Controlling Financial Chaos, and the Role of Law and Regulation

Duke University Law School’s Steven L. Schwarcz is one of the most astute academic writers on the “deep” structures of financial regulation – because beyond the immediacies of financial crisis, whether in 2008 in the US or today in Europe, looking to long-term regulatory structures requires that regulation and regulatory reform start from deeper commitments about the purposes they serve, the role of regulation in markets, and its limits.

If one starts, after all, from a view that regulators can do anything effectively and well, provided they are given the unfettered discretion to do so, and the ability to ignore mere politics, then life is pretty sweet – or, anyway, intellectually easy.  If, on the other hand, one starts from a radical skepticism about the ability of regulators to do anything effectively, and moreover an unfettered faith that there are no market failures and that “private ordering” will always work, then life is also pretty sweet – or at least intellectually easy.  But that doesn’t describe how most of us understand the regulatory situation, which involves both market-fail and regulatory-fail, and tradeoffs between different forms of regulation, public ordering and private ordering.

Professor Schwarcz has been writing a series of papers since before the 2008 financial crisis that account analytically for the leading issues of the financial crisis in the US and, more recently, has been turning to the Eurozone crisis as well.  (I also have to say with considerable embarrassment that I am long over-due on a book manuscript with Steve on financial regulation – slow in coming but gradually getting written, in fits and starts.  ‘Prudence for prudential regulators’, in the current way I’m framing it.)  Some of Professor Schwarcz’s work is highly technical, such as his writing on the deep structures of systemic risk internal to financial firms, but increasingly he has been reaching out to broader audiences, often through published addresses.  His newest is based around a keynote address delivered last year at the European Central Bank, and it aims to present in a short, succinct, and direct way the aims of financial regulation, the market and regulatory failures that are baked into those complicated aims, and the tradeoffs that regulation has to make, understanding that there is no perfect solution.  Put that way, it sounds anodyne, but it attempts – pretty successfully, I think – to address in straightforward language the task of steering between the rock of excessive optimism whether about markets or regulators, on the one hand, and the hard place of excessive skepticism about the ability to rationally design a system of regulation or markets at all.  This piece will be appearing in the Wisconsin Law Review in 2012; introduction is below the fold.

How can the law help to control financial chaos? By financial chaos, I mean the failure of a chain of financial markets or financial firms, or a chain of significant losses to financial firms, that results in increases in the cost of capital or decreases in its availability. The risk that financial chaos will occur is often referred to as systemic risk.

Many regulatory responses to systemic risk, like the Dodd-Frank Act in the United States, consist largely of politically motivated reactions to the 2008 financial crisis, looking for villains (whether or not they exist). To be most effective, however, the regulation must be situated within a more analytical framework.

To create such a framework, we first need to consider what the scope of systemic risk regulation should be. There has been a great deal of regulatory focus on banks and other financial firms. Some of this is path dependent: historically, a chain of bank failures remains an important symbol of systemic risk. The media and politicians also have focused on financial firms because they are so visible and their problems have been so dramatic.

But we also need to recognize that the ongoing trend towards disintermediation—enabling companies to directly access the ultimate source of funds, the capital markets, without going through financial intermediaries—is making financial markets themselves increasingly central to any examination of systemic risk.

For example, although the bankruptcy of Lehman Brothers in 2008 filled the headlines, its trigger was the collapse of the market for mortgage-backed securities. Many of these securities were collateralized in part by risky subprime home mortgages, which were expected to be refinanced through home appreciation. When home prices stopped appreciating, the borrowers could not refinance. In many cases, they defaulted. These defaults caused substantial amounts of investment-grade rated mortgage-backed securities to be downgraded and, in some cases, to default. Investors began losing confidence in these and other rated securities, and their market prices started falling.

Lehman Brothers, which held large amounts of mortgage-backed securities, was particularly exposed. Lehman’s counterparties began demanding additional safeguards, which Lehman could not provide. Absent a government bailout, Lehman filed for bankruptcy. That, in turn, caused securities markets to panic; even the short-term commercial paper market virtually shut down, and the market prices of mortgage-backed securities collapsed substantially below the intrinsic value of the mortgage loans backing those securities. That accelerated the death spiral, causing financial firms holding mortgage-backed securities to appear, if not be, more financially risky; requiring highly leveraged firms to engage in fire-sales of assets (thereby exacerbating the fall in prices); and shutting off credit markets, which impacted the real economy.

This demonstrates that both financial firms and financial markets can, if they fail, be triggers and transmitters of systemic risk. The scope of any regulatory framework for managing systemic risk should therefore include both financial firms and markets.

Before attempting to design such a regulatory framework, we need to examine what the framework’s goals should be. The primary goal for regulating financial risk is micro-prudential: maximizing economic efficiency within the financial system. Systemic risk is a form of financial risk, so efficiency should certainly be a goal in its regulation. But systemic risk also represents risk to the financial system itself. Any framework for regulating systemic risk therefore should also include that macro-prudential goal: protecting the financial system itself.


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