Document Type

Article

Publication Date

2011

Abstract

Because the quickest, simplest way for a financial institution to increase its profitability is to increase its leverage, an enduring tension will exist between regulators and systemically significant financial institutions over the issues of risk and leverage. Many have suggested that the 2008 financial crisis erupted because flawed systems of executive compensation induced financial institutions to increase leverage and accept undue risk. But that begs the question why such compensation formulas were adopted. Growing evidence suggests that shareholders favored these formulas to induce managers to accept higher risk and leverage. Shareholder pressure, then, is a factor that could cause the failure of a systemically significant financial institution.

What then can be done to prevent future such failures? The Dodd- Frank Act invests heavily in preventive control and regulatory oversight, but this Article argues that the political economy of financial regulation ensures that there will be an eventual relaxation of regulatory oversight (the regulatory sine curve). Moreover, the Dodd-Frank Act significantly reduces the ability of financial regulators to effect a bailout of a distressed financial institution and largely compels them to subject such an institution to a forced receivership and liquidation under the auspices of the Federal Deposit Insurance Corporation. But the political will to impose such a liquidation remains in doubt, both in the United States and in Europe.

If bailouts are to be ended, something must replace them, beyond relying on the wisdom of regulators. Because financial institutions are inherently fragile and liquidity crises predictable, this Article proposes a "bail-in" alternative: namely, a system of "contingent capital" under which, at predefined points, a significant percentage of a major financial institution's debt securities would convert into an equity security. However, unlike earlier proposals for contingent capital, the conversion would be on a gradual, incremental basis, and the debt would convert to a senior, nonconvertible preferred stock with cumulative dividends and voting rights. The intent of this design is (1) to dilute the equity in a manner that deters excessive risk taking, (2) to create a class of voting preferred shareholders who would be rationally risk averse and would resist common shareholder pressure for increased leverage and risk taking, and (3) to avoid an "all or nothing" transition, which may evoke political resistance and bureaucratic indecision, by instead structuring a more incremental change.

More generally, in the belief that reliance on enhanced agency oversight will likely produce an ad hoc and politically contingent system of regulation (and thus significant disparities in treatment), this Article recommends, as a supplementary strategy, the use of objective market-based benchmarks that are embedded in the financial institution's corporate governance. It argues that such controls are less subject to political exigencies and more able to provide the economic shock absorber and loss absorbency that an effective response to systemic risk requires.

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