusion In the end, there is only one strategy that meaningfully addresses the problems of systemic risk and excessive risk taking by federally insured banks and the large financial institutions that participate in the shadow banking industry. This strategy is to require that the equity claimants who benefit so handsomely from the financial institution’s risk-taking absorb the losses associated with such risk-taking. This could be done by forcing equity holders to put up additional capital to satisfy the claims of creditors when their institutions become insolvent, as was done prior to the introduction of government-sponsored insurance.60 Alternatively, this result could be achieved by dismantling any financial institution, shadow or traditional, that has grown to the point at which it is too-big-to-fail.61 In other words, since the government cannot seem to make a credible commitment to let creditors of systemically important financial institutions suffer 100% of the losses when such an institution fails, the second best alternative is to break these institutions into pieces small enough for the economy to digest in the case of failure.62 Banking is banking, whether such banking is in the shadows or out in the open. The financial architecture of banking has long featured illiquid, long-term assets that are financed with short-term liabilities. In the case of traditional banks, the short-term assets are deposits. In the case of the megabanks active in shadow banking, the short-term assets are repurchase agreements, commercial paper and other money market instruments.63 The characteristics of these assets make the old-fashioned banks that finance their assets with traditional demand deposits look downright stodgy. We know that the basic business of shadow banking, including OTC derivatives, repurchase agreements, prime brokerage and clearing, are all


Jonathan Macey & Geoffrey Miller, Double Liability of Bank Shareholders: History and Implications, 27 WAKE FOREST L. REV. 31, 31 (1992).

Jonathan Macey & James P. Holdcroft, Failure Is an Option: An ErsatzAntitrust Approach to Financial Regulation, 120 YALE L.J. 1368, 1371 (2011).


See DUFFIE, supra note 7, at 29 (“Large dealers tend to finance significant fractions of their assets with short-term repurchase agreements.”).

2011-2012 IT’S ALL SHADOW BANKING, ACTUALLY 617 susceptible to runs.64 But let’s stop pretending that this makes shadow banking special.



See generally id.

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