Shocks that hit part of the financial system, such as the subprime mortgage market in 2007, can propagate and amplify through the complex network of interconnections among financial and non-financial institutions to take on systemic proportions. The financial crisis of 2007–2009 showed that the consequences of such systemic risk materializing can be catastrophic, prompting economists and regulators to redevelop the academic and regulatory toolkit used to study and curtail such risk. Increasingly, and intuitively given the important role of interconnections, they have resorted to the use of network theory to study systemic risk. Legal scholars, however, have so far largely overlooked this perspective. More importantly, policymakers have too; most of the rules in financial regulation remain 'atomistic', in that they fail to account for the fact that each individual is part of, and plays a role in, a wider network.
In a new paper, forthcoming in The Journal of Corporation Law, we argue that systemic risk can be more effectively mitigated by introducing 'network-sensitive regulations'. Such policies take account of the position and role of an individual institution in the financial network and become progressively stricter as the importance of that institution to the wider network increases.
This approach complements the shift in regulatory emphasis from preserving the stability of individual institutions ('microprudential' regulations or policies) to ensuring the stability of the system as a whole ('macroprudential' regulations or policies) in two ways. First, although there are some network-sensitive macroprudential policies, such as the risk-based capital surcharge for systemically important banks, we show that their implementation is incomplete and patchy. Second, as of yet there is no example of network-sensitive microprudential regulation. We argue that such policies are not only feasible but also helpful in mitigating systemic risk by applying network theory to a novel area: proposals that aim to enhance the corporate governance of systemically important financial institutions (SIFIs).
We consider four policy prescriptions that aim to enhance the corporate governance of SIFIs (one on directors’ liability, two on executive compensation, and one on failing financial institutions’ shareholders appraisal rights) that are currently atomistic in orientation, and show how making them network-sensitive would both increase their effectiveness in taming systemic risk and better calibrate their impact on individual institutions. Our purpose is not to argue in favor of (or against) any specific proposal but rather to highlight the advantages of a shift of paradigm in the direction of network-sensitive regulation in the area of corporate governance.
We first discuss the idea, advocated by John Armour and Jeffrey Gordon, of imposing personal liability on managers and directors of SIFIs. Armour and Gordon argue that managers and directors of SIFIs lack the incentives to account for the systemic relevance of their firm, because US corporate governance pushes managers and officers to focus on stock price maximization and compensates them accordingly, even when maximizing shareholder value creates significant systemic risk. Armour and Gordon suggest that personal liability is an effective means to counter these perverse incentives because it would induce managers and directors to internalize the systemic relevance of their firm. We show that their proposal may better achieve this goal if amended to incorporate the insights of network theory, because it enables us to impose higher expected liability on managers and directors of firms that can impose higher losses on the economy.
Second, some scholars have argued that the compensation structure for managers of systemically important firms—and in particular banks—should be regulated. If bank managers are compensated predominantly with stock and stock options, they will take excessive risks and impose negative externalities on the economy as a whole. For this reason, Bebchuk and Spamann have suggested that part of bank managers’ compensation should be based on a broader basket of securities that includes preferred stocks and bonds, inducing managers to internalize a larger fraction of potential losses from risky projects. Similarly, post-crisis European banking regulations have set a cap on variable compensation equal to 100 percent of the fixed compensation elements (200 percent with shareholder approval). Network theory would allow for better calibration of such policies; managers of SIFIs that create more systemic risk will receive, other things equal, fewer shares and more bonds than managers of SIFIs that pose a relatively smaller threat to the stability of the system.
Finally, we discuss a proposal by Yair Listokin and Inho Mun. They contend that regulation by deal, in which a solid firm acquires a defaulting SIFI, is problematic because it allows the shareholders of the defaulting SIFI to hold the economy hostage: shareholders are aware that by opposing the merger deal they can impose a significant externality on society, which allows them to extract rents from the buyer’s shareholders and/or taxpayers. For this reason, Listokin and Mun suggest that merger voting rights attaching to the target SIFI shares should be replaced by appraisal rights. This proposal entails a trade-off. Because appraisal rights are favorable to shareholders, managers might be induced to act in a reckless way and shareholders might refrain from monitoring them, given that shareholders will be made whole even if the firm goes bankrupt. That is why Listokin and Mun argue that shareholders should be awarded only a fraction of the appraisal value. However, if investors know that they can be stripped of their voting rights without receiving adequate compensation, it will be harder for a SIFI to raise capital, especially if it is close to insolvency but still viable. It is easier to address this trade-off if one builds upon the insights from network theory, with the fraction of the appraisal value awarded to shareholders decreasing as the importance of the firm within the network increases.
These are just three examples of how atomistic regulations can be tweaked to account for individual SIFIs’ interconnectedness. The approach can be extended to other areas, thereby improving the effectiveness of the regulatory framework to preserve financial stability.
Luca Enriques is the Allen & Overy Professor of Corporate Law at the University of Oxford.
Alessandro Romano is a researcher (JSD) at Yale Law School.
Thom Wetzer is a DPhil Candidate in Law and Finance at the University of Oxford.