In their lively disagreement about the role of deregulation in contributing to the 2007-2009 financial crisis, professors Arthur Wilmarth and Paul Mahoney inadvertently illuminate why the processes through which finance is regulated are so ill-suited to that purpose. Finance is dynamic. Today’s financial system bears only a coarse resemblance to the financial system of the 1950s. Tomorrow, the system will evolve yet further and in ways we may not be able to imagine today. In contrast, the legal regime is designed to stagnate. Frictions make statutes and regulations difficult to change, even when market changes have already altered the substantive … Read more
As we approach the 10-year anniversary of the failure of Lehman Brothers, the news is again awash in a debate about whether policymakers could have saved the investment bank. That the issue remains so deeply contested reflects how fundamentally flawed the current legal regime is. Although embodying ideas that are sensible in the abstract, the regime makes the authority to act contingent on facts that policy makers cannot readily discern during periods of systemic distress. Making matters worse, subsequent events, including other actions by those same policy makers, can further skew the critical facts on which legal authority rests. This … Read more
Over the last half century, finance has made remarkable progress explaining the pricing of financial assets. In relying on portfolio theory, however, mainstream pricing models tend to ignore investor preferences for certain asset types. This is a mistake. In a new paper forthcoming in Harvard Business Law Review and available here, I weave recent empirical findings on the demand for “safe assets” with an institutional account of how financial intermediaries increase the effective supply of such assets to demonstrate how investor preferences can drive financial innovation and radically alter the structure of the financial system. By moving beyond abstract … Read more
In a world of “alternative facts” and political rhetoric crafted to mislead, it is easy to forget that idealized visions can at times illuminate more than they obfuscate. In a book review recently published in Harvard Law Review and available here, I attempt to separate fact from fiction in the debate about how best to regulate short-term debt. Although coming down in favor of pragmatism in financial policymaking, the review recognizes the ways that imaginative alternatives can reveal often-obscured choices and help lay the foundation for a better path forward.
The thought-provoking book that motivates the review is The … Read more
There are two established explanations for bank runs: coordination problems among depositors and information asymmetries between bank managers and depositors. In a new paper, “Information Gaps and Shadow Banking,” forthcoming in the Virginia Law Review and available here, I offer a novel, complementary explanation for why short-term creditors run: information nobody possesses.
Both the banking and shadow banking systems use short-term debt to fund longer-term, less liquid assets. That short-term debt is designed to pose sufficiently minimal credit, liquidity, and duration risk that holders can treat the claims as close substitutes for money. This reduces funding costs and has … Read more
On Monday, LendingClub Corp., a leader in the growing online lending space, announced the surprise resignation of its founder and CEO, Renaud Laplanche. Laplanche resigned in response to a board investigation that revealed a number of internal control failures, including the sale of more than $20 million in loans that failed to conform to the requirements imposed by the acquiring investors and the doctoring of dates on loan applications to cover up noncompliance with respect to $3 million in loans sold. These developments triggered a massive decline in LendingClub’s stock price, but also contribute to a growing cacophony of questions … Read more
Is “intermediary influence” all that unique? Can it be isolated? And how much harm really results? These are among the questions Professor Lawrence Cunningham poses in his thoughtful essay and recent post responding to my work on how intermediaries alter institutional arrangements in self-serving and socially costly ways. In the essay, Professor Cunningham also examines the acquisition market to provide additional evidence of intermediary influence while simultaneously introducing the question of how competition limits intermediary influence and the welfare losses that emanate from it.
Professor Cunningham concludes that “far from constituting criticism of Judge’s work, [the] questions [he raises] warrant … Read more
As reflected in the title of the new memoir by Former Federal Reserve Chairman Ben Bernanke, The Courage to Act: A Memoir of a Crisis and Its Aftermath, Bernanke clearly believes that he and other Fed policymakers demonstrated exceptional courage in their handling of the 2007-2009 financial crisis. In a new paper forthcoming in Columbia Law Review and available here, I suggest otherwise. I agree with Bernanke that if one narrows the lens to the Fed’s actions after Lehman Brothers failed in September 2008, the Fed and other financial regulators often displayed great courage and creativity and … Read more
Bagehot, as in Walter Bagehot, was mentioned no less than seven times in the decision splitting the baby in the AIG trial. A nineteenth century British commentator, Bagehot was among the first to recognize that too little liquidity could wreak havoc on a financial system.  In a series of admonitions, known today as Bagehot’s dictum, he admonished central banks to lend freely to any solvent institution with good collateral, but at a penalty rate to minimize the attendant moral hazard. In invoking Bagehot, Judge Wheeler was in good company. Ben Bernanke and other leading policymakers regularly invoked … Read more
“There is an old saw that the Fed chair is the second most powerful person in government. In the aftermath of the financial crisis, that may actually be an understatement.” Nicholas Lemann, The New Yorker:
America has a long and conflicted relationship with central banking. The controversial actions taken by the Federal Reserve during and since the 2007-2009 financial crisis reignited longstanding concerns about vesting so much authority in the hands of a few unelected officials. The Fed’s creative and aggressive use of its authority likely helped to reduce the size of the financial crisis and the magnitude of … Read more
Why haven’t the significant financial and technological innovations of the past thirty years substantially decreased the cost of financial intermediation? What explains the ever-increasing complexity of financial products and markets? Why do so many investors hold actively managed mutual funds despite evidence that their costs typically exceed their benefits? How is it that real estate brokers remain able to charge such high fees despite the rise of the Internet and the increasing capacity of buyers and sellers to connect without their services? These are just a few of the questions that I address in a new article forthcoming in the … Read more
With the stock market regularly surpassing record highs, housing prices surging 13.6 percent in 2013 alone, and unemployment down to 6.7 percent, it is easy to forget just how dire the economic outlook appeared just five years ago. It is also tempting to assume that we have figured out what went wrong and have made the changes necessary to address the fragilities the crisis revealed. After all, academics, policymakers, and other commentators have produced seemingly endless articles and books about the crisis. Congress also passed the Dodd-Frank Act, the most sweeping financial reform bill since the 1930s. A closer look … Read more
It is well known that the Fed injected massive amounts of liquidity into the financial system during the 2007-2009 financial crisis. Far less well known is that the Fed was not the only place banks obtained government-backed liquidity when market sources first ran dry. Moreover, during the early stages of the Crisis, the Fed was not even the primary source of government-backed liquidity. As I reveal in a new paper forthcoming in the Cornell Law Review, and available here, instead of going to the Fed’s discount window, banks increased their reliance on two other forms of government-backed liquidity. … Read more
In A Legal Theory of Finance, Katharina Pistor introduces a provocative new theory about the relationship between law and finance and the role of law in producing and addressing financial instability. Pistor shows that law plays a constitutive role in the financial system; yet, because of irreducible uncertainty and uneven liquidity, legal obligations, fully enforced, “would inevitably bring down the financial system.” Hence, the law-finance paradox. Collapse is avoided, and predictably so, by the relaxation or suspension of legal obligations, revealing law to be inherently elastic. Significantly, however, law’s elasticity is not uniform. “Law tends to be relatively elastic … Read more
My forthcoming article, Interbank Discipline, draws attention to the important role that banks play monitoring and disciplining other banks. To understand the significance of interbank discipline, the Article proposes a new way of thinking about market discipline more generally. In the first wave, advocates of market discipline viewed it as a basis for deregulation. Why expend government resources duplicating the efforts of market participants, the rationale went, particularly considering that regulation can discourage market discipline and markets are often more effective than regulators? The 2007-2009 financial crisis, and numerous scandals preceding it, largely brought an end to such reasoning. … Read more