In her article “A Legal Theory of Finance” Katharina Pistor outlines an important theory about the relationship between laws and finance and highlights the basic legal construction of finance. A legal theory of finance (LTF) asserts that the legal structure of financial markets can contribute not only to the success of the financial markets, but also to their undoing. As a lawyer who has practiced more than 30 years in the finance area, I agree with the starting premise of LTF that laws and finance are inextricably linked, that laws affect finance both in the creating and structuring of the financial markets and in the workout of the meltdown of the financial markets. To the extent that capital flow and liquidity are central to the healthy functioning of the global capital markets, within countries and across the globe, laws provide the structures on which the instruments of finance are built and govern how financial instruments work. The laws are in turn driven by social, economic and political decisions about allocation of resources, what economic activities are to be encouraged and what constituencies will be the beneficiaries of economic success. At the other end of the spectrum bankruptcy laws and court decisions determine how resources are to be distributed and what groups will benefit if markets and institutions fail.
LTF starts with the assertion that finance is legally constructed and does not stand outside the law. Pistor states that financial assets are contracts, the value of which depends on their legal validation. Legally enforceable financial commitments are key to the functioning of international capital markets. The structure of laws in any country governing financial instruments and markets reflects the policies and politics being advanced within that country. These laws dictate the ways capital and liquidity are accessed, with liquidity being key to the ability of modern economies to function, as well as who has access to this capital and liquidity. Laws also establish the structures for the instruments of commerce. For example, in the early 1970s the U.S. government decided that it wanted to encourage home ownership and a strong secondary mortgage market. In 1970 the Federal government authorized FNMA to purchase private mortgages and created Freddie Mac as a competitor to FNMA, all in an effort to facilitate an active and efficient secondary mortgage market. FNMA and Freddie Mac were given the power to issue securities that raised capital to purchase pools of residential mortgages from banks and other institutions, thereby freeing capital in those institutions. This helped to foster the real estate boom and the rapid rise in American home ownership and set an example followed by other countries. The story of the growth in the U.S. mortgage securitization market, the excesses of that market, the financial collapse in 2008 and the U.S. government takeover of FNMA and Freddie Mac is not for this article, but it illustrates how markets are built through the creation of legal structures. In turn, when there are excess growth, bad players and concerns about the markets, the rewriting of the laws will change the hierarchies and who has access to capital, who the lenders are, how lending is done and who profits.
Pistor’s theory is also based on two additional premises, fundamental uncertainty and liquidity volatility. The most recent financial crises, starting in 2008, was largely a crisis of liquidity. Pistor posits that when there is a crisis of liquidity those at the apex will be served, either because laws are elastic (legal obligations are relaxed or suspended) or, as Kathryn Judge states in her comment on Pistor’s article, liquidity support can serve as a substitute for treating law as elastic. The U.S. government takeover of FNMA and Freddie Mac and the bailouts of AIG serve as illustrations of these points.
Pistor’s article is only the beginning of an inquiry into a very complex and very important topic. Among the central themes that will need to be discussed and expanded are:
- How are the laws governing financial instruments and markets formulated, by central governments, through case precedent, by governmental agencies and, increasingly, by transnational bodies.
- The apex issue introduced by Pistor, that where you are in the hierarchy dictates how elastic the law will be in its application in times of financial crisis. Viewed in conjunction with Judge’s view that an institution’s place in the hierarchy will also govern access to liquidity, this raises interesting questions of how to value different institutions, the role of politics, and the global impact of failures within the financial system.
- The implications of the international linkage of the financial markets. Pistor uses examples including the FX markets and the swaps markets to illustrate the interconnectivity of world markets and the necessity for standard rules to allow instruments to be traded in different jurisdictions. The successful functioning of global markets will also be dependent upon there being consistent treatment of market players in times of crisis and consistent decision making as to which players have access to liquidity and therefore will survive.
As Pistor and Judge point out, in light of the issues that arose during the financial crisis of the past five years, it is critical to understand, analyze and consider the issues raised by the LTF. The clearer our understanding of the role that law plays, and the ability to control access to liquidity, the more informed lawmakers, policymakers and judges will be when framing the laws and dictating outcomes of financial disputes.