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The Online Version
of the Magazine
of Cornell Law School


Spring 2011


Volume 37, No 1

Road to Regulation

Professor Charles Whitehead


Charles K. Whitehead, Associate Professor of Law, Cornell Law School

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Table of Contents  Featured Article

Regulating for the Next Financial Crisis


Financial regulation, such as the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act), is often reactive—responding to a crisis, a shift in the markets, or other change that threatens financial stability.(1) The decision in the 1930s to separate commercial and investment banking followed the onset of the Great Depression, which resulted from, among other things, a restrictive monetary policy and a precipitous decline in stock values after transformative growth in the equity markets. Congress regulated financial intermediaries using categories that reflected the functions, products, and services provided at the time. Those categories worked fairly well over the next seventy-five years, with only minimal disruption.

Financial intermediation, however, continues to evolve—which means that regulation, including the Dodd-Frank Act, typically trails change in the marketplace. Take, for example, the chief operating officer of a manufacturer (the Seller) who wishes to increase her sales to an existing, large customer (the Buyer). The Buyer typically pays the Seller on a delayed basis. More sales will result in a substantial boost in profits; but, at the same time, they will increase the Seller’s exposure to the risk the Buyer will fail to make its payments when due. In the 1970s, the COO might have considered the following in order to offset that risk: 

- As a preliminary matter, she might simply decide to self-insure against the increased risk of default (a bad debt reserve)—setting aside capital against that possibility, which could be less expensive than third-party insurance but might not protect the Seller against unexpected loss.

- Alternatively, the COO could ask the Buyer to arrange with its bank to post a letter of credit in the Seller’s favor, in effect substituting the bank’s creditworthiness for the Buyer’s as an independent assurance that payment will be made.

- The COO could also sell the accounts receivable to a factor, which typically purchases them at a discount, taking on the risk of the Buyer’s default, as well as benefiting from any gain if the Buyer pays more than the discounted price. 

- Finally, the COO might purchase a commercial credit insurance policy that is payable upon the Buyer’s default. The insurer, as part of the underwriting process, would actively monitor the Buyer’s credit quality, as well as adjust the amount of its coverage depending on changes in the Buyer’s financial position.

Today, the COO has available to her an even greater menu of new products and strategies to choose from.

- In addition to the traditional options, she could decide, in the first instance, to securitize the Buyer receivables—transferring them to a trust or other entity and then selling interests in the pool to the public. Like factoring, interest holders take on both the risks and benefits of the Buyer’s credit quality.

- Alternatively, the COO might decide to short sell the Buyer’s stock, with any profit from a decline in share price potentially offsetting a portion of the losses it incurs if the Buyer’s credit also declines. Changes in stock price, however, may not completely correlate with the Seller’s losses, resulting in a mismatch (referred to as “basis risk”) between the hedge and the Seller’s exposure.

- The COO could also enter into a credit default swap (CDS) with a hedge fund or other counterparty whose value is tied to one of the Buyer’s outstanding loans or bonds. Using a CDS, the Seller could economically short the Buyer’s credit risk by structuring the swap so that its value increases in the event the Buyer defaults on a referenced obligation. Payments received under the CDS could offset any losses the Seller incurs, subject again to basis risk in the event of a mismatch between the CDS and the amounts owed by the Buyer to the Seller.

- Finally, the Seller could issue credit-linked notes (CLN) in the capital markets whose redemption value at maturity is tied to the Buyer’s credit. If that credit declines, then an amount less than par would be paid to the CLN investors.
In return for that risk, investors would receive a coupon that was somewhat higher than the market standard. Economically, the CLN would be equivalent to the sale by the Seller of ordinary fixed-rate notes against its purchase from the note holders of CDS whose value is referenced to the Buyer.

The example illustrates two important points. First, it highlights a move from regulated (e.g., banks and insurance companies) to less regulated intermediaries (e.g., securities firms and hedge funds), as well as from traditional products and services provided by intermediaries (e.g., letters of credit and insurance) to lower-cost alternatives, in many cases through the capital markets (e.g., securitization and CDS). As a result, traditional intermediaries have lost market share—with banks, most notably, losing ground to less regulated businesses, and the securities markets becoming a lower-cost source of capital and risk-bearing. Second, it illustrates that different intermediaries—irrespective of the traditional categories in which they fall—can achieve similar results today using a variety of products and trading strategies, many of which did not exist thirty years ago. Thus, in this example, the Seller’s exposure to the Buyer could be managed through one or more of a bank, insurance company, securities firm, or hedge fund, in each case with economically similar outcomes.

In short, these aren’t your father’s financial markets. A principal change has been convergence in the products and services offered by traditional intermediaries and new market entrants. The result has been new competition, as well as a shift in capital-raising and risk-bearing from traditional intermediation to lower-cost alternatives. New products and services, often replicating those historically provided by banks, insurers, and others, are now offered by new market participants or through the capital markets. Nevertheless, whether a firm is a bank, insurance company, asset manager, or broker-dealer continues to often be defined using business models that date from the 1930s and 1940s, dictating the principal regulations (and associated costs) to which each firm is subject. As Jamie Dimon, J.P. Morgan Chase’s chairman and CEO, has observed, “A lot of the rules and regulations [we have] are closer to the Civil War than they are to today.”

Is it possible to regulate prospectively? Can we anticipate the next financial crisis and head it off at the pass? Doing so, no doubt, is difficult. To begin down that road, however, requires our existing approach to regulation to affirmatively take account of change in the financial markets. The Dodd-Frank Act, although a step in the right direction, often fails to do just that. As a result, the Act may prompt an overall increase in financial risk-taking. Three examples help illustrate the point: First, non-banks now perform bank-like functions, introducing new risks to the financial markets not directly addressed by the Dodd-Frank Act. Second, by imposing a static separation between banking and proprietary trading, the Dodd-Frank Act may not properly take account of new relationships within a fluid financial marketplace. And, third, much of financial regulation continues to focus on individual firms, each considered separately, without considering the systemic effect of coordinated conduct among market participants. I address each example below.

Old Functions, New Actors. New financial instruments now permit non-banks to perform bank-like functions. In the past, the costs of bank regulation were offset by a special franchise that minimized competition by non-banks. That franchise eroded as new market entrants began to offer lower-cost alternatives. Banks, for example, began to face new competition from money market funds (MMFs) and finance companies that replicated the balance between suppliers and consumers of capital traditionally struck by banks. On the consumer side, finance companies are in the business of lending to retail and business borrowers, relying on MMFs for funding through the sale to them of short-term commercial paper. On the supplier side, MMFs offer investors many of the conveniences of a bank, like checking services, by managing their portfolio investments against the possibility of capital withdrawals. The result, considering MMFs and finance companies together, is the functional equivalent of deposit-taking and lending by banks. Regulatory change also made traditional banking less profitable. For example, the introduction of new regulatory capital requirements in the late 1980s made it more expensive for banks to continue the lending business as they had before, causing them to expand into new products and services. In response, banks modified their business models, which included moving loans off-balance-sheet to a “shadow” banking system set up to minimize regulatory capital charges.

Banks also began to transfer only the credit risk of their loans, separating their role as working capital providers from their traditional function as credit risk managers. Financial regulation helps police the amount of risk a bank can incur, as well as how that risk is managed. But, increasingly, banks relied on new financial instruments—such as CDS—to transfer risk management to less regulated entities, including hedge funds, which could manage the credit risk of a bank’s loan portfolio without extending loans themselves. In effect, new instruments enabled banks to outsource a core function from an industry subject to close, prudential supervision to one that, to a great extent, was beyond regulatory oversight—resulting in an overall market-wide increase in financial risk-bearing. The Dodd-Frank Act expanded hedge fund regulation by, among other things, eliminating the private adviser exemption from the Investment Advisers Act of 1940 and, with some exceptions, by requiring private fund advisers to register with the SEC. Yet, as a practical matter, the new requirements are unlikely to have a substantial effect on the hedge fund industry. In order to attract pension fund investors, many of the largest advisers were already SEC-registered. In addition, the SEC estimates that, based on its current resources, it will not be able to audit a registered investment adviser more than once every eleven years. The Act also does little to directly address the outsourcing of a traditional bank function. To be sure, information the SEC gathers can be provided to the newly created Financial Stability Oversight Council; in principle, this should assist efforts to assess systemic risk. The principal regulator, however, remains the SEC, with a rules-based (rather than prudential) approach to overseeing the industry. The Council, with the vote of seven of its ten members, can impose additional Federal Reserve regulation on systemically important non-bank financial firms. The focus, however, appears to be on individual firms that are “too big” or “too interconnected” to fail—unlikely to include many hedge fund advisers—without considering the broader, systemic effects of outsourcing a traditional bank function, like credit risk management, to a less-regulated industry.

Static Models, Fluid Markets. The Dodd-Frank Act also prohibits any bank or bank affiliate from engaging in proprietary trading or investing in or sponsoring a hedge fund or private equity fund, subject to certain exceptions. The prohibition—known as the “Volcker Rule” (for former Federal Reserve Chairman Paul Volcker, who is credited as its chief architect)—reflects the populist view that proprietary trading distracted banks from their fiduciary obligations to clients, as well as from their core function of providing long-term credit to families and businesses. The Rule, in effect, was motivated by a desire to force banks to return to a traditional banking model—to create a static regulatory divide between commercial and investment banking, much like the Glass-Steagall Act did before its dilution and eventual repeal. By insulating banks from proprietary trading, the Rule’s proponents expect utility services, such as taking deposits and making loans, to once again comprise a bank’s principal activities.

As a starting point, what will happen to proprietary trading? Most likely, it will move to less-regulated businesses—in many cases, hedge funds—that are likely to incur greater risk. That risk can be mitigated if traders are subject to a market discipline that takes account of the full cost of their activities. The financial markets, however, are unlikely to do so—focusing, instead, on investor returns rather than on the broader consequences of hedge fund failure. That failure can be industry-wide. Hedge funds can be affected at the same time and in the same way following large adverse shocks to asset and hedge fund liquidity, irrespective of management style. Thus, the impact of a downturn can be significantly greater than the failure of any one fund. Simply ring-fencing hedge funds may also be difficult. Recall that hedge funds are significant participants in the CDS market, which banks and other financial intermediaries use to manage and transfer credit risk. The Dodd-Frank Act attempts to limit direct counterparty exposure by requiring banks and hedge funds, with certain exceptions, to centrally clear standardized swaps. It does not, however, address the impact on banks if hedge funds, as a group, are unable to manage bank-originated risk or can do so only at higher cost. The result can be a drop in available credit if banks—no longer able to rely on hedge funds—
must limit the amount of new loans they can extend.

In short, even if proprietary trading is no longer located in banks, it may now be conducted by less-regulated entities that affect banks and banking activities. The Volcker Rule fails to fully take account of change in the financial markets. The Glass-Steagall model reflected in the Volcker Rule is a fixture of the past—a financial Maginot Line within an evolving financial system. To be effective, new financial regulation must reflect new relationships in the marketplace. For the Volcker Rule, those relationships include a growing reliance by banks on new market participants to conduct traditional bank functions. Consequently, the Volcker Rule’s static approach to regulating banks may prove to be an ineffective means to address risk. Worse still, it may have the unintended consequence of causing hedge funds to increase risk-taking at a time when banks (as described in the prior example) have come to increasingly rely on them to help manage credit exposure.

Beyond “Too Big” or “Too Interconnected” to Fail. New, market-wide risks also fall outside the current approach to financial regulation. To date, regulation has largely focused on individual firms, each considered separately, without taking account of the systemic risk of coordinated conduct. Bank capital requirements, for example, help minimize the systemic effects of a banking collapse by reinforcing the financial stability of each individual bank. Yet, changes in the financial markets have introduced new risks that extend well beyond individual firms.

Financial risk management, for example, has grown over the last two decades, driven in part by the widespread adoption of “value-
at-risk” (VaR) measures to assess portfolio riskiness. When first developed, VaR was a specialized tool known only to a closed universe of risk managers. However, it quickly became a recognized standard, widely regarded as the Stradivarius of risk management tools. There are, as many have noted following the financial crisis, a number of problems with VaR—the most obvious being that VaR does not fully reflect the riskiness of a portfolio, with “black swan” events falling outside its measure. But sophisticated risk managers have been aware of these limitations and take them into account when deciding how to adjust portfolio risk. What has been more intriguing, I would suggest, is the widespread use of VaR. In particular, VaR has been incorporated into some of the financial industry’s core risk management regulations, reflecting its position as an industry best practice. It has been used, according to regulation, to calculate bank capital requirements, as well as, in the United States, to calculate the capital requirements of some of the world’s largest securities firms, as well as for over-the-counter derivatives dealers.

The concern is that, by standardizing how each trader’s portfolio is measured, different traders may now respond to the same event in a similar way—relying on VaR-based calculations to adjust their risk by selling assets, causing a drop in asset prices, prompting further sales, and so forth. In other words, imposing the same requirements on each individual firm may result in greater uniformity of action—with firms increasingly acting in unison, and in turn, influencing asset prices and the trading activities of others. The result can be a cascading decline in value, with greater coordination—driven by financial regulation—impairing each firm’s ability to manage risk exposure on its own. In short, although regulation can help reduce systemic risk, it itself can become a systemic risk through its ability to increase coordination and reinforce drops in the financial markets. Thus, the decline in CDO prices in 2007 was likely affected by similarly situated investors who decided to unwind their positions at the same time, and then looked to sell even further as market prices continued to decline. No doubt, some portion of the decline reflected each trader’s fear of holding a dwindling asset. Yet, some of it also reflected a market-wide reliance on a common risk management system.

What this suggests is that, as similar risks become dispersed across the marketplace, a focus on only individual entities—such as those that are “too big” or “too interconnected” to fail—will miss systemic problems that arise from market-wide decisions stemming, in this example, from a common response to a drop in price. New regulation must take account of dispersed risks that can still affect the marketplace generally.

A Flexible Response. The upshot is that financial regulation must begin to address “old” risks that arise in new situations and “new” risks that arise as financial instruments, participants, and markets continue to evolve. Stated differently, the financial markets have become more flexible, and so must the regulatory response. Efforts to simply freeze the division among financial intermediaries—such as the Volcker Rule—are likely to simply be outflanked, as evidenced by the inability of financial regulation to keep up with market change over the last thirty years. Partly in response, politicians, regulators, and academics (most notably, Nobel laureate Robert Merton) have advocated a functional approach to regulation, in which equivalent functions are regulated in the same way, irrespective of the institutions performing them. Institutions change over time, they argue, but the core functions will stay the same.

There is certainly an appeal to regulating like functions in the same way. Among other benefits, doing so would ensure that financial supervision is comparable across the financial markets and that customers would receive equivalent protection, irrespective of the intermediary through which they invest. A function-only approach, however, is incomplete precisely because it fails to take account of differences in the institutions performing them. Different structures, and varying agency and other costs, may make differences in regulation appropriate, even if the underlying functions are the same. Instead, regulators must begin to focus on the principal problems that regulation is intended to address, but considered in light of changes in the financial markets, the appearance of new market participants, and gaps in regulation the recent crisis has exposed.

The Dodd-Frank Act, of course, does address some important changes in the financial markets, principally in areas that received significant public attention. Yet, it also contains a number of ambiguities, many of which will not be addressed until new regulations are adopted. Even then, if history is a guide, market participants will again change their behavior—presenting new challenges as the financial markets continue to evolve. There is, however, some hope. Among its duties, the new Financial Stability Oversight Council must identify risks to U.S. financial stability, including regulatory gaps. Thus, the Dodd-Frank Act leaves open the possibility of the Council regulating (or recommending the regulation of) new risks as they come up. Future Council deliberations may include a more holistic approach to regulating the financial markets, and in the process, take into account the shift in capital-raising and risk-bearing from traditional intermediation to new markets and participants. Reflecting those changes may, in turn, help set the stage for a more forward-looking approach to financial regulation—potentially permitting us to begin the process of regulating for the next financial crisis.

1. Portions of this essay are based on the following articles by Professor Whitehead: “The Volcker Rule and Evolving Financial Markets” (Harvard Business Law Review, inaugural issue, forthcoming), “Destructive Coordination” (Cornell Law Review, 2011), “Reframing Financial Regulation” (Boston University Law Review, reprinted in Journal of Financial Transformation, 2010), and “The Evolution of Debt: Covenants, the Credit Market, and Corporate Governance” (Journal of Corporation Law, reprinted in Corporate Practice Commentator, 2009).

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