Regulating Financial Guarantors: Abstraction Bias as a Cause of Excessive Risk-taking

Since the 2008-2009 financial crisis, scholars, regulators, and policymakers have engaged in extensive studies to try to control excessive risk-taking by systemically important financial firms. In a recent article, available here, I argue that those studies do not fully explain the unusually excessive risks taken by financial firms as insurers of bonds and other debt securities, as sellers of protection under derivatives known as credit-default swaps (“CDS”), as providers of credit enhancement in securitization transactions, as issuers of standby letters of credit, and otherwise as guarantors of financial obligations (collectively, “financial guarantors”). Despite their sophistication, financial guarantors tend to … Read more

Time Variation in the Relationship Between News and Returns

How does the stock market respond to news reports about a company? Previous work has found that it takes a few days for prices to fully absorb news, and this underreaction has been attributed to investors’ limited ability to process information. We find evidence for an alternative explanation: Sophisticated institutional investors trade slowly on news to avoid tipping their hands. Once we control for this effect, we find that the market actually overreacts to news.

Academic interest in how markets process information dates back to Eugene Fama’s pioneering work in the 1960’s.  Fama argued that markets are highly informationally efficient, … Read more

Fintech and Banking

In a recent paper, I review the literature on fintech and its interaction with banking. Included in fintech are innovations in payment systems (including cryptocurrencies), credit markets (including peer-to-peer or “P2P” lending), and insurance, with blockchain-assisted smart contracts playing a role. My review paper defines fintech, examines the stylized facts, and then reviews the theoretical and empirical literature. The paper summarizes our knowledge on the main research  questions raised by the literature review and concludes with questions for future research.

Fintech is a hot topic, even though the interplay between information technology and financial services is not a new … Read more

Is the Cost of Equity Greater than the Risk-Free Rate?

As a matter of abstract financial-economic theory, the cost of equity is straightforward. It is the minimum expected return investors require to hold the firm’s equity at the current price. Financial economists may disagree on the best way to estimate the cost of equity or the causal relationships that drive costs of equity, but it is safe to say that we know what we mean by the term when we use it. And, for nearly all equities, we almost always mean an expected return that exceeds the risk-free rate.

But what evidence do we have that the cost of equity … Read more

ICO vs. IPO: Empirical Findings, Information Asymmetry, and the Appropriate Regulatory Framework

Initial coin offerings (ICOs) are a new form of fundraising whereby blockchain-related ventures raise public capital in exchange for newly issued digital tokens. The issued tokens may represent a variety of rights, ranging from financial rights – such as dividend and voting rights – to consumptive rights, such as the right to access a service or a product that the issuer will provide. After the fundraising ends, the issued tokens are generally traded on the secondary market.

ICOs have quickly become popular. While the idea of an ICO debuted in 2013,[1] by 2017, over $10 billion had been raised … Read more

Davis Polk Discusses Financial Action Task Force’s Virtual-Asset Guidance

The Financial Action Task Force (FATF), the inter-governmental body that sets international standards for anti-money laundering (AML) and countering the financing of terrorism (CFT), released a highly anticipated interpretive note and guidance on June 21, 2019, “Guidance for a Risk-Based Approach to Virtual Assets and Virtual Asset Service Providers” (the Guidance), clarifying the application of its 40 Recommendations to virtual assets (VAs) and virtual asset service providers (VASPs).  The Guidance, which builds on steps FATF has taken over several years toward setting international AML/CFT standards for the virtual currency … Read more

Do Advisers Mitigate IPO Underpricing and Withdrawals in Europe?

Many issuers have doubts about the efficiency of the IPO market, despite post-2008 regulations designed to reduce conflicts of interests and the costs of going public.  As a result, fewer companies are choosing to be listed, and many of those that do go public hire independent advisers to gain peace of mind throughout the process[1].

In our new paper, we ask whether such advisers reduce IPO underpricing and whether issuing firms benefit from greater certainty of execution or lower total fees.  We concentrate our analysis on the three leading IPO advisers in Europe (Rothschild, Lazard and STJ Advisors), … Read more

Can Corporate Income Tax Cuts Stimulate Innovation?

There has been a growing debate among politicians and policy makers, both at the state and federal levels, about the impact of taxes on investment, growth, and firm value. The focus has been predominantly on corporate income tax cuts because, as the Congressional Budget Office (2017) reports, the U.S. has the highest top statutory corporate income tax rate among the G20 nations. Without a systematic examination, however, especially one that focuses on the long-term, it is difficult to evaluate the importance of corporate income taxes.

In our article forthcoming in the Journal of Financial and Quantitative Analysis, we contribute … Read more

Libra: The Regulatory Challenges Facebook Ignored

The announcement on June 18 by Facebook of what it calls “a simple global currency and financial infrastructure that empowers billions of people” was sure to receive immediate attention. Facebook founder and CEO Mark Zuckerberg is now on a global “mission.”[1] However, the Libra White Paper is long on Libra’s technology and short on the regulatory challenges it faces around the world.

  • The diagnostic

The need for Libra is based on a diagnostic: People lack access to a global, open, instant, and low-cost way to move money. The project focuses on international payments.

Why is cross-border payment expensive? First, … Read more

Why the New Tax Law Offers a Questionable Incentive to Incorporate

This spring, both Apollo and Blackstone announced that they would be converting from publicly traded partnerships to subchapter C corporations.   In changing their legal forms of organization, they will join two other prominent private equity firms, Ares and KKR, which had earlier announced their intentions to convert from partnerships to corporations.   The conversion of leading private equity firms to corporations has been seen as the vanguard of a mass conversion of businesses from pass-through entities and partnerships to corporations in response to tax rate changes that took effect in 2018.

The late-2017 tax reform, commonly knowns at the Tax Cuts … Read more

How Taxing Short-Term Share Profits Can Foster Innovation

If short-termism shackles innovation, how do we break the chains? Our evidence suggests that increasing capital gains taxes for investors on short-term share appreciation is one possible solution.

Research shows that myopic focus on short-term earnings hurts investments in research and development (R&D), and one key driver of this corporate myopia is the pressure from shareholders with short horizons. The issue is that short-horizon investors are likely to devote their research efforts toward forecasting quarterly profits instead of trying to understand the long-term prospects of a firm’s R&D and investment portfolio. As a result, corporate managers worry that short-horizon investors … Read more

ISS Discusses Why EVA Is a Better Measure of Investment Value Than EBITDA

There’s no doubting the popularity of EBITDA—earnings before interest taxes depreciation and amortization—as a measure of investment value. Analysts like EBITDA because it removes the vagaries of depreciation and taxes and is unaffected by company leverage ratios. EBITDA is certainly a useful indicator of the gross cash operating profit performance of a business. But is it a reliable way to measure the value of a company?

The short answer is, no, not at all. EBITDA is far less correlated to market value than is commonly thought, and it is riddled with omissions and distortions that make it a highly unreliable … Read more

Arnold & Porter Discusses the End of LIBOR

As alerted in our previous Advisories, LIBOR, the “world’s most important number,” is being phased out. Created almost 50 years ago on August 15, 1969—opening day of the Woodstock music festival—LIBOR began as a floating, market-determined interest rate for syndicated loans, but over time has become the benchmark interest rate for an estimated $350 trillion in outstanding financial arrangements around the world. These contracts include public and private loans and bonds; consumer financial products such as credit cards, mortgages and student loans, and some $200 trillion in interest rate derivatives.

Due in large part to concern that the determination of … Read more

Why We Shouldn’t Regulate Reputation Risk at Banks

What do payday lenders, firearms retailers, porn stars, churches, coal mines, and condom companies have in common? All have complained that regulators pressured financial institutions to close their accounts over reputation-risk concerns.  In a my article (available here), forthcoming in the Georgia Law Review, I explain that broad regulation of reputation risk does not reduce bank risk and unnecessarily politicizes bank regulators.

Financial regulators say reputation risk is the risk of negative public opinion or negative publicity. Wells Fargo, for example, hurt its reputation by opening millions of unauthorized customer accounts. Reputation is important to all businesses, but it … Read more

Network-Sensitive Financial Regulation

Shocks to only part of the financial system, such as the collapse of the subprime mortgage market in 2007, can spread and intensify through the complex interconnections among financial and non-financial institutions to become systemic threats. The consequences can be catastrophic, prompting economists and regulators to study and find ways to curtail such threats by using network theory. Legal scholars, however, have so far largely overlooked that approach, as have policymakers. Most financial regulation remains atomistic, in that it fails to account for the fact that each individual is part of, and plays a role in, a wider network.

In … Read more

The Imperative for Blockchain Accounting

For hundreds of years, the basic flowchart of accounting information has been the same.  A firm records its own transactions, maintains a record of those transactions, and reports those transactions (Soll, 2014, xiv).  Trends in technology make it inevitable that this basic information flowchart will end.  In the future, multiple parties will record each transaction, and many more parties will maintain encrypted copies of each transaction.  Anyone with the required keys to access a firm’s records will be able to generate financial reports for the firm.

For historical reasons, the move to blockchain is inevitable.  Over the centuries, information records … Read more

Venture Bearding

For founders of companies, appealing to funders can be everything – and that often means projecting a masculine image.  In a recent article, we coined the term “venture bearding” to describe this phenomenon, a tactic that can make the difference between raising capital and laying off employees.

To understand why, consider that investors  feel most comfortable with people like themselves, and that the vast majority of investing partners at venture capital firms are men. It’s no surprise, then, that in 2018, all-female startups took in only 2.2 percent of venture capital dollars.  Women-led startups that did close deals averaged only … Read more

Debevoise Discusses Guidance on Applying Bank Secrecy Act Framework to Convertible Virtual Currency

The Financial Crimes Enforcement Network (“FinCEN”) issued interpretive guidance on May 9, 2019 explaining how the agency intends to apply its existing regulatory framework to companies offering common types of convertible virtual currency (“CVC”) products and services (the “CVC Guidance”).1 Although FinCEN largely summarizes and distills existing guidance, participants in these emerging markets have welcomed additional clarity on the agency’s evolving approach.

This update summarizes the CVC Guidance, outlines its application to specific types of CVC activities and discusses its practical import for the market.


FinCEN explains that participants in … Read more

Regulatory Arbitrage, Unclear Terminologies: A Challenge to Global Cryptoasset Regulations

Few innovations in finance have emerged in recent years that are as controversial or present as many challenges to regulators and policymakers as cryptoassets. A key question for regulators and market participants is the extent to which the difference between cryptoassets and traditional financial assets is more form than substance? It is an important question since the answer defines the appropriateness of existing regulation for cryptoassets and related activities. In an inaugural research study on the global cryptoasset regulatory landscape, a team of researchers at the Cambridge Centre for Alternative Finance has aimed to shed light on this question by … Read more

Emergency Guarantee Authority: The Pros and Cons

Today, we present a debate among preeminent scholars about Columbia Law School Professor Kathryn Judge’s proposal for an emergency guarantee authority that could help contain the fallout from another financial crisis. The first piece is Professor Judge’s summary of her proposal. It is followed by responses from Professor Morgan Ricks at Vanderbilt Law School, Graham Steele at Stanford University’s Graduate School of Business, and Professor Stephen G. Cecchetti at the Brandeis International Business School and Kermit L. Schoenholtz at New York University’s Leonard N. Stern School of Business.… Read more