The Squam Lake Report: Fixing the Financial System*

In these excerpts from The Squam Lake Report, fifteen distinguished economists analyze where the global financial system failed, and how such failures might be prevented (or at least their damage better contained) in the future. Although there were many contributing factors to the crisis—including “agency” problems throughout the financial system and a bankruptcy code poorly suited for reorganizing financial firms—at the core of the problem is a potential conflict between the risk-taking proclivity of financial institutions and the interests of the economy at large that must be managed at least in part through more effective regulation. The Squam Lake Report provides a nonpartisan plan to transform the regulation of financial markets in ways designed to limit systemic risk while preserving—to the extent possible and prudent—the economies of scale and scope that justify the existence of today's large financial institutions. To reduce the risks that large banks will fail, the authors call for higher capital requirements based on more effective assessments of the risks of bank assets and liabilities, as well as a new systemic regulator that should be part of the central bank. To reduce the costs of failure when it occurs, the authors propose that banks be required to create “living wills” laying out their plan to sell assets or shut down operations in the event of financial trouble. As part of that plan, regulators are urged to “aggressively encourage” banks to issue “contingent” debt capital securities that convert into equity.     

Why European Banks Are Undercapitalized and What Should Be Done About It

Major European banks are significantly undercapitalized as compared to large American banks, and, more importantly, as compared to the capital levels they would need to survive another severe financial crisis. Bank capital shortfalls in Italy, Spain, Germany, France and the United Kingdom, in particular, are largely the consequence of European bank regulations that: (1) apply static risk weights to assets like mortgages and sovereign debt; (2) fail to require an overall market‐based capital ratio that is high enough to enable banks to survive a severe financial crisis; (3) fail to get banks to promptly write down their impaired assets to market value; (4) subject banks to weak stress tests that can create a false impression of capital adequacy; and (5) fail to compel banks to retain sufficient earnings and to raise sufficient capital externally to eliminate capital shortfalls promptly, all apparently out of fear that being tougher might cause investors and customers to lose confidence in the banks. This article summarizes important recent independent bank stress testing that has quantified the capital shortfalls in European banks. The recent highly publicized regulatory interventions to resolve failing European banks were inevitable due to these shortfalls. The authors recommend steps European bank regulators should take to address the problem and to eliminate the risk of serious capital shortfalls. In the absence of such steps, bank depositors, customers, and security holders should be prepared to expect further unwelcome surprises as the risks inherent in allowing undercapitalized banks to operate will continue to materialize in more bank failures.     

Speed Bankruptcy: A Firewall to Future Crises

During the 2008 financial crisis, the U.S. government purchased large equity stakes in major financial institutions. The author argues that another source of equity was available : the long-term bonds issued by these same banks. Overnight debt-to-equity conversions, or what the author refers to as “speed bankruptcy,” could have helped restore these firms to health, while at the same time ending the implicit government guarantee of big-bank debt. While many prominent economists have proposed such conversions, the practical details have received little attention. The author addresses key legal concerns, the political viability of such conversions, and how they fit in with other proposals such as contingent convertibles and funeral planning.     

The Effect of Bankruptcy Protection on Investment: Chapter 11 as a Screening Device

Asymmetric information and conflicts of interest between equity and debt holders can force a distressed but efficient firm to liquidate and may enable a distressed inefficient firm to continue. In the extreme, if it is costless for an inefficient firm to mimic an efficient firm in a debt restructuring, efficient and inefficient firms are equally likely to continue or liquidate. This article shows that Chapter 11 procedures impose costs on inefficient firms that would otherwise mimic efficient firms. This separation induces voluntary filing for bankruptcy by inefficient firms and consequently enables efficient firms to continue when they would otherwise be liquidated.     

Emerging from Chapter 11 Bankruptcy: Is It Good News or Bad News for Industry Competitors?

A firm under Chapter 11 bankruptcy protection may emerge from bankruptcy in a more advantageous competitive position within its industry to the detriment of their industry rivals. Using a sample of 264 firms that emerged from Chapter 11 bankruptcy during the period 1999-2006, I find that its industry competitors demonstrate negative postemergence long-term equity returns and deteriorating financial performance. Additional tests indicate that this outcome is less likely due to overall industry distress. Competitors tend to be more adversely affected if they are in more concentrated industries, if they have lower credit quality, when a more efficient firm emerges, and when the duration of bankruptcy is longer. This study suggests a need to reconsider Chapter 11's role in promoting competition and allocation of resources given its negative externalities on industry competitors.     

Cash-flow shortage as an endogenous bankruptcy reason

This paper develops a simple model for a leveraged firm and endogenizes the firm’s bankruptcy point by assuming that equity issuance is costly. Equity-issuance costs reflect the difficulties in issuing new equity for firms that are close to financial distress. The resulting model captures cash-flow shortage as a reason to go bankrupt, though the equity value is positive. I analyze the optimal bankruptcy point as well as corporate bond prices and yield spreads for various levels of equity-issuance costs in order to study the impact of different liquidity constraints. Finally, I discuss the consequences on optimal capital structure.     

Do stock prices reflect undisclosed financial statement information? Evidence from the OTCBB

I exploit a regulatory change that mandated that Over-the-Counter Bulletin Board (OTCBB) firms must comply with the reporting requirements of the 1934 Securities Exchange Act. I use this change to examine the association between equity values and financial statement data in voluntary and mandatory disclosure environments. Before the change, disclosure of financial statement information was voluntary for most of these firms. I study firms that initiate SEC filing after the change and classify them as disclosing and nondisclosing based on whether they voluntarily disclosed financial statement information before the regulatory change. In these firms’ initial SEC filings after the eligibility rule, they retroactively disclose financial statement information for the year prior to compliance with the rule. Thus I can observe previously withheld financial data. I find that the choice to voluntarily disclose is negatively associated with firm characteristics related to proprietary costs and with situations in which accounting information plays a less important role in resolving information asymmetry. For nondisclosing firms, I find evidence that equity values reflect financial statement data, even though this information was not publicly available, and that compliance with mandatory SEC disclosure requirements strengthens this association. For disclosing firms, I find evidence that suggests investors viewed their voluntary disclosure of financial statement data as credible and fail to find evidence that compliance with mandatory reporting requirements enhances this association.     

How to Design a Contingent Convertible Debt Requirement That Helps Solve Our Too‐Big‐to‐Fail Problem*

As bank regulatory reform tries to come to grips with the lessons of the financial crisis, several experts have proposed that some form of contingent convertible debt (CoCo) requirement be added to the prudential regulatory toolkit. In this article, the authors show how properly designed CoCos can be used not just to absorb losses, but more importantly to encourage banks to recognize losses and replace lost equity in a timely way, as well as to manage risk more effectively. Their proposed CoCos requirement strengthens management's incentives to promptly replace lost capital and enhance risk management by imposing major costs on the managers and existing shareholders of banks that fail to do so. Key elements of the proposal are that conversion of the CoCos into equity would be (1) triggered at a high trigger ratio of equity to assets (long before the bank is near an insolvency point), (2) determined by a market trigger (using a 90‐day moving average market equity ratio) rather than by supervisory discretion, and (3) significantly dilutive to shareholders. The only clear way for bank managements to avoid such dilution would be to issue equity into the market. Under most circumstances—barring an extremely rapid plunge of a bank's financial condition—management should be able and eager to replace lost capital in a timely way; as a result, dilutive conversions should almost never occur. Banks would face strong incentives to maintain high ratios of true economic capital relative to risky assets, and to manage their risks effectively. This implies that “too‐big‐to‐fail” financial institutions would not be permitted to approach the point of insolvency; they would face strong incentives to recapitalize long before that point. And if they should fail to issue new equity in a timely manner, the CoCos conversion would provide an alternative means of recapitalizing banks well before they reach the brink of insolvency. Thus, a CoCos requirement would go a long way to resolving the “too‐big‐to‐fail” problem. Such a CoCos requirement would not only increase the effectiveness of regulation, but also reduce its cost. It would be less costly for banks to raise CoCos than equity, reflecting both the lower adverseselection costs of CoCos issuance and the potential tax advantages of debt. And precisely because of the low probability of CoCo conversion, the Cocos would be issued at relatively modest (if any) discounts to otherwise comparable but straight subordinated debt. Thus requiring a mix of equity and appropriately designed CoCos would be less costly to banks, and would entail less of a reduction in the supply of loans than would a much higher book equity requirement alone.     

Coming Through in a Crisis: How Chapter 11 and the Debt Restructuring Industry Are Helping to Revive the U.S. Economy

During the recent financial crisis, U.S. bankruptcy courts and debt restructuring practitioners were faced with the largest wave of corporate defaults and bankruptcies in history. In 2008 and 2009, $1.8 trillion worth of public company assets entered Chapter 11 bankruptcy protection—almost 20 times the amount during the prior two years. And the portfolio companies of U.S. private equity firms faced a towering wall of debt that, many observers predicted, was about to wipe out most of the industry. But far from the death of private equity or a severe contraction of corporate America, the past three years have seen an astonishingly rapid working off of U.S. corporate debt overhang, allowing corporate profits and values to rebound with remarkable speed and vigor. And as the author of this article argues, corporate America's recovery from the recent financial crisis provides a clear demonstration of the importance of U.S. bankruptcy laws and restructuring practices in maintaining the competitiveness of U.S. companies and the long‐run growth of the U.S. economy.     

Optimal bank reorganization and the fair pricing of deposit guarantees

When should regulators close a financially ailing bank? FDIC practice in the US has moved in the direction of early closure. In contrast, banking regulators in Japan continue to follow a more patient approach. This paper analyses a series of models in which closure rules and bailout policies arise endogenously through the interaction of (i) regulators' attempts to minimize discounted, expected bankruptcy costs, and (ii) equity-holders' incentives to recapitalise banks. We characterize subsidy policies for distressed banks that implement socially optimal closure rules at minimum financial cost to regulators and which reduce moral hazard.     

Examining bank SEOs: Are offers made by undercapitalized banks different?

Despite extensive monitoring, banking operations are often considered opaque, and despite explicit capital adequacy regulation, banks may have substantial discretion in their financing. Both monitoring and capital regulation have changed substantially over time, with the adoption of FDICIA being one important breakpoint. This article empirically studies seasoned equity offerings (SEOs) by banks to understand how opacity and capital regulation interact to determine the timing of bank SEOs and their market valuation. SEOs both by banks that are undercapitalized relative to regulatory standards and also well-capitalized banks are fully discretionary when it comes to SEOs, even before FDICIA. Both undercapitalized and well-capitalized banks experience similar and significantly negative stock price reactions to SEO announcements, and also have similar prior patterns of insider trading and similar economic drivers of the issuance decision. Moreover, post-SEO abnormal stock returns are similar to benchmark returns for both types of issuers in the long run, suggesting that, contrary to the well-documented evidence for industrial SEOs, investors understand the value implications of bank SEOs upon announcement. The evidence implies that undercapitalized banks' SEOs are more discretionary and that all bank SEOs are less opaque than implied by earlier studies.     

The Impact of Corporate Governance and Audit Quality on the Cost of Private Loans*

The objective of this paper is to examine whether banks discriminate between firms on the basis of their financial condition when assessing the credit default risk, and to what extent corporate governance and auditor quality mitigate such risks in the pricing of new bank loans. The results indicate that, depending on the probability of bankruptcy, banks rely on different monitoring devices. For firms with a low probability of bankruptcy, banks do not rely on the quality of corporate governance or the auditor's industry specialization. However, auditor tenure and a change in auditor affect the spread. For firms with a high probability of bankruptcy, the spread is adjusted for the quality of corporate governance and the auditor's specialization. These results are robust to alternative specifications and measures.     

Reporting Discretion and the Choice of Fresh Start Values in Companies Emerging from Chapter 11 Bankruptcy

Using a sample of seventy-two firms that adopted fresh start reporting upon their emergence from Chapter 11 bankruptcy, I test whether management estimates of fresh start equity values are misstated and whether such misstatements are related to characteristics of individual firms' bankruptcy process. I predict that the reported fresh start value reflects a tension between managerial incentives to promote the acceptance of the plan of reorganization, and incentives to enhance future reported performance. I test whether the tendency to overstate the fresh start equity value is increasing in factors affecting the acceptance of the reorganization plan (i.e., bankruptcy claimants' relative bargaining power) and decreasing in factors affecting postbankruptcy reported performance (i.e., the probability of future losses). I find that, relative to the market value of equity immediately after emergence from Chapter 11, the fresh start equity value is, on average, understated by about 4%. The difference between the fresh start equity value and market value also exhibits significant cross-sectional variation (an average absolute error of 11%). Consistent with my first prediction, the misstatement is increasing in the relative bargaining power of junior claimants. In contrast to my second prediction, the misstatement is also increasing in the likelihood of future reported losses. This result suggests that firms that are more likely to experience postbankruptcy financial distress are more concerned with obtaining acceptance for their plan than with the effects of the fresh start equity value on postbankruptcy performance. Finally, I document that the misstatement in the fresh start equity value is negatively related to whether firms have undergone prepackaged bankruptcies, and positively related to replacement of a prebankruptcy CEO.     

Multiple corporate governance attributes and the cost of capital – Evidence from Germany

This paper investigates the extent to which corporate governance affects the cost of debt and equity capital of German exchange-listed companies. I examine corporate governance along three dimensions: financial information quality, ownership structure and board structure. The results suggest that firms with high levels of financial transparency and bonus compensations face lower cost of equity. In addition, block ownership is negatively related to firms' cost of equity when the blockholders are other firms, managers or founding-family members. Consistent with the conjecture that agency costs increase with firm size, I find significant cost of debt effects only in the largest German companies. Here, the creditors demand lower cost of debt from firms with block ownerships held by corporations or banks. My findings demonstrate that a uniform set of governance attributes is unlikely to satisfy suppliers of debt and equity capital equally.     

Should banks own equity stakes in their borrowers? A contractual solution to hold-up problems

This paper develops a model to answer the question whether a bank should hold a share of the equity of a borrowing firm. The model shows that a small equity stake held by the bank can have a significant and positive impact on the lending relationship. The benefit of bank equity participation arises from the reduced ability of the bank to extract rents from the firm in multiple rounds of financing. This, in turn, improves the firm’s incentive to make investments in profitable projects that require future outside finance. The benefit is likely to be significant for small to medium size firms, growth firms, and firms with ongoing capital needs. The paper addresses, from a corporate finance perspective, the current debate about whether banks should be allowed to own equity stakes in corporations – and how large these equity stakes should be.     

Lessons from the financial crisis: failure of markets or failure of regulation?

The popular, demagogic narrative after the global financial system's collapse in 2008 has held that the financial crisis signalled the failure of capitalism. However, regulators across the world must realize that the financial crisis was not brought about by the failure of markets but by the failure of governments to appropriately regulate markets. Beginning in the 1980s, and continuing over the quarter-century that followed, regulators afforded the world of big finance an unaffordable luxury: insurance against possible failure. As a result, banks and financial institutions became adept at turning their insulation from disorderly failure, as enforced by free markets, into insulation from market discipline, as inflicted by myopic regulators. This ‘too big to fail’ syndrome combined with the incorrect belief perpetrated by the Federal Reserve Chairman Alan Greenspan that financial companies, powered by a rational motive not to lose money, could police themselves and one another. In turn, such sanguine beliefs led to considerable over-supply of financial innovation. The supply created its own demand as the financial world operated under the implicit guarantee (and market distortion) created by the ‘too big to fail’ syndrome.

The errors laid bare by the financial crisis clearly call for regulatory reform. But in designing that reform, regulators across the world should avoid the temptation to seek heavy-handed new approaches. Instead, policymakers should look to the long-term success of the system of rules whose decay brought about the crisis. Prudent regulations must seek to reinforce the fundamental principle that no one, however big or small, can be made immune to failure. Such pro-market regulation of finance is essential to preserving and fostering countries’ economic futures.     

Geographic diversification and firm value in the financial services industry

This paper investigates whether geographic diversification is value-enhancing or value-destroying in the financial services sector, broadly defined. Our dataset comprises approximately 3579 observations over the period from 1985 to 2004 and covers the entire range of U.S. financial intermediaries — commercial banks, investment banks, insurance companies, asset managers, and financial infrastructure services firms. We use two alternative measures of geographic diversification: (1) a dummy variable whether the firm reports more than one geographic segment and (2) the percentage of sales from non-domestic operations. Our results indicate that geographic diversification is not associated with a significant valuation discount in financial intermediaries. However, when accounting for the firms' main activity-areas, we find evidence of a significant discount associated with geographic diversification in securities firms and a premium in credit intermediaries and insurance companies. All these results are robust after taking into account functional diversification of the firms, a potential endogeneity of both functional and geographic diversification, and a potential value transfer from equity to debt holders by using estimates of the market value of debt.     

Bankruptcies of small firms and lending relationship

This paper empirically investigates the role played by relatively small banks in the Japanese local credit market. We test the hypothesis that small banks enhance the recovery rate from the financial distress and reduce the bankruptcy ratio of small firms. Empirical evidence suggests that small banks specialize more in relationship loans to small firms. However, this expertise is limited to the loans to unincorporated firms or those with a very small number of employees.     

Creditor control rights and firm investment policy

We present novel empirical evidence that conflicts of interest between creditors and their borrowers have a significant impact on firm investment policy. We examine a large sample of private credit agreements between banks and public firms and find that 32% of the agreements contain an explicit restriction on the firm's capital expenditures. Creditors are more likely to impose a capital expenditure restriction as a borrower's credit quality deteriorates, and the use of a restriction appears at least as sensitive to borrower credit quality as other contractual terms, such as interest rates, collateral requirements, or the use of financial covenants. We find that capital expenditure restrictions cause a reduction in firm investment and that firms obtaining contracts with a new restriction experience subsequent increases in their market value and operating performance.