Did Deregulation End the “Quiet Period” of Low-Risk Banking?

From the New Deal until the 1970s, banks were on a tight leash. Regulators controlled the rate of interest they could pay on deposits. Banks could not underwrite or deal in corporate securities. With some exceptions, they could not expand geographically.

These restrictions were gradually eliminated beginning in the 1970s. Simultaneously, banking grew riskier. From the end of World War II to 1970, bank failures were virtually nonexistent. From that time on, the U.S. experienced waves of bank distress culminating in the financial crisis of 2007-09.

It is tempting to conclude that the deregulation caused the instability. I believe, however, … Read more

The Deregulation Debate: The Challenge of Using Static Rules to Govern a Dynamic System

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

Do Investors Care Who Did the Audit?

In 2008, the U.S. Department of the Treasury’s Advisory Committee on the Auditing Profession called for a “standard-setting initiative to consider mandating the engagement partner’s signature on the auditor’s report” as a way to increase audit transparency.[1] The Public Company Accounting Oversight Board (PCAOB) considered this call, weighing investor benefits (e.g., increased transparency) against potential costs to the audit profession (e.g., increased litigation risk and administrative costs). After considerable discussion with registrants, investors, and audit firms, the PCAOB responded in December 2015 by enacting Rule 3211, Auditor Reporting of Certain Audit Participants.

The new rule mandates that auditors … Read more

Lehman Brothers: How Good Policy Can Make Bad Law

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

A Retrospective on the Demise of Long-Term Capital Management

The 10th anniversary of the harrowing financial events of September 2008 is nearly upon us.  The anniversary will undoubtedly be marked by various retrospectives analyzing those events.  For a longer-term perspective, though, it may be helpful to consider another anniversary that will be observed in September 2018:  the near failure of Long-Term Capital Management, L.P. and its fund, Long-Term Capital Portfolio, L.P. (collectively “LTCM”) 20 years ago.  LTCM was the largest hedge fund operating in the United States and its brush with death provided a preview of some of the forces that would contribute to the near collapse of the … Read more

Why Do Firms Go Public Through Debt Instead of Equity?

Private firms can gain access to capital markets in several ways. The most well-known approach is through an initial public offering (IPO) of equity, and high-profile firms typically attract a large amount of attention from the popular press when they go public. However, a less publicized approach is going public through an initial public debt offering (IPDO), an alternative option for tapping public markets. One example of an IPDO firm that issued public debt (through a private subsidiary) before issuing public equity is United Parcel Service Inc. The company was founded in 1907, filed its IPO S-1 registration statement on … Read more

How Markets Learn to Value the Financial Performance of Socially Responsible Firms

Market reactions to a company’s performance on environmental and other social issues are ambiguous, because it is difficult to measure social and financial performance and how they affect each other. We, however, create a virtual value-weighted portfolio based on the list of “100 Best CSR companies in the world” published by Reputation Institute and show that investing in this portfolio could provide investors annual abnormal returns of between 1.98 percent and 2.74 percent.

Corporate social responsibility (CSR) facilitates the integration of business operations with values so that the interests of all stakeholders—including customers, suppliers, employees, communities, governments, society, and the … Read more

Buy-Side Analysts and Earnings Conference Calls

The role of sell-side equity analysts in the capital markets has been researched extensively by academics over the past several decades. In contrast, due to data limitations, there has been little research on buy-side analysts. Buy-side analysts work for institutional investment firms and have different incentives and responsibilities than do their sell-side counterparts working at brokerage firms. That makes buy-side analysts not only worthy of study in their own right, but also makes it unclear whether the inferences and conclusions from the sell-side analyst literature also apply to buy-side analysts. While it is widely assumed that buy-side analysts conduct fundamental … Read more

Hidden Holdouts and the Puzzling Pricing of Collective Rights: An Analysis of the Venezuelan Debt Crisis

The emergence of “activist” investors across a range of markets has been one of the most interesting phenomena of the past few decades (see here, here and here). These investment funds seek to capture rents from their investments by “actively” enforcing their rights.  Activist investors pursue this strategy in markets in which the majority of investors are passive. Much of the discussion of this development in both the financial press and the academic literature has focused on activists acquiring equity positions in order to influence a firm’s management policies (see here and here). Our focus, however, is … Read more

Debevoise & Plimpton Discusses a Turning Point for FinTech

On July 31, 2018 the Office of the Comptroller of the Currency (“OCC”) announced it will begin accepting applications from non-depository FinTech companies for a special purpose national bank charter. [1] This announcement caps a years-long and much anticipated initiative by the agency to make federal banking charters available to FinTech firms (see our prior analysis, here and here describing previous developments).

The OCC’s action came on the same day that the Treasury Department released the fourth report (the “Report”) mandated by Executive Order 13772, setting forth the Trump administration’s “core principles” for regulating the U.S. financial system.[2]  The … Read more

The Role of Relationships and Informal Norms in Entrepreneurial Finance

Contracting parties in an on-going relationship often rely on informal norms to resolve disputes and reduce transaction costs.  Known as “relational contracting,” this concept is typically studied in the context of procurement contracts between manufacturers and suppliers,[1] but it also applies in finance.[2]  A pre-existing relationship between an external investor and an entrepreneur can reduce monitoring costs, limit opportunistic behavior, and lower the initial cost of capital.

Despite the benefits of a relational contract, investors seeking to fund startups may need to look beyond their existing networks to find an entrepreneur with an innovative business plan.  Consistent with … Read more

The Role of Artificial Intelligence and Machine Learning in Risk Management

Lending in China is a risky proposition. When a U.S. bank needs to decide whether to approve a loan to a U.S. customer, it simply accesses the customer’s credit report, which is often the deciding factor. The bank can thus reasonably manage its credit risks based on the historic default rates for the lending categories it specializes in.

In China, however, about 80 percent of potential borrowers have no credit record. That has left lenders with two approaches to credit risk: concentrate on lending to the highly sought-after 20 percent of borrowers with credit records and live with less profitable … Read more

Do Financial Analysts Help Improve Firm Productivity?

Academic researchers in corporate finance have in recent years taken a renewed interest in the impact of private firms on employment, growth, and other positive developments in national economies. In a recent article, we develop this new field of research by looking at how the financial system can foster (or hinder) a firm’s ability to make productive investments. Access to capital is a key factor in the success of firms with valuable investment opportunities, and financial analysts could improve access to external financing by producing and disseminating firm-specific information. As such, researchers have found that analysts help to reduce information … Read more

Latham & Watkins Discusses U.S. Inversion Regulations After New Tax Law

On July 11, 2018, the US Department of the Treasury (Treasury) and the Internal Revenue Service (the IRS) issued final regulations (the Regulations) continuing efforts aimed at curbing cross-border corporate expatriation transactions — commonly referred to as inversions — and diminishing the tax advantages associated with inversions.

The Regulations generally follow the guidance provided in notices and temporary and proposed regulations promulgated during the 2014-2016 period (the Prior Guidance), with certain clarifications and modifications. Differences between the Regulations and the relevant Prior Guidance are generally technical, and the Regulations do not change fundamental policy decisions reflected in such guidance.[1]Read more

Where the Fisch, Hamdani, and Davidoff Solomon Theory of Passive Investors Goes Awry

President Reagan once said, “I’ve heard that hard work never killed anyone, but I say why take the chance?”  In a recent paper, professors Jill Fisch, Assaf Hamdani, and Steven Davidoff Solomon (hereafter “FHDS”) argue that passive investors – the big index funds that many of us invest with – have no choice but to work hard. FHDS argue that passive funds must compete with active funds for investors by engaging with portfolio companies, and, most importantly, that this engagement is designed to improve the performance of their passive funds. As FHDS put it, “Our fundamental insight is that … Read more

How Institutional Investors Gain an Information Advantage: Evidence From Option Backdating

Institutional investors are often viewed as informed traders, and individuals attempting to trade in the same market as institutions are likened to “tourists playing poker with professionals in the smoky backroom of a Las Vegas casino.”[1] So how do institutional investors gain their trading edge? By analyzing data based on public signals? By obtaining privileged information from connections? Or, is it just pure luck?

In our article, “Option Backdating Announcements and Information Advantage of Institutional Investors” (Journal of Accounting, Auditing, and Finance, in press 2018), we attempt to identify the source of institutional investors’ information advantage by … Read more

The Consequences of Restatements for Outside Directors

Serving on a public company’s board of directors carries responsibilities and risks as well as benefits for directors.  If directors do not carry out their duties effectively, they risk damaging their reputation, losing their board seats, and facing shareholder lawsuits.  In a recent paper, “Consequences of Restatements for Outside Directors,” I review the academic literature to identify the consequences directors face if the company on whose board they serve must restate its financial reports.

A restatement is required when a firm, its auditor, or the SEC finds that a prior period financial statement is materially inaccurate, forcing the company to … Read more

Empowering the Poor: Turning De Facto Rights into Collateralized Credit

The shrinking middle class and the widening gap between the rich and the poor threaten social and financial stability. The noted economist Hernando De Soto has explained how the lack of credit increases wealth inequality. Largely due to poverty, 70 percent of the world’s population lacks registered title to their land, even in developed countries. The poor therefore cannot use their homes as collateral to borrow and create wealth. The impact is devastating not only to individuals but also to commerce, because mortgage lending is the primary source of capital used to start small businesses.

My new article, available hereRead more

Taking Investor Preferences Seriously

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