Posts Tagged ‘systemic risk’

Abstract: 
We analyze shareholders’ incentives to change the leverage of a firm that has already borrowed substantially. As a result of debt overhang, shareholders have incentives to resist reductions in leverage that make the remaining debt safer. This resistance is present even without any government subsidies of debt, but it is exacerbated by such subsidies.

Our analysis is relevant to the debate on bank capital regulation, and complements Admati et al. (2010). In that paper we argued that subsidies that favor debt over equity are the key reason that banks funding costs would be lower if they “economize” on equity. Subsidies come from public funds, and reducing them does not represent a social cost. It is thus irrelevant for assessing regulation. Other arguments made to support claims that “equity is expensive” are flawed.

Like reduction in subsidies, the effects of leverage reduction on bank managers or shareholders do not represent a social cost. In fact, we show that debt overhang creates inefficiency, since shareholders would resist recapitalization even when this would increase the combined value of the firm to shareholders and creditors. Moreover, debt overhang creates an “addiction” to leverage through a ratchet effect. In the presence of government guarantees, the inefficiencies of excessive leverage are not fully reflected in banks’ borrowing costs.

Since banks’ high leverage is a source of systemic risks and imposes costs on the public, resistance to leverage reduction leads to social inefficiencies. The main beneficiaries from high leverage may be bank managers. The majority of the banks’ shareholders, who hold diversified portfolios and who are part of the public, are likely to be net losers. Our analysis highlights the critical importance of effective capital regulation and high equity requirements, especially for large and “systemic” financial institutions.

We analyze shareholders’ preferences when choosing among various ways leverage can be reduced. We show that, with homogeneous assets, if the firm’s security and asset trades have zero NPV, and the firm has a single class of debt outstanding, then shareholders find it equally undesirable to deleverage through asset sales, pure recapitalization, or asset expansion with new equity. When these conditions are not met, shareholders can have strong preferences for one approach over another. For example, if the firm can buy back junior debt, asset sales are the preferred way to reduce leverage. This preference for asset sales, or “deleveraging,” can persist even if such sales are inefficient and reduce the total value of the firm.

 Keywords: capital regulation, financial institutions, capital structure, “too big to fail,” systemic risk, bank equity, debt overhang, underinvestment, recapitalization, deleveraging, bankruptcy costs, Basel.

JEL Classifications: G21, G28, G32, G38, H81, K23

New research paper titled: Elective Shareholder Liability for Systemically Important Financial Institution (newly titled as: Solving the Problem of Bailouts: A Theory of Elective Shareholder Liability)
by Peter Conti-Brown
Date: February 16, 2011
Stanford University, Rock Center for Corporate Governance
Rock Center for Corporate Governance at Stanford University Working Paper No. 97

Abstract:
Despite the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) and the initial proposal of Basel III, the debate regarding the regulation of systemically important financial institutions (SIFIs) continues unabated. Prominent among the present proposals is one led by prominent financial economists who argue in favor of 15% capital adequacy requirements for banks. So far, banks and their political supporters have resisted this proposal, claiming that it presents the banks with prohibitive and unnecessary costs. This Article proposes a mechanism, called elective shareholder liability, that provides the shareholders of the largest banks with a way to identify the costs of higher capital adequacy beyond simply the subsidies that come by way of the implicit governmental guarantees that the SIFIs presently enjoy. Elective shareholder liability gives SIFIs the option to subject themselves to the 15% capital adequacy, or, if not, grant a bailout exception to the SIFI’s present limited shareholder liability status. The latter is structured as an obligatory governmental cause of action for the recoupment of all bailout costs against the shareholders, assessed on a pro-rata basis. The cause of action would include an up-front stay on litigation to ensure that there are, in fact, taxpayer losses to be recouped, and to dampen government incentives for over-bailout, political manipulation, and crisis exacerbation. The cause of action would also give the government the authority to declare the shareholders’ use of the corporate form to evade liability null and void. After explaining the structure and benefits of elective shareholder liability, the Article addresses more than a dozen potential objections. Close inspection of these objections, however, reveals that the overall case for elective shareholder liability is strong as a matter of history, law, and economics.