The Changing Landscape of Global Financial Governance and the Role of Soft Law [1 ed.] 9789004280328, 9789004280311

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The Changing Landscape of Global Financial Governance and the Role of Soft Law

Nijhoff International Trade Law Series Editorial Board Robert Howse (New York University) Miguel Maduro (European University Institute) Joost Pauwelyn (Graduate Institute of International Studies, Geneva) Jan Wouters (University of Leuven) Kern Alexander (University of Zurich)

VOLUME 14

The titles published in this series are listed at brill.com/nint

The Changing Landscape of Global Financial Governance and the Role of Soft Law Edited by

Friedl Weiss Armin J. Kammel

LEIDEN | BOSTON

Library of Congress Cataloging-in-Publication Data The changing landscape of global financial governance and the role of soft law / edited by Friedl Weiss, Armin J. Kammel. pages cm. -- (Nijhoff international trade law series ; volume 14) Includes bibliographical references and index. ISBN 978-90-04-28031-1 (hardback : alk. paper) -- ISBN 978-90-04-28032-8 (e-book : alk. paper) 1. Financial institutions, International--Law and legislation. 2. Soft law. I. Weiss, Friedl, 1946- editor. II. Kammel, Armin J., editor. K1066.C46 2015 332’.042--dc23 2015012317

This publication has been typeset in the multilingual “Brill” typeface. With over 5,100 characters covering Latin, ipa, Greek, and Cyrillic, this typeface is especially suitable for use in the humanities. For more information, please see http://www.brill.com. issn 1877-7392 isbn 978-90-04-28031-1 (hardback) isbn 978-90-04-28032-8 (e-book) Copyright 2015 by Koninklijke Brill nv, Leiden, The Netherlands. Koninklijke Brill nv incorporates the imprints Brill, Brill Hes & De Graaf, Brill Nijhoff, Brill Rodopi and Hotei Publishing. All rights reserved. No part of this publication may be reproduced, translated, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior written permission from the publisher. Authorization to photocopy items for internal or personal use is granted by Koninklijke Brill nv provided that the appropriate fees are paid directly to The Copyright Clearance Center, 222 Rosewood Drive, Suite 910, Danvers, ma 01923, usa. Fees are subject to change. This book is printed on acid-free paper.

Contents Foreword VII Preface Ix Acknowledgments xII List of Figures and Tables xIiI List of Contributors xiv Introduction: Key Theoretical Parameters of the Soft Law Debate: A Basic Overview xvii Chris Brummer

Part 1 Theoretical Reflections 1 Government Versus Markets – A Change in Financial Regulation 3 Armin J. Kammel 2 A Law and Economics Framework for Financial Regulation 28 Aristides N. Hatzis 3 The Device of Soft Law: Some Theoretical Underpinnings 47 Friedl Weiss 4 The Dogma of Capital Regulation as a Response to the Financial Crisis 59 Heidi Mandanis Schooner

Part 2 Specific Legal and Policy Responses 5 The Politics of International Financial Law in the Aftermath of the Global Financial Crisis of 2008 81 Douglas W. Arner 6 The Changing Landscape of European Financial Supervision from an Institutional Perspective 99 Alfred Schramm

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The Dodd-Frank Act Does Not Solve the Too-Big-to-Fail Problem 125 Arthur E. Wilmarth, Jr

8 Say on Pay, Soft Law and the Regulatory Focus on Enforcement and Transparency 172 Poonam Puri and Simon Kupi 9 Consumer Protection through Soft Law in an Era of Global Financial Crisis 233 Ruth Plato-Shinar and Rolf H. Weber 10 Moving from Soft Law to Hard Law in the Derivatives Arena: A Case Study 258 Christian A. Johnson

Part 3 Regional Aspects 11 Financial Crises and the Changing Relationship between Banks and Their Customers in Singapore 283 Sandra Annette Booysen 12 From Rule-Taker to Rule-Maker: China’s Changing Roles in Global Banking Regulation 312 Chao XI 13 Regional Economic and Financial Integration in Asia: Challenges from the Global and Financial Crisis 337 Chayodom Sabhasri 14 The Debt Crisis and Its Impact on Developing Countries 368 Jamshid Damooei 15 Limiting Financial Crisis: Demands on the New Financial Architecture from the Perspective of NGOs and Developing Countries 392 Stephany Griffith-Jones and Matthias Thiemann Index 417

Foreword The Role of Political Standard Setting and the Growing Importance of the Financial Stability Board The 2007–2008 financial crisis exposed major weaknesses in the regulatory framework of the global financial markets. One such weakness was the lack of world-wide common standards and regulations to set a level playing field for financial markets and institutions. HistoricaIly, financial governance has emerged at the national level, whereas financial markets and institutions were increasingly operating across borders, leaving ample room for the global financial sector to exploit regulatory arbitrage opportunities. The corollary was a race to the regulatory bottom, and an increase in systemic risk and financial fragility across the globe. Efforts to harmonize or at least to coordinate financial regulatory policies globally started way before the outbreak of the recent financial crisis but gained fierce momentum thereafter. An important step toward effective global financial governance was accomplished with the establishment of the Financial Stability Board (FSB) in 2009. The FSB succeeded the Financial Stability Forum (FSF) set up by the G-7 in the aftermath of the Asian financial crisis. Membership of the FSB was expanded to include representatives of the G-20, putting the FSB on much stronger institutional ground than its forerunner. Furthermore, it was provided with a broader mandate to address vulnerabilities and to develop and implement strong regulatory, supervisory and other policies to strengthen financial stability. The FSB collaborates with international organizations like the International Monetary Fund and the World Bank, and it oversees and coordinates the work of international standard-setting bodies such as the Basel Committee, the International Organization of Securities Commissions, and the International Association of Insurance Supervisors. The FSB also has a mandate to coordinate activity among these bodies and to monitor the implementation of standards by national financial authorities in banking and securities regulation. In principle, the role of the FSB which has emerged in the short time in which it has been in operation can be grouped under three headings: First, promoting amendments in international rulemakers’ existing standards, such as the leverage ratio within the Basel III framework; second, launching new regulatory reform initiatives; and third, monitoring compliance with international rules at the domestic level. Eminent examples of such regulatory reforms that were initiated by the FSB are the global regulatory framework for

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systemically important financial institutions, efforts to regulate over-the-counter derivatives markets as weIl as to strengthen oversight and regulation of the shadow banking system. The FSB sets guidelines and issues standards and recommendations that are not legally binding. However, in important fields such as banking and derivatives regulation, this practice differs from pure standard setting by private or semi-state transnational regulatory networks that evolved as the dominant paradigm of self-regulation in global financial governance during the decades preceding the crisis. Most of the FSB’s standards and recommendations are envisaged to be adopted as part of domestic law. The recent history of regulatory reform corroborates the success of this strategy even though the FSB lacks instruments to sanction noncompliance. The standard setter’s goal is to eventually have soft law transformed into hard law. Implementation of standards is helped by measures that increase peer pressure. Such measures are facilitated by the close interaction between the FSB and the G-20, which directly oversees the FSB. The interaction between democratically accountable representatives of G-20 governments and experts from independent regulatory institutions and professional associations that act as private standard setters gives the FSB a unique position. Since the outbreak of the crisis, the G-20 and the FSB have been important drivers of reform alongside regulatory reform initiatives at the national or European Union level. Given the FSB’s lack of legally binding instruments and its recourse to soft law instruments, such as standards, recommendations and peer pressure, this is a remarkable success. The actions that the FSB is taking today will ultimately shape the future of macro-financial stability across the world. Prof. Dr. Ewald Nowotny

(Governor of the Austrian National Bank / OeNB)

Preface The famous but disputatious Austrian economist Ludwig von Mises once wrote that “[t]houghts and ideas are not phantoms. They are real things. Although intangible and immaterial, they are factors in bringing about changes in the realm of tangible and material things.”1 This quote nicely reflects the main motivation of the editors of this volume since it was not, of course, their intention simply to bring out yet another book on the global financial crisis but one about change “in the realm of tangible and material things” triggered by the financial crisis. Consequently, it is about change that clearly affects everybody, albeit in different ways: a financial institution, a retail investor, an investment banker, government budgets, the real economy, politicians, regulators, the industry, NGOs, the third world and the law in general – just to name but a few. In light of this consideration, the compilation of this edited volume as its title „The Changing Landscape of Global Financial Governance and the Role of Soft Law “indicates, is about reflecting this change. This book is the product of the collaborative efforts of well-established international scholars of high renown from different academic backgrounds and different regions of the world each contributing their respective analysis and perspective in order to initiate broad, balanced and interdisciplinary discussion of the changes triggered by the global financial crisis. Unlike other publications on the global financial crisis, this book is not laying claim to providing some new conceptual or dogmatic solutions. Instead, its authors seek to stimulate broad creative thinking, harnessing insights from their own disciplinary backgrounds. Although the book, therefore, presents different perspectives, ideas, approaches and potentially controversial suggestions, all contributions offer thoughtful reflections on the changing landscape of global financial governance and in particular on the role of soft law. This is also underscored by Chris Brummer’s introductory remarks on the “Key Theoretical Parameters of the Soft Law Debate: A Basic Overview”. In order to structure these diverse contributions, the book is consisting of three parts. Part I consists of theoretical reflections providing common ground for the specific chapters included in the following two parts. Part II covers contributions reflecting specific legal as well as policy responses to the global financial crisis at various levels. Part III, finally, includes specific reflections on change in the landscape of global financial governance, in particular from a regional perspective. 1 See von Mises (1957), Theory and History, 96.

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Part I opens up with theoretical analyses discussing the changing relationship between governments and markets. Armin J. Kammel, following an interdisciplinary approach, critically describes this change in his contribution “Government versus Markets – A Change in Financial Regulation”. Aristides N. Hatzis too adopts an interdisciplinary approach addressing “A Law & Economics Framework for Financial Regulation – Ten Questions and Answers”. In the following, Friedl Weiss provides a legal analysis reflecting on “The Device of Soft Law – Some Theoretical Underpinnings” by retracing the chief arguments supportive of the increased use and importance of soft law in the current debate. This part concludes with a chapter by Heidi M. Schooner’s on “The Dogma of Capital Requirements as a Clear Response to the Financial Crisis” providing an analysis of one of the core responses to the global financial crisis. Part II, bringing together broader specific legal and policy responses, starts with Douglas W. Arner’s reflections on “The Politics of International Financial Law in the Aftermath of the Global Financial Crisis of 2008” stressing the increasing importance of international financial law. This chapter is followed by Alfred Schramm’s overview of “The Changing Landscape of European Financial Supervision from an Institutional Perspective” drawing the picture of institutional responses to the global financial crisis. This European perspective is followed by specific U.S. regulatory responses which are described in Arthur E. Wilmarth’s concise reflections on “The Dodd-Frank Act does not solve the Too-Big-to-Fail Problem”. After these reflections on institutional responses Poonam Puri and Simon Kupi concentrate on “Say on Pay, Soft Law and the Regulatory Focus on Enforcement and Transparency”, while Ruth Plato-Shinar and Rolf H. Weber provide a comprehensive discussion of “Consumer Protection through Soft Law in an Era of Global Financial Crisis”. Part II is concludes with a case study by Christian A. Johnson’s case on “Moving from Soft Law to Hard Law in the Derivatives Area”. Part III, consisting in particular of studies of regional aspects, starts with a Singaporean perspective on “Financial Regulation and the Changing Rela­ tionship between Banks and Their Customers” by Sandra Annette Booysen. In the next chapter entitled “From Rule-Taker to Rule-Maker: China’s Changing Roles in Global Banking Regulation” Chao Xi provides a specifically Chinese viewpoint. These regional Asian perspectives are rounded off by Chayodom Sabhasri’s discussion of “Regional Financial Integration in Asia and the Challenge of The Global Financial Crisis”. Part III concludes with two contributions both of which addressing the changes caused developing countries by the global financial crisis. The first is Jamshid Damooei’s analysis of the “Economics of the Debt Crisis and its Impact on the Developing World”, the second a chapter on “Limiting financial crises: Demands on the new financial

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architecture from the perspective of NGOs and Developing Countries” by Stephany Griffith-Jones and Matthias Thiemann provides a broader outlook including on the role of NGOs. We do hope that these broad and different perspectives on the Changing Landscape of Global Financial Governance and the Role of Soft Law will be of valuable input in both the scientific discourse on these issues but in particular on practical policy considerations because in the light of von Mises’ eyes we always have to reflect that “[t]houghts and ideas are not phantoms. They are real things.”

Acknowledgments The authors would like to thank a number of persons for the invaluable help which they have given us when editing this book. We particularly extend our appreciation to Veronika Moser of the Institute of European, International and Comparative Law at the University of Vienna whose patient and unwavering secretarial support greatly facilitated the editorial process. Thanks are also due to Lisa Hanson, John Bennett and Michael Mozina with Brill Nijhoff Publishers for their kind and unstinting encouragement and help. Last but not least we would like to thank our close relations and friends for their tolerance of the fact that we have been necessarily preoccupied with the research for and editing of this book. Friedl Weiss Armin J. Kammel

List of Figures and Tables Figures 13.1 Numbers of FTA in East Asia by total FTAs and signed and in effect 342 13.2 Percentage of Global Value Chain (GVC) participation rate of selected emerging Asian economies, 2010 349 13.3 International production networks 350 13.4 Intra-Regional Greenfield FDI among the selected East Asia emerging market 353 13.5 GDP and capital formation growth in selected Asian countries 354 14.1 Economic performance of low income countries and others 377 14.2 Real GDP growth in recent past and near future in various groups of countries 379 14.3 Foreign direct investment (inward and outward) in selected groups of developing countries (in millions of US dollars at current exchange rate) 380 14.4 Net direct investment (in billions of $USD) 381 14.5 Net private financial flows (in billion of $USD) 382 14.6 Net private portfolio flows (in billions of $USD) 383 14.7 Percentage change in terms of trade of good and services in various regions 384 14.8 World’s income level classified as personal remittances in various regions (in $US) 385

Tables 0.1 Four qualitative features of IFL xx 13.1 FTA status by selected country, 2013 343 13.2 FTA by WTO notification, 2013 345 13.3 Imported input share of exports in emerging Asia, by industry group, 1995 and 2005, in percent 351 13.4 Intra-Regional trade 352 13.5 GDP growth rate 355 13.6 Export growth rates of plus three countries 356 13.7 Export growth rates of ASEAN countries 356 13.8 Restriction on trade in financial services 358 13.9 Summary of medium-term policy challenges 360 13.10 Monetary policy framework for East Asia 361 13.11 Macro-Prudential policy measures in East Asia 364 15.1 Potential sites of policy-intervention 406

List of Contributors Douglas W. Arner Professor and Head of the Department of Law at the University of Hong Kong, Hong Kong Sandra Annette Booysen Assistant Professor at the Faculty of Law at National University of Singapore (NUS), Singapore Chris Brummer Professor of Law at Georgetown University Law Center, USA Jamshid Damooei Professor of Economics Chair of the Department of Economics, Finance, and Accounting at California Lutheran University (CLU), and Co-Director of the Center for Leadership and Values in the School of Business at CLU, USA Stephany Griffith-Jones Financial Markets Program Director at the Initiative for Policy Dialogue at Columbia University, USA Aristides N. Hatzis Associate Professor of Philosophy of Law & Theory of Institutions at University of Athens, Greece Christian A. Johnson Professor of Law and Associate Dean for Academic Affairs, University of Utah College of Law, USA Armin J. Kammel Honorary Professor and Faculty Member at the Department of Economic Law and European Integration at Danube University Krems and Adjunct Faculty Member at California Lutheran University (CLU). Visiting Fellow with the Institute of Advanced Legal Studies (IALS) and Fellow in Law & Economics with the Institute of Economic Affairs (IEA), both in London; Austria Simon Kupi regulatory lawyer with the Independent Electricity System Operator (IESO) in Toronto, Canada

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Ruth Plato-Shinar Founder and Director of the Center for Banking Law at the Netanya Academic College and Research Fellow at the Van Leer Jerusalem Institute, Israel Poonam Puri Associate Dean and Professor at Osgoode Hall Law School, York University in Toronto, Canada Chayodom Sabhasri Associate Professor at the Faculty of Economics, Chulalongkorn University in Bangkok, Thailand Heidi Mandanis Schooner Professor of Law at Columbus School of Law, The Catholic University of America, USA Alfred Schramm Lecturer at Danube University Krems and expert in international affairs with the Austrian Financial Market Authority (FMA), Austria Matthias Thiemann Junior Professor for the Sociology of Banking, Money and Finance, Goethe Universität Frankfurt/Main, Germany Rolf H. Weber Professor for Civil, Commercial and European Law at the University of Zurich and visiting Professor at the University of Hong Kong; Switzerland Friedl Weiss Professor of EU and International Economic Law in the Department of European, International and Comparative Law at the University of Vienna, Austria Arthur E. Wilmarth, Jr. Professor of Law and Executive Director of the Center for Law, Economics & Finance at George Washington University Law School, USA Chao XI Associate Professor and Assistant Dean for Graduate Studies and Director of LLM Programs at the Faculty of Law, The Chinese University of Hong Kong, Hong Kong

Introduction: Key Theoretical Parameters of the Soft Law Debate: A Basic Overview Chris Brummer* Soft law has become a critical focal point for theorizing international financial law, and for good reason: not only do regulators routinely depend on soft law to grease the wheels of cross border financial cooperation, but it is also a convenient means by which financial authorities elide domestic stumbling blocks and hurdles to economic coordination. As such, it is among the most visible instruments of “minilateral” economic diplomacy reshaping interstate cooperation writ large.1 The debates unfolding in the following pages reflect serious questions relating to the appropriateness of soft law along two very different lines of inquiry. On the one hand is what can be understood as the “effectiveness” inquiry of soft law. Along this line of questioning, scholars have explored soft law’s usefulness and efficacy in light of the fact that it embraces no pretension of legal obligation. The second line of inquiry interrogates the “legitimacy” of soft law, and with it the appropriateness of administrative rulemaking machinations that routinely circumvent traditional legislative operations. Both inquiries are deceptively complex, and will be elaborated in the book. For now it is worthwhile to note that the question of effectiveness explores whether informal communication and agreements – like those between financial regulatory authorities – enjoy coerciveness or “compliance pull.” It arises against the backdrop of tradition, where treaties have long occupied a special place in global economic affairs. In this tradition, treaties are unique means of making international commitments credible. Their creation requires significant levels of governmental involvement, including leadership by heads of state and usually ratification by legislatures, and in doing so generates official obligations on the behalf of governments and nation-states.

* Chris Brummer is Professor of Law at Georgetown University Law Center. 1 Other key instruments include strategic alliances, which increasingly populate all forms of economic diplomacy, and financial engineering, which has become especially prevalent in international monetary affairs. See generally, Chris Brummer, Minilateralism: How Trade Alliances, Soft Law and Financial Engineering are Redefining Economic Statecraft (2014).

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Scholars consequently agree that states can face considerable reputational costs where they do not honor their “hard law” obligations. Where countries fail to honor their commitments, they send a signal to the international community that they cannot always be trusted; they thus risk assuming bad reputations that could hamper their future prospects for cooperation from and with others.2 International treaties additionally enable the formation of institutions that can enhance compliance. Treaties can, for example, create mechanisms for surveillance that police compliance with their terms – and thus make it easier to identify and punish cheaters.3 Dispute settlement can also be embraced so that ambiguities are clarified and arguments between treaty parties resolved. Soft law, by contrast, allows little, if any, space for the creation of a formal legal obligation under the norms and rules of contemporary international law. Instead, instruments of international financial diplomacy are inherently informal and expressively carry no official obligations on behalf of any government or state. Rules are not memorialized as treaties, but instead promulgated as codes of conduct, memoranda of understanding, and best practices. As a result, debates about international financial law routinely involve the effectiveness of informality and whether informal instruments can and should play a role in a world where backtracking from international regulatory commitments can undermine the health and safety of the global financial system.4 As mentioned above, the second line of queries involves the legitimacy of soft law as a means of international economic coordination. In short, treaties, the traditional means of economic (and non-economic) diplomacy, memorialize legal obligations between countries and often require approval by national legislatures. As a result, treaties are not only able to express commitments in

2  This idea has been articulated by a variety of theorists, but for a comprehensive assessment see Andrew Guzman, How International Law Works (Oxford: Oxford University Press, 2007), 71–111. See also Chris Brummer, Soft Law and the Global Financial System 140–43 (2012). 3 Kenneth W. Abbott & Duncan Snidal, Hard and Soft Law in International Governance, 54 Int’l Org. 421, 429 (2000)(noting that treaties establish monitoring provisions to detect noncompliance with the commitments); see also Charles Lipson, Why Are Some International Agreements Informal? 45 Int’l Org. 495, 518 (1991)(noting that it is less costly to abandon informal commitments). 4 See, e.g., Pierre-Hugues Verdier, Transnational Regulatory Networks and Their Limits, 34 Yale J. Int’l L. 113 (2009); Edward F. Greene & Joshua L. Boehm, The Limits of “Name-and-Shame” in International Financial Regulation, 97 Cornell L. Rev. 1083 (2012); Eric J. Pan, Challenge of International Cooperation and Institutional Design in Financial Supervision: Beyond Transgovernmental Networks, 11 Chi. J. Int’l L. 243 (2010). It can also, as a more general matter, lead to policy fragmentation. See Greg Shaffer & Mark Pollack, Hard and Soft Law: What Have We Learned? in International Law and International Relations: Insights from Interdisciplinary Scholarship (2012), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2044800.

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more precise terms than customary international law, but they are also imbued with legitimacy and imply and reflect the direct “consent of the governed.” Soft law, especially in the context of international financial regulation, often enjoys no such obvious legitimacy. Instead it routinely circumvents traditional legislative actors and swaps treaty ratification with administrative processes. Regulatory agencies and financial authorities take the lead in the crafting, and expressing support for, international financial standards and regulations, not elected representatives.5 As a result, standard setting is a highly technocratic – and arguably nondemocratic – exercise that defies traditional categories of consensual international rulemaking. Scholars sympathetic to soft law (including myself) have nonetheless issued a variety of responses to these concerns. As to effectiveness, a growing body of literature has grown to suggest that international financial regulation, even in its soft law form, is more coercive than at least traditional theories of public international law would suggest. Scholars have noted the importance of market participants, international surveillance mechanisms, and the standard setting bodies themselves that can collectively help to bolster the seriousness and stickiness of core international commitments.6 Among these tools have included peer review processes of international standard setting bodies, the work of traditional international organizations like the World Bank and IMF, and the services of market participants like investment analysts, accounting firms, and auditing companies (among others) that can reinforce and buttress rules and practices believed to serve the best interests of investors. At the same time, scholars have increasingly focused on the wider architecture of international financial regulation, and, while noting lapses of certain core democratic processes, have emphasized the embeddedness of international financial regulation in an organizational structure animated by politically accountable actors.7 The fact that the Financial Stability Board (FSB), a major forum of (largely unelected) financial authorities, takes instruction from the G-20 leaders, indicates that it is subject to at least some forms of accountability 5  Chris Brummer, Minilateralism, How Trade Alliances, Soft Law and Financial Engineering are Redefining Economic Statecraft 170 (2014). 6 See, e.g., Chris Brummer, How International Financial Law Works (and How It Doesn’t), 99 Geo. L.J. 257 (2011); Rolf H. Weber, The legitimacy of the G20 as a global financial regulator, Bank. Fin. Law Rev. 28, 389–407 (2013); see also Anne-Marie Slaughter & David Zaring, Networking Goes International: An Update, 2 Ann. Rev. L. Soc. Sci. 211, 217 (2006) (describing how informal networks are promoting coordination in economic issue areas and regulation more generally). 7  See Brummer, supra note 1, at 192. Similar observations relating to the political nature of standard-setting, which in turn reflects varying degrees of democratic legitimacy, have been raised by Stavros Gadinis, The Financial Stability Board: the New Politics of International Financial Regulation, 48 Tex. Int’l L.J. 157 (2013).

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and responsiveness from a body that is, at least for the most part, led by democratically elected heads of state. Similarly, the participation of executive agencies in the FSB, like the US Treasury Department, alongside market supervisors like the U.S. Securities and Exchange Commission, has insured the participation, input and even leadership from elected officials or their chosen representatives. As the following pages will show, no one account holds a monopoly on its descriptive salience for either the effectiveness or legitimacy query. Indeed, as the chart below illustrates, several descriptive configurations are possible for international financial law (Table 0.1). For some, international financial law might be described as both ineffective and illegitimate. That is, scholars may conclude that soft law features do not enjoy the compliance pull necessary for achieving strategic objectives of financial authorities, and may furthermore deem its operationalization as inherently non democratic. Alternatively, international financial law might be thought of as effective but illegitimate. From this standpoint, international financial law is sufficiently operationalized and implemented by national market and regulatory infrastructures to be acknowledged as having efficacy in the world; however, this process may nonetheless be viewed as nondemocratic and thus ultimately illegitimate. A third interpretation of international financial law could posit it as ineffective but legitimate. Thus, from this vantage point, soft law is not sufficiently supported by international or domestic institutions to be properly binding or effective. However, its association with democratic actors, and intermediation via forums with the participation of democratic actors, is sufficient enough to lay serious claims to legitimacy. In this way, international financial law may resemble international humanitarian protocols that, though legitimate (and certainly even more widely accepted as “law”), are frequently flouted by despots. Finally, international financial law could be understood as effective and legitimate. From this standpoint, international financial law constitutes a form of minilateral economic diplomacy that effectively replicates the effectiveness Table 0.1 Four qualitative features of IFL

Effective Ineffective

Legitimate

Illegitimate

E, L I, L

E, G I, G

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and binding nature of traditional hard law, and does so in ways that most countries would recognize and accept as both authoritative and legitimate. This “strong form” interpretation of soft law would thus lead to larger questions as to the degree to which such success could supplant and even challenge formal institutional forms and mechanisms in other similar issue areas. Of course, generalizations, especially in international financial law, are difficult. In practice, both legitimacy and effectiveness will depend on the rule or standard in question. Regulatory, market and institutional ecosystems matter: some rules and standards may have their origins directly in the G-20, whereas others may be largely the projects of the FSB – or as in the case of the increasingly internationalized restrictions on proprietary trading by banks, of individual nation states. And as for effectiveness, some rules have strong governmental monitoring mechanisms, active private sector (market) participation and sanctioning, and high political resonance. They may additionally have domestic laws pushing for compliance with international norms. In other areas, however, monitoring may be weak, market participation minimal, or low political salience. Coupled with little traditional law, the compliance pull and legitimacy of such mechanisms may be weak. These considerations can likewise be useful when explaining varying speeds and degrees of domestic policy implementation among regulatory issue areas. For example, transatlantic regulators had, for the most part, come to what can be viewed as a consensus on the rules and standards that should relate to bank capital, though the pace of implementation had diverged due to the European Union’s first order process of creating a Banking Union and supervisor. Derivatives coordination, by contrast, took a step forward (in the so called Path Forward8), then a step back, as key issues relating to swap execution facilities and pre-trade transparency hampered global coordination between the EU and US. Ultimately, a general consensus was reached, with plenty of questions persisting as to just how coherent implementation would be.9 Progress on streamlining US and EU accounting, meanwhile, had slowed in some cases to a crawl, with harmonization of IFRS and US GAAP a distant dream. And crossborder resolution likewise is far from accomplished.10 8

9  10

See Press Release, Commodity Futures Trading Comm’n, The European Commission and the CFTC reach a Common Path Forward on Derivatives, (July 11, 2013) at http://www.cftc .gov/PressRoom/PressReleases/pr6640-13. Robert Dilworth & Colin Lloyd, Bumps on the EU/US Path Forward, Int’l. Fin. L. Rev (Dec. 2013) available at http://www.iflr.com/Article/3288748/Bumps-on-the-EUUS-Path-Forward.html For an authoritative comparison of the implementation of the G-20 agenda by transatlantic regulatory authorities see, Atlantic Council, The Danger of Divergence: Transatlantic

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In hindsight, one can begin to hazard some guesses as to why this was the case. In the wake of the 2008 and Eurozone crisis, there was a high degree of political consensus relating to the necessity to better regulate banks and impose higher capital requirements. Furthermore, market participants were themselves highly concerned with bank stability and the market itself had occasionally punished banks operating in jurisdictions that were slow to implement Basel III, and rewarded institutions that were fast-tracking compliance and shoring up their balance sheet.11 At the same time, unilateral measures and principles that eschewed the G-20 process like the Volcker Rule took longer to spread. By comparison, market mechanisms were weaker (as was political will) to push for greater coordination of accounting standards or the completion of cross border resolution mechanisms. Harmonizing accounting rules across borders requires national regulatory authorities relinquishing control over basic presumptions about the value of different assets, and forcing varying (unequal) levels of “switching costs” for firms changing accounting regimes. Similarly, few financial or political authorities have been enthusiastic about the prospect of giving up control over the local assets of foreign financial institutions were a new financial crisis to ensue. As a result, international reforms have been slow on crossborder resolution coordination – and the institutional measures to support the achievement of G-20 objectives have been relatively weak. Ultimately, the fact-dependent and varied nature of today’s international regulatory ecosystem makes it hard to do good scholarship. It requires at a basic level understanding how highly diverse institutions, markets and informal commitments all interact. It also requires an appreciation of political forces – and the fact that the political and economic cycles in which international commitments are made will not necessarily be the same as those when standards are implemented on the ground as rules. Only then, by examining commitments, their institutional backdrop, and the circumstances and environment in which they are made can theories begin to serve not only academics, but also today’s practitioners of economic statecraft. This book provides an excellent set of readings for precisely such work.

Financial Reform & the G20 Agenda (Chris Brummer, rapporteur, 2013), available at http:// www.atlanticcouncil.org/images/publications/Danger_of_Divergence_Transatlantic _Financial_Reform_1-22.pdf 11  In April 2013, for example, Deutsche Bank’s share price jumped 6 percent the day it unveiled its cash call for meeting Basel III’s higher regulatory requirements, despite the 10 per cent dilution for shareholders. See James Wilson & Daniel Schäfer, “Cash Call Helps Shore up Deutsche Bank’s Balance Sheet,” Financial Times (Apr. 30, 2013), http://www .ft.com/intl/cms/s/0/83be1a82-b1a4-11e2-b324-00144feabdc0.html#axzz2dInujB56 (emphasis added).

part 1 Theoretical Reflections

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chapter 1

Government Versus Markets – A Change in Financial Regulation Armin J. Kammel* 1 Introduction The global financial crisis of 2007/08 has triggered a substantial discussion about the role, dangers and regulation of financial markets. This is understandable considering its enormous impact and still lingering consequences. Yet it is remarkable that past crises1 such as the 1997 Asian currency crisis, the 1998 Russian financial crisis or the Argentine economic crisis of 1999–2002 had much less of an impact in terms of public and academic debates although the 1997 Asian crisis triggered some – in the meantime likely forgotten – literature on international financial regulation2 unlike the events of 2007/2008. This is unfortunate since useful proposals regarding a future international financial architecture were then made. However, it is probably the unprecedented even unique nature of the recent global financial crisis, in terms of magnitude and complexity that distinguishes it from past occurrences.3 Due to the devastating effects of the crisis causing numerous bank failures around the globe from Newcastle4 to Iceland,5 in the US and continental * Dr. Armin J. Kammel is Honorary Professor and Faculty Member at the Department of Economic Law and European Integration at Danube University Krems and currently a Visiting Fellow with the Institute of Advanced Legal Studies (IALS) in London. 1 For a good overview of the past crises, see Buckley/Arner (2011), From Crisis to Crisis. 2 Among the vast literature see only Eatwell/Taylor (2000), Global Finance at Risk. 3 This assumption is empirically well evidenced by Reinhart/Rogoff (2011), This Time Is Different. See also the recent book by former Chairman of the Federal Reserve Alan Greenspan stressing the “almost unanticipated crisis of September 2008.” Greenspan (2013), The Map and the Territory, 7. 4 Although one might immediately think of the fall of Lehman Brothers, the dramatic events started in September 2007 with the run on the Newcastle-based bank Northern Rock. When considering some historical details of Northern Rock, it is worth noting that when the bank became a public limited company in October 1997, it incorporated the amalgamation of 53 building societies. The gradual transformation of Northern Rock from a risk-averse building society to the demutualized Northern Rock plc is significant and is still subject to legal actions and claims. Moreover, this transformation triggers interesting questions regarding the role of law as persuasively laid out in Gray/Akseli (2011), Financial Regulation in Crisis? 5 See e.g. Sighvatsson/Gunnarsson, Iceland’s financial disaster and its fiscal impact in LaBrosse/ Olivares-Caminal /Singh (ed./2011), Managing Risk in the Financial System, 133–154. © koninklijke brill nv, leiden, 2015 | doi 10.1163/9789004280328_002

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Europe as well as the newly emerging financial centers of the Middle and Far East culminating in a global economic crisis, the regulatory pendulum, not surprisingly, has been swinging in the direction towards more, comprehensive and complex government intervention. This is a trend that can be witnessed over the past few years and is intended to constitute a proper response to the various failures that were considered to be at the root of the crisis. Although individuals, particularly small and medium-sized enterprises as well as sovereign states are still struggling with the consequences of the crisis, one can clearly observe that the current regulatory drive has also led to a changing relationship between governments and markets. In particular politicians were quick in stating the need for regulatory responses. Consequently, enormous political pressure was built up to either introduce new or to strengthen existing regulation all over the globe. Also most academic commentators echoed the need for more regulation as well as government intervention by quickly concluding that globalization and market liberalization were the roots of the crisis.6 Furthermore, the role, impact and importance of economics as a science were substantially questioned7 often by reducing it to the two diverging schools of thought represented by John Maynard Keynes and Friedrich August von Hayek.8 These two schools representing the pro-interventionists on the one side and the market liberals on the other will remain9 and continue to add flavor to the discussion about the future relationship between governments and markets. Nevertheless, since the prevailing view is that governments have to stop markets making the same mistakes over and over again and that it seems also widely undisputed that more regulation is the (only) solution, this contribution is intended to shed some more light on the current change in financial regulation. Against this background, it is important to accept that financial regulation as such requires interdisciplinary skills which make it a complex undertaking. This became in particular obvious during and since the financial crisis. 6 For examples see Arestis/Basu (2003), Financial Globalization and Regulation, Schinasi (2005), Safeguarding Financial Stability or Kenen/Swoboda (ed./2000), Reforming the International Monetary and Financial System. 7 See the article in The Economist of July 16th, 2009 entitled “What went wrong with economics.” 8 See among others the analysis by Wapshott (2011), Keynes-Hayek, The Clash that Defined Modern Economics, who tends to favor Keynes but cannot neglect the importance of Hayek. This typically reflects the mainstream economic discussion which often culminates in effusive statements such as the “return of the master” as in Skidelsky (2012), Keynes – The Return of the Master. 9 Exemplary in this context is Hammond (2012), Ron Paul vs. Paul Krugman.

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Therefore, this chapter will first examine economic rationales of financial regulation by addressing both the concept of market failure and the “economics of politics.” This will be followed by an analysis of inherent problems of financial regulation before shifting the focus onto the challenges regarding an “international financial law.” It then concludes with considerations about the future economic and regulatory role of the government. 2

Financial Regulation and Its Economic Rationales

2.1 General Remarks When analyzing the reasons and justifications for financial regulation,10 one always finds its foundations in economics which highlights a fact that has often been neglected, namely the interdisciplinary nature of financial regulation. This means that typically based on economic rationales, policy makers and regulators issue regulations in the form of various legal acts. By assessing the underlying economic rationales of financial regulation, it becomes obvious that the main economic rational in this respect is market failure. However, numerous associated rationales also have to be taken into consideration, as elaborated in the following. 2.2 Market Failure Market failure, the concept of economic theory describing the inefficient allocation of goods and services by the market causing an outcome which is not Pareto-optimal is traditionally referred to as the main economic rationale for government intervention and thereby regulation. This is the mainstream neoclassical and Keynesian approaches which hold that government is able to improve inefficient market outcomes.11 It is worth recalling that the general 10

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See in general terms also Goodhart, Financial Regulation in Eijffinger/Masciandaro (ed./2011), Handbook of Central Banking, Financial Regulation and Supervision, 326–353. It is worth noting that two important objections to this pro-interventionist approach exist. One is the argument from Public Choice Theory and scholars of the Chicago school of economics that market failure is not necessarily desired because the costs of government failure may be worse than those of market failure it attempts to fix. Consequently, government failure is seen as the result of inherent problems of democracy as well as the power of rent seekers, typically understood as special-interest groups, in both the private sector and in the government bureaucracy. The other objection is brought forward by Austrian school of economics that market failure is not existing since – simply put – “inefficiency only arises when means are chosen by individuals that are inconsistent with their

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economic dogma of market efficiency can be traced back to Adam Smith12 and that it was later mathematically confirmed by Arrow and Debreu13 in the sense that free markets reach an equilibrium that is Pareto-efficient in allocation. However, it is believed that various factors can cause markets not to be Paretoefficient, such as imperfect information or incomplete markets.14 Therefore, although market failure is typically the main economic rationale justifying government intervention, three main reasons15 for its occurrence need to be specifically applied in the context of financial markets. This will be attempted in the following section by analyzing them as associated rationales to the overriding dogma of market failure. 2.3 Associated Rationales Associated rationales can either be a particular form of market failure or trigger one of its mentioned main reasons. Depending on how they are clustered,16 four to six such associated rationales can be detected being (a) systemic risks, (b) correction of other market imperfections and thereby enhancing the efficient allocation of funds and risks, (c) the need for consumer confidence and consumer protection, (d) moral hazard, (e) consumer demand for regulation and (f) other motives including the “grid lock problem.” These multiple layers of associated rationales give an idea about the complexity of financial ­regulation and its respective policy responses.

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desired goals” which underscores its typical approach of methodological individualism and methodological subjectivism. See in this respect only Cordato (1980), The Austrian Theory of Efficiency and the Role of Government, 396. This is often referred to as the “invisible hand” or first welfare theorem which confirms that free markets channel an economic system that reaches the required level of production. See Smith (1776), The Wealth of Nations IV, 246. For a detailed analysis see Arrow/Debreu (1954), Existence of an equilibrium for a competitive economy. This is often referred to as the “Greenwald-Stiglitz theorem”; and Greenwald/Stiglitz (1986), Externalities in economies with imperfect information and incomplete markets. Mainstream economics traditionally accepts market failure caused by (a) monopolies or a state of the market in which a small group of businesses hold significant market power; (b) externalities being costs or benefits which affects a party that did not choose to incur that cost or benefit; (c) the service or product being a “public good.” Among others, a comprehensive analysis is provided by Llewellyn (1999), The Economic Rationale for Financial Regulation while Niemeyer (2001), Economic Analysis of Securities Market Regulation and Supervision in particular refers to the practical challenges in this context.

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2.3.1 Systemic Risks One outcome of the financial crisis has clearly been an increased awareness of systemic risks17 and of associated challenges. Consequently, (potential) systemic risks, typically defined18 as risks that an event will trigger a loss of economic value or confidence in, and attendant increases in uncertainty about, a substantial portion of the financial system that is serious enough to quite probably have significant adverse effects on the real economy,19 are the main reasons for contemporary financial regulation. Such regulations are attempts to ensure that no such systemic risks can potentially harm the financial system. In this respect, the proper functioning of the payment and settlement systems and therefore the liquidity of markets are of major concern for policy makers and financial supervisors. Main policy responses in order to better control and mitigate systemic risks are in terms of banking regulation the introduction of the Basel III framework20 which amended the pre-crisis Basel II framework substantially in terms of its risk-sensitive measures21 as well as of the Dodd-Frank Act,22 17

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Such systemic risks should not be mistaken for systematic risks which in finance stand for aggregate or market risks. This has also been clearly underscored by Hansen (2013), Challenges in Identifying and Measuring Systemic Risk, 4–5. Moreover, reference shall be made to Eijffinger, Defining and Measuring Systemic Risk in Eijffinger/Masciandaro (Ed./2011), Handbook of Central Banking, Financial Regulation and Supervision, 383–412 as well as Selody, The nature of systemic risk in LaBrosse/Olivares-Caminal/Singh (Ed./2011), Managing Risk in the Financial System, 19–31. Other useful conceptual approaches to systemic risks can be found e.g. in Kaufman/Scott (2003), What is Systemic Risk, and Do Bank Regulators Retard or Contribute to It? or Hansen (2012), Challenges in Identifying and Measuring Systemic Risk. This definition has already been suggested by the G10 Report on Consolidation in the Financial Sector (2001). It basically covers all facets and features experienced during and since the global financial crisis and is a good example for the fact that in-depth considerations on potentially severe (global) financial crisis already existed coinciding with the substantial body of literature on financial crises in particular since the 1997 Asian crisis. Basel III or the Third Basel Accord is a global regulatory standard on bank capital adequacy, stress testing and market liquidity with the clear policy mission to strengthen bank capital requirements by increasing banking liquidity and decreasing bank leverage. The Third Basel Accord can be found at www.bis.org/bcbs/basel3.htm. See, among others, Moosa, Basel II to Basel III: a great leap forward? in LaBrosse/OlivaresCaminal/Singh (Ed./2011), Managing Risk in the Financial System, 374–398. The Dodd-Frank Act was signed into federal law in July 2010 and is considered to be the most comprehensive reform of financial regulation in the U.S. since the Great Depression; It is available at www.sec.gov/about/laws/wallstreetreform-cpa.pdf.

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Title I.23 Furthermore, specifically in terms of capital market regulation, the introduction of the Alternative Investment Fund Manager Directive (AIFMD),24 the European Market Infrastructure Regulation (EMIR)25 or Dodd-Frank Act, Title IV26 and VIII27 have to be mentioned. 2.3.2 Correction of Other Market Imperfections Aside of systemic risks, government intervention is commonly justified so as to correct other market imperfections which include, among others, asymmetric information or externalities. Both of them are of direct relevance for financial markets because in case of asymmetric information,28 when one counterpart is better informed than the other, it is assumed that informed traders will only buy when the asset is undervalued and sell when the asset is overvalued. In case of externalities,29 however, impact trading systems in terms of limiting competition and thereby constituting monopoly structures or triggering certain risk-taking. 23

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Title I of the Dodd-Frank Act is the “Financial Stability Act of 2010” which constitutes the foundation for the establishment of two new agencies, the Financial Stability Over­sight Council and the Office of Financial Research, tasked to primarily monitor systemic risk issues. The AIFMD, Directive 2011/61/EU, entered into force on 22 July 2013 and basically establishes a new regulatory framework for all (investment) fund structures, other than the Undertakings for Collective Investment in Transferable Securities (UCITS), already regulated since 1985. The EMIR framework based on EU Regulation 2012/648/EU entered into force 16 August 2012 and is intended to increase the stability of over-the-counter (OTC) derivatives markets, primarily through central clearing obligations. Title IV of the Dodd-Frank Act is the “Private Fund Investment Advisers Registration Act of 2010” which requires previously exempt investment advisers as well as hedge fund managers and private equity managers to register with and report to various federal government agencies. Title VIII of the Dodd-Frank Act is the “Payment, Clearing, and Settlement Supervision Act of 2010” intended to mitigate systemic risks by tasking the Federal Reserve to introduce uniform standards for the management of such risks by in particular systemically important financial institutions (SIFIs). In economics, asymmetric information is studied in the context of principal-agent problems by applying adverse selection models. Suffice it to mention the classic works of Akerlof (1970), The Market of Lemons, and of Spence on signaling as well as of Stiglitz on screening. On externalities see in particular Goodhart, Financial Regulation in Eijffinger/ Masciandaro (Ed./2011), Handbook of Central Banking, Financial Regulation and Supervision, 330–332.

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Main policy responses to correct such other market imperfections are, among others, Title VII of the Dodd-Frank Act,30 and the revision of the Market Abuse Directive (MAD II),31 the aforementioned EMIR framework as well as certain delegated acts amending EU Prospectus law.32 2.3.3 Need for Consumer Confidence and Consumer Protection Another and very popular rationale is the need to strengthen consumer confidence and consumer protection. The underlying (economic) argument in this respect is that only a transparent and efficient price formation process ensures proper consumer protection as well as sufficient competition between traders, brokers and other market participants. The aforementioned rationales of asymmetric information and externalities are closely linked to these aspects in particular since (certain) market power of market participants is by trend to the detriment of small(er) ones. However, since this rationale is often stressed in a political context, as seen during and since the global financial crisis, it is often not clear what consumers need to be protected against33 because since risk is central to financial markets, regulation should basically not protect investors against making losses, taking risks or making mistakes but to correct market imperfections and failures.34 Main policy responses in order to strengthen consumer confidence and consumer protection are Titles IX35 and X36 of the Dodd-Frank Act, the recent agreement on the – scheduled – revision of the EU Directive on Markets in 30 31 32 33 34 35

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Title VII of the Dodd-Frank Act is the “Wall Street Transparency and Accountability Act of 2010” which primarily determines rules for over-the-counter (OTC) swaps markets. For recent developments regarding possible delegated acts concerning the EU Market Abuse Regulation see http://ec.europa.eu/internal_market/securities/abuse/index_en.htm. These amendments see at http://ec.europa.eu/internal_market/securities/prospectus/ index_en.htm. This crucial point had already been critically discussed by Niemeyer (2001), Economic Analysis of Securities Market Regulation and Supervision, 37–38. This thought had already been brought up decades ago. See in this respect, Llewellyn (1995), Regulation and Retail Investment Services, 16. Title IX of the Dodd-Frank Act is the “Investor Protections and Improvements to the Regulation of Securities Act” which strengthens the (enforcement) powers of the SEC, creates an Office of the Investor Advocate as well as improves the regulation of credit rating agencies. Title X of the Dodd-Frank Act is the “Consumer Financial Protection Act of 2010” which establishes the Bureau of Consumer Financial Protection with the aim to regulate ­consumer financial products and services.

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Financial Instruments (MiFID II)37 or EU regulations on short-selling practices38 and financial benchmarks.39 2.3.4 Moral Hazard The moral hazard rationale for regulation is typically linked to specific “safety net” arrangements40 such as deposit insurance or lender of last resort. It concerns the questions whether consumers may become less careful in the knowledge that potential compensation schemes are in place and financial institutions may be induced to more (or excessive) risk – taking due to their investors being protected by deposit insurance schemes. Main policy responses in this context are Titles III41 and VI42 of the DoddFrank Act, as well as the revision of existing deposit guarantee schemes43 and, possibly, amendments to the existing system of investor compensation schemes44 in Europe. 2.3.5 Consumer Demand for Regulation Acknowledging that regulation may also fail, Llewellyn45 mentions private self-regulation, reinforced by common, commercial and contract law stemming from consumer demand. Properly satisfied, he argues, it would lead to welfare 37 38 39

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Commissioner Michel Barnier welcomed the agreement, see the statement at http:// europa.eu/rapid/press-release_MEMO-14-15_en.htm?locale=en. EU Regulation 236/2012/EU, has been complemented by some regulatory technical standards (RTS). In September 2013, the European Commission published a proposal for a regulation on indices used as benchmarks in financial instruments and financial contracts. For further details on this proposal see http://ec.europa.eu/internal_market/securities/benchmarks/index_en.htm. For further discussions on these issues, see Llewellyn (1999), The Economic Rationale for Financial Regulation, 28–30. Title III of the Dodd-Frank Act is the “Enhancing Financial Institution Safety and Soundness Act of 2010” which – among other provisions – increased the amount of deposits insured by the FDIC and the NCUSIF from USD 100,000 to USD 250,000. Title VI of the Dodd-Frank Act is the “Bank and Savings Association Holding Company and Depository Institution Regulatory Improvements Act of 2010” or better known as the “Volcker Rule” which aims to reduce the amount of speculative investments and restricts asset purchases of insured depository institutions. Moreover countercyclical capital requirements may be imposed on such insured institutions. In July 2010 the European Commission adopted a proposal for a thorough revision of Directive 94/19/EC on deposit guarantee schemes. See the proposal of the European Commission to amend Directive 97/9/EC on investor compensation schemes in July 2010. For more detail see Llewellyn (1999), The Economic Rationale for Financial Regulation, 30–32.

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gains. From a material perspective, such possible consumer demand is typically associated with lower transaction costs for consumers, a lack of information or reasonable demands for a certain degree of assurance mechanisms when engaging in transactions with financial firms. It is important to note in this respect that consumers need to be aware that (any) regulation is supplied at a cost.46 The policy response to consumer demands for regulation is reflected in the ongoing “tsunami” of financial regulation since the prevailing (political) environment stimulates a general expectation that (government) regulation per se is the panacea for resolving the global financial crisis. This mostly uncritical view leads to the unfortunate situation in which the regulatory option of (industry) self-regulation is (in particular in Europe) left in the shades.47 2.3.6 Other Motives including the “Grid Lock Problem” Further economic rationales for regulation include the competitiveness of the financial sector or the challenges stemming from money laundering. The competitiveness of (parts of) the financial industry has commonly been one policy goal of regulation reflecting the desire for efficiency of the markets.48 Moreover, the extraordinarily increasing numbers of international financial transactions gave rise to undesirable developments, particularly the large scale phenomenon of money-laundering that is the hiding of criminal revenue and transforming it into legitimate financial positions. Consequently, anti-moneylaundering measures have continuously been introduced over the last decades including significant reporting requirements. Another motive in this context is the so-called “grid lock problem”49 which means that although (financial) firms have a rational interest in not behaving against the interests of their consumers,50 circumstances may occur in which 46 47

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Ibid., 32. For a more comprehensive discussion of the changing relationship between government regulation and self-regulation see, among others, Kammel (2012), Corporate Governance in the Financial Services Industry, 1709–1712 and Baldwin/Cave/Lodge (2012), Under­ standing Regulation, 105–164. One of the 2013 Nobel Laureates in Economics, Eugene Fama, focused most of his work on the theory of efficient capital markets based on his well-known 1970 paper on Efficient Capital Markets: A Review of Theory and Empirical Work. Interestingly, the other 2013 Nobel Laureate in Economics, Robert Shiller, stressed the behavioral element of market participants which often undermines the efficiency of capital markets. See e.g. Shiller (2003), From Efficient Markets Theory to Behavioral Finance. For further details on this problem, see Llewellyn (1999), The Economic Rationale for Financial Regulation, 27–28. This has been argued, among others, by Benston (1998), Regulating Financial Markets.

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such firms, nonetheless, adopt hazardous strategies contrary to the interests of their consumers, due to short-term advantages and a lack of trust that their competitors do not behave hazardously. Main policy responses to these other motives are, in terms of the “grid lock problem,” new regulations on executive compensation as part of the DoddFrank Act51 and the introduction of remuneration policies by amending the EU Capital Requirements Directive (CRD III)52 and, in terms of the anti-moneylaundering measures, the continuous efforts of the Financial Action Task Force (FATF)53 as well as the increased international pressure on “tax havens.”54 2.4 Consequences of the Rationales for Financial Regulation Against the background of these rationales for financial regulation, it has to be taken into consideration that any regulatory agency has to be able to practically address their multiple facets. In other words, due to their interdisciplinary nature and international dimension, regulatory bodies have to have the respective expertise and experience to properly address the associated challenges of these rationales and to accept that reliance on international cooperation is a necessary pre-condition to meet today’s regulatory demands. Nevertheless, before discussing pertinent deliberations, certain inherent problems of financial regulation and of regulatory actions relating to the global financial regulation have to be raised in order to flesh out the concluding arguments of this contribution. 3

Inherent Problems of Financial Regulation

3.1 General Aspects Even though it seems that financial regulation is generally considered to be the right answer to the negative occurrences and damages in relation to the global financial crisis, some structural problems inherent in the nature of financial 51

Regarding the specific sections 951–955 of the Dodd-Frank Act on executive compensation see in more details www.sec.gov/spotlight/dodd-frank/corporategovernance.shtml. 52 See in more details http://ec.europa.eu/internal_market/company/directors-remun/ index_en.htm. It has to be mentioned in this context that also the AIFMD as well as the forthcoming amendment of the UCITS Directive (UCITS V) introduce new provisions regarding remuneration policies. 53 More information about the ongoing works of the FATF can be found at www.fatf-gafi.org. 54 Further analyses on tax havens is provided, among others, by Gravelle (2013), Tax Havens: International Tax Avoidance and Evasion or Palan/Murphy/Cahvagneux (Ed./2009), Tax Havens: How Globalization Really Works.

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regulation have to be discussed.55 In this context, two interlinked layers, which are often confused in practice, have to be pointed out: financial regulation in the structural and in the material sense. Financial regulation in the structural sense means the institutional settings, hence the regulatory authorities and agencies, whereas financial regulation in the material sense describes the regulatory acts, hence regulatory (enforcement) actions by such agencies and any legislative or statutory acts issued by such agencies or policy-makers. Never­ theless, inherent problems of financial regulation discussed below affect both layers due to their intertwined nature. Furthermore, regulatory theory points out that two essential criteria should be meet for any financial regulation to be efficient and effective: the costs and benefits56 and its acceptance. This implies that any financial regulation, in both its structural and material sense should be subject to a thorough cost-and-benefit analysis and designed in such a manner as to be acceptable to the regulated agents since it would otherwise lead to turmoil. If these two criteria are not met, financial regulation cannot be effective and hardly efficient.57 In order to ensure that these two criteria are met, certain inherent problems of financial regulation58 have to be faced and managed as outlined in the following section. 3.2 Specifics Issues Inherent in Financial Regulation Among the numerous specifics of financial regulation, a few should be highlighted, being (a) the ability of the regulator, (b) moral hazard, (c) enforceability of regulation, (d) consumer, (e) time and (f) conflicts. 3.2.1 The Ability of the Regulator As already indicated, any regulator has to be in the position and able to impose regulations meaning that both the availability of information as well as the enforceability of the regulation is ensured. This has been clearly stated by the 55

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These inherent problems of financial regulation have already been addressed by Niemeyer (2001), Economic Analysis of Securities Market Regulation and Supervision. It is an irony that the global financial crisis clearly underlined them in each and every respect. The analysis of costs and benefits – in conjunction with regulatory impact assessments – are crucial means of evaluating and influencing regulatory policy. For a comprehensive discussion see Baldwin/Cave/Lodge (2012), Understanding Regulation. For further references see Baldwin/Cave/Lodge (2012), Understanding Regulation, 25–37. These problems are primarily based on the discussion by Niemeyer (2001), Economic Analysis of Securities Market Regulation and Supervision.

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IOSCO Objectives and Principles of Securities Regulation59 (referred to as “the Principles”) which, referring to the principles of the regulator in Section A, require that the responsibilities of the regulator should be clearly and objectively stated, that the regulator should be operationally independent and accountable in the exercise of its functions and powers, that the regulator should have adequate powers, proper resources and the capacity to perform its functions and exercise of powers, that the regulator should adopt clear and consistent regulatory processes, that the staff of the regulator should observe the highest professional standards, including appropriate standards of confidentiality, that the regulator should maintain or contribute to a process of monitoring, mitigating and managing systemic risk, appropriate to its mandate, that the regulator should establish or contribute to a process of reviewing the parameters of regulation regularly and that the regulator should seek to ensure that conflicts of interest and misalignment of incentives are avoided, eliminated, disclosed, or otherwise managed. Against the background of these principles, it is more than doubtful that every regulatory agency in the financial sector is (fully) compliant with them,60 failing which a (public) review is called for in respect of compliance by each regulator with these principles. Even more importantly, such a review should establish whether alternative solutions might be more appropriate.61 59

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The most recent IOSCO Objectives and Principles of Securities Regulation of June 2010 are available at www.iosco.org/library/pubdocs/pdf/IOSCOPD323.pdf. It has to be noted that they should not be confused with the IOSCO Objectives and Principles of Securities Regulation of May 2003 since the latter reflect a “pre-crisis perspective.” In general, IOSCO principles can be considered as international soft law. It is worth pointing out that the IOSCO Objectives and Principles of Securities Regulation require that the (38) principles need to be practically implemented under the relevant legal framework. However, it is interesting to note that (national) regulators like to refer to these principles to underline their respective regulatory duties. On the contrary it seems that the bid weakness of these principles is their lack of enforcement, in particular regarding those sets of principles that are directly addressed to the respective regulatory agency. The Principles also make a direct reference to self-regulation in Section B stating that where the regulatory system makes use of Self-Regulatory Organizations (SROs) that exercise some direct oversight responsibility for their respective areas of competence, such SROs should be subject to the oversight of the regulator and should observe standards of fairness and confidentiality when exercising powers and delegated responsibilities. This principle at least accepts that self-regulation is an efficient tool within the regulatory environment. For a more detailed discussion on the changing relationship between government regulation and self-regulation, see Kammel (2012), op. cit. supra, note 47.

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Moreover, the need for cooperation in (international) financial regulation is reflected in Section D of the “Principles” which states that the regulator should have the authority to share both public and non-public information with domestic and foreign counterparts, that regulators should establish information sharing mechanisms that set out when and how they will share both public and non-public information with their domestic and foreign counterparts and that the regulatory system should allow for assistance to be provided to foreign regulators who need to make inquiries in the discharge of their functions and exercise of their powers. This emphasis on cooperation between regulators is the consequence of the global financial crisis which prompted a trend towards “re-nationalization” of regulatory activities. However, it remains more than doubtful that the situation has significantly changed over the last few years, although, at least in the EU, a new framework62 of regulatory cooperation has meanwhile been introduced. 3.2.2 Moral Hazard Although moral hazard is typically considered to be an economic rationale for regulation, it is important to accept that imposing new financial market regulations may cause a shift of incentives of regulated agents so that – in analogy to the above highlighted “safety net” arrangements – individual agents may become less careful. This phenomenon can be observed in particular during the last couple of years since both policy-makers as well as regulators tend to give – in particular retail – investors the impression that financial products are either “risk-free” or “suitable” to them, since specific regulatory measures “for investor protection”63 have been introduced. Consequently, financial regulation can also have a negative effect of adverse selection in terms of consumer behavior. 3.2.3 Enforceability Like any regulation, financial regulation may practically be unenforceable due to wrong regulatory solutions chosen. In this context, the Principles in Section C require that the regulator should have comprehensive powers of inspection, investigation surveillance and enforcement and that the regulatory system should include a credible compliance program ensuring their effectiveness. 62 63

For further details see Schramm [chapter 6 in this volume], as well as http://ec.europa.eu/ internal_market/finances/committees/index_en.htm. According to the Principles the first of the three objectives of securities regulation is “protecting investors” and basically each and every regulatory measure since the global financial crisis is, among others, justified by this objective.

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This means in practical terms that ideally the so-called “DREAM framework”64 with the regulatory tasks of detecting, responding, enforcing, assessing and modifying should be applied, although it seems that due to the “ad hoc” nature of recent financial regulatory measures, most of the conceptual aspects of this theoretical framework have been neglected. 3.2.4 Consumer Over-Protection The Principles state in their Sections E to I specific requirements for certain market participants or market structures. This includes issuers (Section E), auditors, credit rating agencies and other information service providers (Section F), collective investment schemes (Section G), market intermediaries (Section H) and secondary markets (Section I). All of them are an indicative of consumer protection. However it is often difficult to understand what consumer protection really stands for because it seems that financial regulation should in principle not protect investors against making losses, taking risks or making mistakes65 but to be put in a situation in which they are able to take an informed investment decision. This implies that there is a fine line between those two objectives and often regulators are tempted to over-regulate financial markets by (excessively) stressing the argument of consumer protection which is typically supported by politicians due to their short-term interest in political especially electoral support by the general public. Nevertheless, this often leads to the paradox situation in which public (and political) support for a regulatory measure exists, although the (general) public is not (fully) aware of its consequences and how it is practically affected by the proposed measure.66 3.2.5 Time An inherent problem of financial regulation is clearly the aspect of time, in particular when considering the speed and innovation of financial markets. This puts any regulatory agency typically in the uncomfortable situation that in most instances – also when considering the DREAM framework – its actions are re-active rather than pro-active. 64 65 66

Regarding a detailed analysis of the DREAM framework see Baldwin/Cave/Lodge (2012), Understanding Regulation, 227–258. Again, reference should be made to the discussion by Niemeyer (2001), Economic Analysis of Securities Market Regulation and Supervision, 37–38. For an excellent recent example see the proposal to introduce a financial transaction tax (in Europe) which is not only targeted at speculators, investment bankers and highfrequency traders but also affects simple retail investors trading a few stocks or bonds. Moreover, it is also neglected that the efficiency and effectiveness of such a tax is only granted if introduced globally. For this proposal see http://ec.europa.eu/taxation_ customs/taxation/other_taxes/financial_sector/index_en.htm.

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As a result, the global financial crisis serves as a justification for increased regulatory reporting requirements put forward in numerous recently issued regulations.67 This attempt, however, of regulators seeking to obtain more and significantly more detailed information from market participants is a twoedged sword. First, because it causes expectations that regulatory agencies are aware of everything happening in the market and therefore are put in the situation to properly react in a timely manner and secondly, because there are good reasons and sufficient legal grounds in certain jurisdictions to encompass liability considerations regarding the competent regulatory agency. 3.2.6 Conflicts Finally, (financial) regulation is inherently subject to potential conflicts for various reasons. First, tensions may arise in terms of the flexibility and the predictability of regulation, second, harmonization of regulation ensuring an efficient level-playing field for market participants (as currently discussed in terms of packaged retail investment and insurance based products [PRIIPS] in the EU), third, regulatory competition and arbitrage causing unbalanced regulatory requirements between competitive markets, fourth, balancing the request for consumer protection with the desire of market participants of minimal regulatory intervention and fifth, ensuring efficiency and in particular compatibility between different levels of regulation.68 These are but only a few examples of conflicts financial regulation is facing. Against the background of these multiple layers of potential conflicts, it is important to create awareness for a substantial accentuation of these conflicts by the increase in “ad hoc” regulatory measures potentially leading to – and already reflected in reality69 – uncoordinated regulatory action and non-compatible ­regulatory pillars. 3.3 Consequences of the Inherent Problems of Financial Regulation In view of these various problems inherent in financial regulation, doubts are justified that the existing lopsidedness of the prevailing notion of regulation in the form of government intervention constitutes the panacea as is claimed by some. This can be underlined by the politically driven agenda of recent 67 68 69

Examples in this context are, among others, the Basel III framework, the Dodd-Frank Act, the EMIR framework or the AIFMD. See also, among others, Baldwin/Cave/Lodge (2012), Understanding Regulation, 373–408. For example, since the outbreak of the global financial crisis around twenty regulatory frameworks have either been newly introduced, amended or extended in the EU alone. It is not surprising, therefore, that the ensuing lack of coherence and compatibility causes – which is the practical irony – legal uncertainty for the regulated entities.

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financial regulation as seen on both sides of the Atlantic. Taking into account that in a substantial number of instances, financial regulation has been issued by regulatory agents without any practical experience in financial markets and/or is advocated by consumer protection agencies which claim to possess the knowledge, expertise, experience and in particular legitimacy to patronize individual (retail) actors of financial markets and protect them against making losses, taking risks or making mistakes (without their consent), sparks significant skepticism as to the right way forward. Consequently it is unfortunate that modern financial regulation seems to be primarily politically driven. However, before following up on these considerations, certain regulatory reactions to the global financial crisis need to be interlaced in this context. 4

Regulatory Reactions to the Global Financial Crisis

4.1 General Considerations When examining accounts of why and how the global financial crisis could have emerged,70 the argument is often brought forward that it was due to a lack of information about the activities of certain actors. However, when considering the pre-crisis regulatory framework and the respective warnings of central banks about the under-pricing of risk and excessive leveraging up to two years before the crisis as well as regular such warnings by the Bank of International Settlements (BIS) in combination with the existing knowledge in the financial sector about these incidents, one cannot but conclude that the problem was not the lack of information but the lack of instruments that can be used to counter the bubbles in asset prices and bank lending.71 However, what is generally considered to have been the underlying problem is the pro-cyclicality of regulatory instruments which underlines the broadly articulated call for making capital and liquidity requirements counter-cyclical and potentially time-varying.72 Nevertheless, as Goodhart73 rightly pointed out there are four counterarguments to be considered, namely (a) a raise of the 70

71 72

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For a good overview see Kaufman, The Financial Turmoil of 2007–20XX: Causes, Culprits and Consequences in LaBrosse/Olivares-Caminal/Singh (Ed./2013), Financial Crisis Management and Bank Resolution, 1–10. See Goodhart (2009), The Regulatory Response to the Financial Crisis, 30. For g a good analysis see Capiro, Safe and Sound Banking: A Role for Countercyclical Regulatory Requirements in Eijffinger/Masciandaro (Ed./2011), Handbook of Central Banking, Financial Regulation and Supervision, 383–412. See Goodhart (2009), op. cit, supra note 71 32.

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cost of borrowing in good times, (b) if not introduced globally, would shift business off-shore, (c) impose a significant information burden on financial institutions and (d) provide incentives for off-loading assets onto associated off-balance sheet entities due to the imposition of greater costs on financial institutions. Despite of the broad consensus that a systemic shift from pro-cyclical regulatory tools to more counter-cyclical action was needed, the regulatory reactions taken can be compared to a sprinkler system which in numerous ways has not been properly adjusted. This can be explained by reference to two characteristics of human behavior. The first is a (re-)action because there is a need to do something and the second when doing something, then “the more the better.” 4.2 “Sprinkler System” of Actions When the crisis erupted, it became clear that despite its US origins it had an international dimension74 which was addressed by the establishment of two important institutions, the Financial Stability Board75 and the G-20.76 Market failure had to be countered by government intervention in the absence of belief in the self-restoring powers of the market. Hence, restoring the banking system became the overriding regulatory goal by ensuring the functioning of central banks to maintain financial stability77 as well as implementing (cross-border) bank insolvency78 mechanisms. Such 74

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See Arner/Norton, International Responses to the Global Financial Crisis in LaBrosse/ Olivares-Caminal/Singh (Ed./2013), Financial Crisis Management and Bank Resolution, 11–30. The Financial Stability Board has been established – according to its mission statement – to coordinate at international level the work of national financial authorities and international standard setting bodies and to develop and promote the implementation of effective regulatory, supervisory and other financial sector policies in the interest of financial stability. See www.financialstabilityboard.com. The Group of Twenty (G20) is – according to its mission statement – the premier forum for its members’ international economic cooperation and decision making. See www.g20 .org. Since the global financial crisis, the G20 has become the dominant political decisionmaking body which triggered numerous regulatory initiatives that had been or are about to be implemented at supranational and national level. It became clear that central banks should be able to contribute to maintaining financial stability and that their primary role is not limited to achieving price stability. See Goodhart (2009), op. cit. supra note 71, 34–41. Winding down troubled banks and protecting creditors of insolvent banks became one of the key focus areas of financial regulators which is to be welcomed because in particular in case of banking institutions with a global reach, it is far more difficult to find proper

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measures have been complemented by re-assessing the functioning of deposit insurance systems79 and deliberations on how to best tackle the “too-big-tofail” problem.80 Moreover, regulatory action has increasingly been directed beyond the borders of – traditional – banking business which introduced the new concept of “shadow-banking.”81 This concept of “shadow-banking,” from its introduction has become the main justification for more extensive regulatory restrictions on actors – primarily of capital markets – which either have or have not been subject to regulation. Such shadow-banking entities that have been regulated for a long time are Money Market Funds (MMF),82 whereas those that have not been subject to regulation are primarily hedge funds.83

79

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means to wind down such entities. For pertinent reflections see in particular Lastra/ Olivares-Caminal, Cross-Border Insolvency: The case of financial conglomerates in LaBrosse/Olivares-Caminal/Singh (Ed./2013), Financial Crisis Management and Bank Resolution, 269–290 as well as Mayes, Resolution Methods for Cross-Border Banks in the Present Crisis in LaBrosse/Olivares-Caminal/Singh (Ed./2013), Financial Crisis Manage­ ment and Bank Resolution, 303–328. Regarding the protection of creditors of insolvent banks see Campbell, Protecting Creditors of Insolvent Banks: How should the rights of different types of creditors be best managed? in LaBrosse/Olivares-Caminal/Singh (Ed./2013), Financial Crisis Management and Bank Resolution, 203–216. For further details see Cartwright, Understanding, Awareness and Deposit Insurance in LaBrosse/Olivares-Caminal/Singh (Ed./2013), Financial Crisis Management and Bank Resolution, 139–154. The “too big to fail” problem refers to the theory that the failure of financial institutions which gained a certain size and are heavily interconnected (globally) would have disastrous effects on the economy with the consequence that the government has to support them when facing difficulties. For an excellent analysis of this issue see, among others, Wilmarth, Finding a solution to the “too-big-to-fail” problem in LaBrosse/OlivaresCaminal/Singh (Ed./2011), Managing Risk in the Financial System, 208–232. The term “shadow-banking” had been coined to describe non-bank financial intermediaries that provide a range of financial services which are similar to commercial banks and typically includes hedge funds, money market funds (MMF), structured investment vehicles (SIV) or securities broker dealers. However, it has to be stressed that both the meaning and the scope of the term “shadow-banking” is subject to dispute in literature. In this regard, see only Fein (2013), The Shadow Banking Charade. MMF have been subject to regulation in both the EU and the US which makes it a bit awkward to categorize them as shadow-banking entities since the fact that they have been under regulatory oversight and supervision is contradicting with “being in the shadow.” Hedge Funds have become subject to significant regulation as a result of the global financial crisis. In the EU, hedge funds were the trigger of and are now in scope of the AIFMD and in the US they have to be registered according to Dodd-Frank Act, Title IV, or the “Private Fund Investment Advisers Registration Act of 2010.”

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As these general considerations on regulatory reactions reveal, a broad range of actions has already been taken, in fact numbering thousands of pages of regulatory measures. Still they give the impression to amount to no more than being patchwork. 5

The Lack of an “International Financial Law”

This patchwork of regulatory reactions can easily be identified by the different regulatory approaches taken in various parts of the world addressing the same issues stemming from G-20 decisions. Examples in this respect are the different steps taken with respect to the regulation of hedge funds84 as well OTC clearing obligations85 on both sides of the Atlantic. Although both examples are direct outflows of respective G-20 summits, the U.S. and the EU, nonetheless, took different regulatory measures in terms of regulatory scope, oversight, requirements, intervention mechanisms or sanction regimes engendering incompatible regulatory environments. Consequently, even though regulatory actions may share the same origin, their respective design and transposition may still be significantly different. This underscores the aforementioned patchwork design of modern regulatory actions with two important implications: From a practical point of view, market participants with cross-border and/ or international operations, face difficulties complying with such fragmented regulatory environments. Apart from the need to ensure legal compliance IT infrastructure too has to be programmed, reporting obligations to be fulfilled, information documents for clients to be amended and organizational measures to be taken according to the regulatory requirements of the respective 84

85

In the EU, the AIFMD framework basically regulates all funds that are not in scope of the traditional UCITS framework by introducing organizational, capital, reporting and transparency requirements for so-called alternative investment funds (AIF). See supra note 24. Contrary to this, Title IV of the Dodd-Frank Act or the “Private Fund Investment Advisers Registration Act of 2010” (only) requires previously exempt investment advisers as well as hedge fund managers and private equity managers to register and report to various federal government agencies. See supra note 26. The EMIR framework is intended to increase the stability of over-the-counter (OTC) derivatives markets, primarily through central clearing obligations. See supra note 25. Basically the same intention but in a different design with different requirements is followed by Title VIII of the Dodd-Frank Act or the “Payment, Clearing, and Settlement Supervision Act of 2010” which intends to mitigate systemic risks by tasking the Federal Reserve to introduce uniform standards for the management of such risks by in particular systemically important financial institutions (SIFIs). See supra note 27.

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framework. Since business operations occur in various jurisdictions, this constitutes not only an operational nightmare but also implies operational and organizational risks which are challenging to manage. Typically, these issues are addressed in bilateral or multilateral discussions with regulators or legislators in search of practicable ways forward to resolve them, endeavors which often prove unattainable. Consequently, different organizational infrastructures reflecting the respective regulatory requirements may often be the only (practical) solution available. Such outcomes, typically do not permit generating any economies of scale but increase organizational costs and (directly or indirectly) the costs for the clients. Aside from this, an interesting theoretical aspect has to be taken account of. Although in the midst of a “regulatory tsunami,” there is – as Brummer86 correctly points out – a relative absence of a uniformly robust and comprehensive regulatory architecture. Ironically, despite widespread calls for a complete overhaul of the international financial system, the recent regulatory actions just add to the inefficiency of the status quo of the regulatory patchwork environment. This merely underscores the current lack of a (truly) “International Financial Law.”87 Although, dogmatic and theoretical considerations may well point to the benefits of such a body of law, its practicality, given the recent experiences of regulatory responses to the global financial crisis as well the (global) efforts made in terms of promoting integrity in financial markets88 has to be critically assessed. Nevertheless, an improvement to the status quo would be the improving of the institutional support system by promoting monitoring and information sharing because this would improve the quality of international standards which would continuously undergo checks and scrutiny to ensure their best application.89 Moreover this would reflect the proper practical and regulatory needs in order to ensure a sound regulatory system. This would not necessarily lead to the establishment of an international financial “super-regulator”90 but to the better coordination between already existing 86 87

88 89 90

See Brummer (2011), How International Financial Law Works, 311. It is interesting to note that although many publications are entitled with clear references to “international financial law” rarely any is convincingly arguing in theory and showing the necessary steps to be taken in practical terms in order to establish a new substantive body of law with international enforcement tools. Consequently, this will remain a key issue for future research in this field. See among others Freis, The G-20 Emphasis on Promoting Integrity in Financial Markets in Giovanoli/Devos (Ed./2010), International Monetary and Financial Law, 104–126. This is stressed by Brummer (2011), op. cit. supra, note 86, 312. Regarding the proposal of a new World Financial Organization, see among others only Eatwell/Taylor (2000), Global Finance at Risk.

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international bodies. If successful this would most likely end the existing regulatory discrepancies around the globe and help create a more coherent, consistent and thereby efficient regulatory global landscape avoiding regulatory arbitrage and thus creating legal certainty for all market participants financial service providers as well as investors. However, though one should not be too naïve thinking that the way forward is that easy, some of the pertinent proposals91 will be worth considering in the future. Moreover, it has to be stressed that the establishment of a new substantive body of law, such as “international financial law” with proper and efficient enforcement tools is neither the panacea nor can it be achieved quickly. Therefore, careful considerations combined with in-depth theoretical and in particular practical analyses are necessary to move such a huge and complex undertaking in the right direction. In addition, it would be advisable to ensure strong political willingness and commitment internationally to move forward. Experience in the trade area with the establishment of the body of international economic law92 and its organizational infrastructure is at hand and despite all its shortcomings provides ample insights on which regulatory mistakes to repeat thereby avoiding certain inefficiencies. In any case, only future will tell if this may be a proper way forward but the fact remains that it would have an important impact on the relationship between government and markets. 6

Outlook: Government versus Markets

Deriving from the above discussion, five implications for the (changing) relationship between government and markets can be detected: First, the global financial crisis has clearly shown that the regulatory pendulum has not been swinging in the direction of more, comprehensive and complex government intervention which triggered numerous new regulatory measures at international, supranational and domestic level. Second, policymakers and the general public do consider that the financial industry in the broad sense (because unfortunately not even experienced legislators and regulators tend to differentiate between the various market segments) is the perpetrator and therefore the culprit of the global financial crisis which (easily) justifies the regulatory actions taken. Third, these developments have to be seen as a “thrust 91 92

For a thorough discussion of the existing literature and a balanced proposal see Brummer (2011), How International Financial Law Works. For a comprehensive overview of international economic law covering both material as well as institutional aspects, see Lowenfeld (2008), International Economic Law.

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reversal” to the financial liberalization of the past decades which triggers new perspectives regarding the changing relationship between governments and markets. In this context, it should be pointed out that the economic role of the state,93 is changing having peaked due to (unlimited) public spending having reached sustainable ceilings in most countries. This calls for alternative solutions of government intervention, both in fiscal and regulatory policy. Fourth, the inter-connectedness of (international) financial markets has gradually been answered by increased cooperation and collaboration efforts of financial regulators and legislators. Although the regulatory patchwork became more complex, efforts made in this regard cannot be denied. Fifth, the lack of a substantive international body of law, such as an “international financial law” is apparent and may be an integral part of the solution towards enhanced regulatory coordination and cooperation leading to more consistency and coherence as well as efficiency in the regulatory landscape. As these implications show, the current complexity of financial regulation triggered by the one-way swinging of the regulatory pendulum is most likely the core of the problem to be addressed for three reasons: First of all, the newly introduced complexity of financial regulation is no guarantee against the recurrence of future incidents. On the contrary, the increased reporting requirements may become a kind of “Sword of Damocles” for regulators in the future because due to the vast and very detailed amount of reporting information received as a result of the respective regulatory frameworks in all market segments, neither macro- nor micro-prudential supervisors will be unable to decline responsibility for the detection, identification and if need be intervention in terms of systemic risk or other dangers to the functioning of the financial system. Consequently, liability considerations against supervisors (and in this context cases for state liability) will cumulatively occur whereas no regulator or supervisor has so far been held liable for regulatory failures in the context of the global financial crisis. Second, the suggested feelings of safety and hedging of risks of the financial system in general but individual financial actions taken in particular due to imposed regulatory measures may have a boomerang effect in the future. This becomes clear when one recalls that finance deals with the allocation of assets and liabilities over time under conditions of certainty and uncertainty which simply means risk that can be managed by various tools. Consequently, concealing or even denying the existence of risk in finance is foolish. Nevertheless, public efforts in promoting financial education would be the right way forward 93

For a comprehensive analysis of the changing economic role of the state see Tanzi (2011), Government versus Markets, 39–304.

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because this would ensure that people would take proper decisions in terms of their financial actions. Finally, making the regulatory pendulum swing even stronger in the direction towards more, comprehensive and complex state intervention contains a great deal of danger which had already been identified by the Austrian economist Ludwig von Mises who in his “Human Action” stressed that “[t]he effect of [state] interference is that people are prevented from using their knowledge and abilities, their labor and their material means of production in the way in which they would earn the highest returns and satisfy their needs as much as possible. Such [government] interference makes people poorer and less satisfied.”94 Nowadays, such phenomenon is also called “paternalism” which can be commented, by quoting von Mises again as follows: “[a]ll rational action is in the first place individual action. Only the individual thinks. Only the individual reasons [and] [o]nly the individual acts.”95 Even when not agreeing with von Mises’ seemingly harsh and unambiguous admonition, re-thinking the need and role of financial regulation against the continuously changing relationship between government and markets should always be on our agenda before taking concrete and hasty actions. Any paternalistic actions taken will not necessarily be rational, effective and to the benefit of investors. Consequently, the main role of financial regulation should be to provide a sound framework ensuring that the individual takes the right decision and not to further increase the cost of regulatory complexity without thereby attaining and enhanced safety net for the future. Bibliography Akerlof, G.A. (1970), The Market of Lemons: Quality Uncertainty and the Market Mechanism, Quarterly Journal of Economics, Vol. 84, No 3: 488–500. Arestis, Ph./ Basu, S. (2003), Financial Globalization and Regulation, The Levy Eco­ nomics Institute Working Paper No 397. Arner, D.W. (2007), Financial Stability, Economic Growth, and the Role of Law, Cambridge University Press. Arrow, K.J./ Debreu, G. (1954), Existence of an Equilibrium for a Competitive Economy, Econometrica, Vol. 22, No 3: 265–290. Baldwin, R./ Cave, M./Lodge, M. (2012), Understanding Regulation – Theory, Strategy, and Practice, Second Edition, Oxford University Press. 94 95

So von Mises (1998), Human Action, 736. So von Mises (1979), Socialism, 424.

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Benston, G.J. (1998), Regulating Financial Markets: A Critique and Some Proposals, Hobart Paper No 135, Institute of Economic Affairs. Brummer, Ch. (2011), How International Financial Law Works (and How it Doesn’t), Georgetown Law Journal, Vol. 99: 257–327. Buckley, R.P./Arner, D.W. (2011), From Crisis to Crisis – The Global Financial System and Regulatory Failure, Kluwer Wolters Publishing. Cordato, R.E. (1980), The Austrian Theory of Efficiency and the Role of Government, The Journal of Libertarian Studies, Vol. 4, No 4: 393–403. Eatwell, J./ Taylor, L. (2000), Global Finance at Risk – The Case for International Regulation, The New Press. Eijffinger, S./ Masciandaro, D. (Ed./2011), Handbook of Central Banking, Financial Regulation and Supervision – After the Financial Crisis, Edward Elgar. Fama, E. (1970), Efficient Capital Markets: A Review of Theory and Empirical Work, The Journal of Finance, Vol. 25, No 2 (May): 383–417. Fein, M.L. (2013), The Shadow Banking Charade. Available at SSRN: http://ssrn.com/ abstract=2218812. Giovanoli, M./Devos, D. (Ed./2010), International Monetary and Financial Law, Oxford University Press. Goodhart, Ch.A.E. (2009), The Regulatory Response to the Financial Crisis, Edward Elgar. Gravelle, J.G. (2013), Tax Havens: International Tax Avoidance and Evasion, Con­ gressional Research Service, 7–5700. Gray, J. / Akseli, O. Ed. (2011), Financial Regulation in Crisis? – The Role of Law and the Failure of Northern Rock, Edward Elgar. Gray, J. / Hamilton, J. (2006), Implementing Financial Regulation, John Wiley & Sons. Greenspan, A. (2013), The Map and the Territory – Risk, Human Nature, and the Future of Forecasting, Penguin. Greenwald, B./ Stiglitz, J.E. (1986), Externalities in economies with imperfect information and incomplete markets, Quarterly Journal of Economics, Vol. 101: 229–264. Hammond, J.R. (2012), Ron Paul vs. Paul Krugman – Austrian vs. Keynesian Economics in the Financial Crisis, CreateSpace Independent Publishing Platform. Hansen, L.P. (2013), Challenges in Identifying and Measuring Systemic Risk, BFI Working Paper Serier No 2012–012. Kammel, A.J. (2012), Corporate Governance in the Financial Services Industry – Is there still a Role for Self-Regulation? International In-house Counsel Journal, Vol. 6, No 21 (Autumn): 1709–1718. Kaufman, G.G./ Scott, K.E. (2003), What is Systemic Risk, and Do Bank Regulators Retard or Contribute to It? Independent Review, Vol. 7 (Winter): 371–391. Kenen, P.B./ Swoboda, A.K. (Ed./2000), Reforming the International Monetary and Financial System, IMF.

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Labrosse, J.R./ Olivares-Caminal, R./Singh, D. (Ed./2011), Managing Risk in the Financial System, Edward Elgar. Labrosse, J.R./ Olivares-Caminal, R./Singh, D. (Ed./2014), Financial Crisis Management and Bank Resolution, informa law. Llewellyn, D.T. (1995), Regulation and Retail Investment Services, Economic Affairs, Vol. 15 (Spring): 12–17. Llewellyn, D.T. (1999), The Economic Rationale for Financial Regulation, FSA Occasional Paper Series, No 1. Lowenfeld, A.F. (2008), International Economic Law2, Oxford University Press. Niemeyer, J. (2001), An Economic Analysis of Securities Market Regulation and Supervision: Where to Go after the Lamfalussy Report? SSE/EFI Working Paper Series in Economics and Finance, No 482. Palan, R./Murphy, R./ Chavagneux, Ch. (2009), Tax Havens: How Globalization Really Works, Cornell University Press. Reinhart, C.M./ Rogoff, K.S. (2011), This Time is Different – Eight Centuries of Financial Folly, Princeton University Press. Schinasi, G.J. (2005), Safeguarding Financial Stability – Theory and Practice, Bernan Press. Scott, H.S. (2008), International Finance: Law and Regulation, Second Edition, Sweet & Maxwell. Shiller, R.J. (2003), From Efficient Markets Theory to Behavioral Finance, Journal of Economic Perspectives, Vol. 17, No 1 (Winter): 83–104. Skidelsky, R. (2012), Keynes – The Return of the Master, Penguin. Smith, A. (1776), The Wealth of Nations, available at: www.ifaarchive.com/pdf/smith_-_ an_inquiry_into_the_nature_and_causes_of_the_wealth_of_nations[1].pdf. Tanzi, V. (2011), Government versus Markets – The Changing Economic Role of the State, Cambridge University Press. Von Mises, L. (1979), Socialism – An Economic and Sociological Analysis, Liberty Press. Von Mises, L. (1998), Human Action – The Scholar’s Edition, Ludwig von Mises Institute. Wapshott, N. (2011), Keynes – Hayek, The Clash that Defined Modern Economics, W.W. Norton & Company.

chapter 2

A Law and Economics Framework for Financial Regulation Ten Questions and Answers Aristides N. Hatzis* 1. This book brings together contributions grappling with various features of soft law governance in the emerging global financial architecture from a legal, economic and financial regulatory perspective. What could a “Law & Economics” approach offer to such a discussion? And what is “Law & Economics” anyway? “Law & Economics,” or as often referred to “Economic Analysis of Law,”1 is the result of the interdisciplinary collaboration of two quite different sciences, law, being a normative science and economics, an empirical social science. They also differ in the methods and analytical tools used respectively. To a clueless, formalist lawyer with a naïve understanding of the economy they may seem like an odd couple. They may likewise appear odd to an ivory tower economist with a naïve understanding of the rich institutional framework regulating but also framing and supporting a market setting. However, everyone with minimal practical experience in either field quickly realizes how collaboration between them is pivotal in many respects because its rationale is very obvious: Law regulates society with a set of rules designed to achieve certain goals; these goals are usually linked to society’s welfare in a broad sense. Economics seek to maximize welfare (both individual and social) and can be helpful towards securing efficiency even where a particular legal system, most improbably, does not pursue welfare as its primary goal, since every legal system wishes to be efficient. The problem with legal science is that it aspires to regulate society without possessing the tools to understand society or to assess the effectiveness of the regulation ex ante or ex post (Hatzis 2009). Is it possible to regulate society

* Aristides N. Hatzis is an Associate Professor of Philosophy of Law & Theory of Institutions at University of Athens. I wish to thank Armin Kammel, Yulie Foka-Kavalieraki and Friedl Weiss for valuable comments. The usual caveat applies. 1 For an introduction to Law & Economics themes and literature, see Posner (2014), Cooter and Ulen (2011) and Shavell (2004).

© koninklijke brill nv, leiden, 2015 | doi 10.1163/9789004280328_003

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without being familiar with the way society operates, its nuts and bolts? Apparently not! As Oliver Wendell Holmes (1881: 1) has aptly put it: “The life of the law has not been logic; it has been experience.” However “Law & Economics” is not a second-rate service or sub-discipline with the mission of informing law about the way the market works – offering a touch of experience to legal reasoning. “Law & economics” is a discipline about the way economy and society should be regulated and the tools that are appropriate for such an endeavor. This discipline offers law the analytical tools of microeconomics and game theory that are necessary not only for its acquaintance with the market process but also for the efficient regulation of the markets and of society in general. This efficiency is not necessarily economic. Efficient in this context means satisfactorily achieving the goals set by the democratic process for any particular law or regulatory framework. It offers economics a view of the economy where legal rules and regulations do not operate as constraints on individual choices but provide solutions in case of market failures, offering at the same time a framework which is essential for economic development. It goes without saying that when we are discussing financial regulation we are essentially discussing law and economics. We need a view of the market, a set of legal instruments and a theory of how financial markets should legally be regulated. The Law & Economics of (financial) regulation is thus based on the general “Law & Economics” approach. 2. Isn’t “law and economics” a neo-liberal approach which is hostile to regulation and state intervention? In general, such perception has to be considered as being wrong and it is an indication that one is not familiar with the rich law & economics literature and its basic texts (Coase 1960; Posner 2014; Cooter and Ulen 2011; Shavell 2004). Law & economics is about regulation. It’s about choosing the best institutional framework, the optimum legal tools for intervening in a market, the appropriate legal instruments to correct market failures. It is also about choices to be made between the enactment of necessary legal rules and the unregulated freedom which allows the parties to arrange themselves, their economic relationships, to get involved in transactions and to design their contracts. It’s about predicting ex ante and assessing ex post what is worse, the market or the government failure, choosing the least worst option and trying to minimize the losses. The fundamental text in support of this approach is Ronald Coase’s seminal paper “The Problem of Social Cost.” According to Coase (1960: 16–18, 44): It is clear that an alternative form of economic organization which could achieve the same result at less cost than would be incurred by using the

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market would enable the value of production to be raised. […] An alternative solution is direct government regulation. Instead of instituting a legal system of rights which can be modified by transactions on the market, the government may impose regulations which state what people must or must not do and which have to be obeyed. […] It is clear that the government has powers which might enable it to get some things done at a lower cost than could a private organization (or at any rate one without special governmental powers). But the governmental administrative machine is not itself costless. It can, in fact, on occasion be extremely costly. Furthermore, there is no reason to suppose that […] regulations, made by a fallible administration subject to political pressures and operating without any competitive check, will necessarily always be those which increase the efficiency with which the economic system operates. […] [D]irect governmental regulations will not necessarily give better results than leaving the problem to be solved by the market or the firm. But equally, there is no reason why, on occasion, such government administrative regulation should not lead to an improvement in economic efficiency. This would seem particularly likely when […] a large number of people are involved, and in which therefore the costs of handling the problem through the market or the firm may be high. […] The problem is one of choosing the appropriate social arrangement […] [i]n choosing between social arrangements within the context of which individual decisions are made, we have to bear in mind that a change in the existing system which will lead to an improvement in some decisions may well lead to a worsening of others. Furthermore we have to take into account the costs involved in operating the various social arrangements (whether it be the working of a market or of a government department) as well as the costs involved in moving to a new system. In devising and choosing between social arrangements we should have regard for the total effect. The above paragraph sums up the Law & Economics approach to almost everything – including regulation. It is not dogmatic, nor automatically prolaissez-faire (even though there is empirical evidence that market arrangements are generally more efficient than government regulations or judicial decisions)2 and it is based on the findings of economics. It is not an ideological approach, it is a scientific approach based on economic theory and empirical research. 2 “If the law is to take its cues from economics, should efficiency or intentions govern? Oddly, the latter. The people who make a transaction – thus putting their money where their mouths

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3. What is the value added of such an approach and why does regulatory theory need the insights from law & economics? First of all, most of the seminal works in the 1960s and 1970s on economic regulation came from scholars involved in Law & Economics (see especially the works of George Stigler, Richard Posner, Sam Peltzman, Harold Demsetz et al.)3 and affiliated institutionally or methodologically with the Chicago School of Political Economy (Stigler 1988; Samuels 1993). Most of these scholars (mainly Richard Posner) were also active in the development of the Law & Economics approach (Posner 2014), so the methodological framework is identical: rational choice theory (the empirical Chicago version).4 In this respect regulation theory is part of a general approach to Law & Economics, one could call it, rather offhand, “applied Law & Economics.” Law & Economics offer a methodological framework to regulation theory, a framework that is necessary for a field that is more technical than theoretical. Regulation of the economy or society needs to be based on a theory about human behavior – about individual and corporate actors. It should be based on a theory about markets and human relations. It should also be based on a theory of institutions and institutional design. Law & Economics offers a unified theory for all the above. It offers concepts and analytical tools that are not only necessary but indispensable for any regulation theory (see Posner 2014: Chapter 9–16). 4. What is the essence of such a theory? How can it briefly be described? A market economy creates wealth through market transactions and exchanges based on consent. These exchanges and transactions do not only help the market participants realize their goals; they also increase society’s wealth through surpluses created by the mechanism of efficient resource allocation. This does not mean that state intervention is not necessary. Market

are – ordinarily are more trustworthy judges of their self-interest than a judge […] who has neither a personal stake in nor first-hand acquaintance with the venture on which the parties embarked when they signed the contract. So even if the goal of contract law is to promote efficiency rather than to enforce promises as such […] enforcing the parties’ agreement insofar as it can be ascertained may be a more efficient method of attaining this goal than rejecting the agreement when it appears to be inefficient.” (Posner 2003: 96–97) 3 See especially the works of Stigler and Friedland (1962); Stigler (1971, 1975); Demsetz (1968); Peltzman (1976); Posner (1971, 1974, 1975). See also Stigler (1988); Samuel (1993) and Peltzman (1993). 4  The Chicago version of RCT is more empirical and less axiomatic from the Princeton version. The Chicago version is methodologically influenced by the work of Milton Friedman, George Stigler, Gary Becker and Richard Posner. See Foka-Kavalieraki and Hatzis (2014).

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forces (like reputation) and social norms (like trust) can exert pressure on parties to perform according to their promises. However, for this wealth-creation mechanism to function smoothly, contracts should be encouraged and should also be enforced by the law. A free, competitive market under the shadow of the rule of law, where property rights are protected and contracts are enforced, is the ideal setting for economic development (Acemoglu and Robinson 2012). However, even the most competitive markets face a number of economic and social problems. The major economic problem is the existence of market failures. The major social problem is the inequitable distribution of resources. These problems call for further state intervention. Α night-watchman state’s legal framework does not seem enough for ensuring social welfare. The correction of market failures and some redistribution seems necessary. The problem is that regulation can be unsuitable in several cases. First of all, regulation is not the right way to achieve redistribution. There are other mechanisms of state intervention which can achieve this goal more efficiently (at least more efficiently than regulation) and without distorting markets too much. These mechanisms are taxation and the welfare state. Any attempt to achieve redistribution with regulatory tools is ill-fated. Let’s take the example of closed shops or closed professions. The barriers to entry in this case, redistribute wealth from the consumers and future competitors to embedded interests. This kind of regulation distorts the market and encourages wasteful rent-seeking activities leading to social loss, a negative-sum game decreasing total social welfare.5 On the other hand, when a government regulatory authority attempts to correct a market failure, there is always the danger that the intervention distorts the market instead of normalizing it. In some of these cases (e.g. rent control, crowding out effect) government failure can be far worse than market failure and it should be avoided since regulation is supposed to improve (or normalize) a situation, not aggravate it (see Becker 1958; Stigler 1971; Niskanen 1971). Thus, regulation can only be appropriate for these situations where a market failure can be reasonably corrected with a legal rule which will restore balance in the market with minimal cost (Manne 2012). 5. What are such situations, as discussed above? Can this be understood as an ad hoc quest or is there a more robust approach? The Law & Economics approach to market failures has the advantage of being both theoretical and pragmatic. It is based theoretically on microeconomics 5 Greece is the textbook example of such a catastrophe (Hatzis 2012).

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and at the same time connects theory with legal practice by examining the efficiency of legal rules as these are applied in the real world. One should realize that law is a broader regulatory tool than statutes, executive orders or administrative decisions. A legal framework regulating the market has numerous tools at its disposal and as a result some of them are per se contradictory. Judicial decisions, especially in common law countries (but in civil law countries as well), are sources of law. Legal rules stemming from legal precedent have the same authority as statutory law and should be considered a type of government regulation since they are enforced by the state and they are promulgated by courts, a branch of government. This fact emphasizes the need for a theoretically unified general approach to regulation, an approach that it will also offer a criterion for choosing the appropriate regulatory tools for an intervention in the market. The fact that this is necessary is obvious if one considers the idea of regulatory impact assessment (RIA).6 This kind of ex ante or ex post assessment of government regulation has never been used before or after a major court decision (e.g. on the enforcement of rent-control regulations) despite the fact that its repercussions might be far more severe for a sector in the economy than an executive order. The international experience of government regulation and its assessment shows that the ad hoc treatment (both in theory and in public policy) is highly problematic (Stigler 1988). Against this background, the categorizations of market failures in the light of L&E should be illustrated: For a market exchange to lead to an efficient allocation of resources (thus creating wealth) there are at least two prerequisites. The parties involved should be rational and adequately informed.7 The presumption of rational choice theory is that the agents are rational, in that they always calculate the most effective way to satisfy their preferences, in other words, they are utility maximizers (subject to constraints). The parties generally know better than anyone else where their own interests lie8 and will do whatever is necessary to satisfy their preferences by choosing the best means to their ends. There is the initial assumption, as in the mainstream neoclassical economic theory, that 6  Regulatory Impact Analysis (RIA) is a systematic approach to critically assessing the positive and negative effects of proposed and existing regulations and non-regulatory alternatives. See Radaelli and de Franceso (2010). 7 “The possibility of coordination through voluntary cooperation rests on the elementary yet frequently denied proposition that both parties to an economic transaction benefit from it, provided the transaction is bilaterally voluntary and informed.” (Friedman 1962: 13) 8  Cf. Smith (1776, 456): “[E]very individual, it is evident, can, in his local situation, judge much better than any statesman or lawgiver can do for him” [IV.ii.10].

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the parties can efficiently regulate their transactions and relationships and they can solve all the potential problems stemming from the development of this relationship.9 In a world of perfect competition, market exchanges could always lead to an efficient outcome. In this world of perfect information and competition, opportunism would wane, given the existence of reputational effects (since information is costless)10 and the possibility of private sanctions. In such a world, the only function of law would be the enforcement of contracts – but even this would be redundant since market forces would assure contractual performance (Klein and Leffler 1981) – and any intervention by the state (through any form of regulation) would be inefficient. However, actual markets are merely the “reflection” of the idea of a perfect market with perfect competition and perfect (and thus symmetrical) information. Nevertheless, in an institutionally mature free market economy, where the gap between the theoretical concept of perfect competition and the reality of real markets is not so vast, there is a good chance that many markets are very close to this ideal or to an acceptable version of it. These markets do not need regulation because most of the time the cost of regulating an already fairly regular and competitive market is much higher than the benefit to be derived from regulation (or stemming from regulation). Quite often regulation is the result of rent-seeking which is rational behavior for the rent-seekers but totally unreasonable for a society. Of course there are markets which heavily suffer from these “market imperfections.” In these cases the discrepancy between imperfect and perfect competition is so great as to create serious problems regarding many aspects of economic life. There are five conditions11 that must be met in order for the market to be perfect. If one of these conditions is not met then there might be a problem calling for regulation:12

9 

There is however considerable critique to the rational agent model. See Foka-Kavalieraki and Hatzis (2011) for references to the literature. 10  In a world of perfect information there are no transaction costs for gathering and processing information. 11 See Cooter and Ulen (1996: 186–193 and also 1988: 234–235 for an older, quite different, more detailed and less practical formulation). The following paragraphs draw heavily from Foka-Kavalieraki and Hatzis (2009). 12  This does not mean that there will always be a problem when one of the conditions does not apply in a particular situation. In many cases, the “failure” is not so critical as to justify an intervention by the state and “government failure” can be worse than the market failure. See Buchanan et al. (1980).

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(a) The market should be competitive. There must be enough potential market participants, e.g. many buyers and many sellers (that is, no monopolies, monopsonies or oligopolies). None of the parties should have great market power in the particular market and use it to extract monopoly rents (Carlton and Perloff 1994, 801–807, also 376–379). More accurately, the party that has the market power should not exploit it abusively in its own favor, thus making the bargain extremely one-sided.13 A non-­ competitive market, where power is concentrated in a way that hinders competition, should be regulated in order to foster competition: by removing barriers to entry, breaking the cartels, protecting the consumer, etc. Even when there is a natural monopoly,14 regulation can create competition in some of the services offered and protect the consumers by regulating and monitoring the behavior of the monopoly. (b) The information should be adequate and as symmetrical as it is reasonable in the particular market setting. The parties involved should be informed of the nature and consequences of their choices. This does not mean that there should be no (primary) uncertainty as to future events, but that there should be no severe informational asymmetries or symmetrical informational imperfections (usually the seller has much more information than the buyer), distorting the choice of either party (see e.g. Aghion and Hermalin 1990). A market where asymmetries of information are a typical phenomenon (e.g. the market for medical services, financial services, insurance, etc.) might need to be regulated so as to achieve more symmetry. Increasing the amount of information available to the participants, dealing with problems such as adverse selection, “markets for lemons”15 etc. could also be worthwhile goals for a regulator. (c) There should be no severe externalities. The market transactions must not have negative third party effects (externalities). The cost of the transaction in its entirety must be borne by the parties involved and not by any 13

This is basically a problem of antitrust law and economics, where there are widely contradicting views. See especially Posner (1976) and Viscusi et al (2005). 14  Sometimes it is more efficient for a single firm to supply an entire market because of economies of scale (Pindyck and Rubinfeld 1995: 339). 15 In a market with asymmetries in information the problems of adverse selection and “lemons” lead to the dominance of the low-quality products or services instead of the highquality ones. In the first case the buyer is offering a median price or a salary, getting offers only from the producers and suppliers of bad-quality products and services. In the second case this asymmetry leads to undersupply of good-quality products in a market and a oversupply of low-quality products (lemons). Buyers are aware of the problem so they lower their expectations even more by offering less money and being offered more “lemons.”

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other third party that has nothing to do with the particular exchange.16 A market where there are severe externalities (e.g. pollution) might need to be regulated in order for these externalities to be internalized. (d) The transactions and exchanges should not be the result of coercion. The market actors must only be constrained by the factor of scarcity (in their income, time, energy, technology, etc.) in the materialization of their preferences. Their choices must be free and not subject to any kind of restriction by private parties (e.g. threat) or by the state. Such restrictions would result in a distortion of choice – and consequently in the distortion of the price mechanism. Any constraint on choice would destroy the value of prices as a signal to a competitive market17 and its only effect would be redistribution of wealth from one party to another without the creation of value. A market, where there are signs of coercion in any form (e.g. black markets), might need to be regulated in order to ensure genuine consent18 and an efficient reallocation of resources. (e) The transaction costs should be minimal. The cost of engaging in any transaction should be far less for the parties involved than the surplus created by their transaction. Problems arise from an absence of or an inefficiently low amount of search, bargaining or enforcement of an agreement because of high transaction costs. A market with high transaction costs might need to be regulated in order for these costs to be diminished. Regulation can lessen the search, bargaining and enforcement (including monitoring) costs of the transactions by removing transactioncost-generating obstacles or by strengthening norms that can function as transaction cost-saving devices (e.g. trust). In this very brief description of the five major failures of the market process we should add collective action (especially situations regarding the so-called Prisoner’s Dilemma) and agency problems: (f) A myopic, narrowly rational, selfish behavior can lead to broader societal losses. In the long run cooperation is beneficial for everyone when there 16  See generally Papandreou (1994). 17  See generally the seminal article on this problem by Hayek (1945). See also the interwar Mises and Hayek vs. Lange controversy. See Mises (1920 and 1922), Hayek (1935) and Lavoie (1985). 18 In a previous paper we offer a criterion for the distinction of coercion from a hard choice where there is genuine consent. It is a choice one prefers to have rather than not (see Foka-Kavalieraki and Hatzis 2009).

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is no incentive to act cooperatively in the short run (dominant strategy), especially when free-riding is a widespread practice that remains undetected and unsanctioned. (g) The most important agency problem is “regulatory capture” (Stigler 1971) when special interest groups “capture” the regulatory authority who is supposed to supervise them. The captured regulator serves the interests of industry instead of the public interest. 6. To what extent is this framework useful for financial regulation? The financial system is part of the market. It’s a part that is crucial to the efficient allocation of resources. A well-functioning financial system is imperative for saving, investment, wealth maximization and risk allocation. In modern advanced capitalist economies market exchange is based on an institutionally mature and free financial system.19 However, all these above mentioned types of market failure are also present in the financial system. The most important structural problem in such a system is the allocation of risk. Most dealings are essentially tradeoffs involving decisions about how to allocate risk. Considering that most consumers of financial services are risk-averse and relatively uninformed (there are great asymmetries of information in the financial market if we compare individual and institutional investors) the financial system should be regulated to protect the average consumer from opportunism, oligopolies and transaction costs (especially monitoring costs). At the same time a legal framework regulating financial services should be constructed to protect the financial system as a whole by ensuring the necessary stability and security of transactions that is imperative for any economic system to function efficiently. The above framework can be fruitfully used to answer the most fundamental question about financial regulation: is regulation necessary? To put it differently, is regulation likely to improve the financial system or the particular financial sector or is it more likely to create more distortions and/or to be unreasonably costly with uncertain benefits? (Claessens and Kodres 2014) This is a question that has rarely been treated with the necessary value-free attitude. Many scholars are prejudiced in that they are inclined towards a model of self-regulating market or preoccupied with the view that regulation can by definition improve market outcomes. A Law & Economics approach avoids 19

See especially Chortareas et al. (2012; 2013) (2013: the higher the degree of an economy’s financial freedom, the higher the benefits for banks in terms of cost advantages and overall efficiency; the effects of financial freedom on bank efficiency tend to be more pronounced in countries with freer political systems in which governments formulate and implement sound policies and higher quality governance).

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this manichaean schism by emphasizing that this is a question to be answered primarily by science (economic theory and empirical research), not politics or ideology. A second question, related to the first, is how can we overcome financial market failures in particular situations: by direct state intervention in the form of regulation or by inducing market-solutions? E.g. should credit risk assessment be left to private agencies or should it be undertaken by a government agency, a national independent authority, an international organization? A third question to be answered reflects again a tradeoff. It’s the tradeoff between wealth maximization and risk allocation. As Steven Shavell has indicated in a seminal paper (Shavell 1980) no legal rule can serve both. A heavily regulated market might boost financial stability and ensure consumer protection but at the cost of diminished flexibility and efficiency. A less regulated market might offer great opportunities for profit and innovation but with a cost to stability and confidence. Regulators should answer the above questions before taking decisions on the necessity, the type and the priorities of a particular regulation. The danger that is lurking here is the impulse for a knee-jerk reaction, for ad hoc rules not based on a theoretical framework, for a political treatment of an economic problem. A final note on the type of regulation: since asymmetries in information are colossal in financial markets, especially between financial institutions and consumers of financial services, there is also a major problem related to the transaction costs (in the broader sense) of gathering information, bargaining for financial products, monitoring the activities and getting effective legal protection against illegal, unfair or opportunistic behavior. A set of legal rules offered to the consumers asking for redress is not enough in this case for obvious reasons (esp. when access to justice is costly or the administrative costs prohibitively high). The only way to ensure efficiency and trust is a close supervision of the stock exchanges, the banking system (commercial and investment banking) and the publicly traded companies. This is the only way to ensure adequate information, minimization of transaction costs and market confidence (Kammel 2005). However we should emphasize here how difficult it is not only to avoid regulatory capture but also to establish institutions that serve the general social welfare and not the vested interests of the financial services industry (Raghuram and Zingales 2003). 7. Does this mean that every investor should be protected equally? Equal protection is not the way forward because the amount of protections is related to the tradeoff we alluded above. Bank depositors, pensioners and insurance beneficiaries should be protected more heavily than mutual fund investors. The two groups allocated the risk differently ex ante and most

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probably they also perceive risk differently. Safety is very important to the former, profit is more important to the latter. They should both be protected from opportunistic behavior (compliance regulation) but the former should also be protected from the volatility of the markets that can lead a financial institution to insolvency.20 Capital and solvency regulations and deposit insurance serve this purpose. However the cost of greater protection is moral hazard21 and a growing need for more protection by consumers who do not have the incentive to monitor financial institutions and to become more sophisticated. Apparently herein lies another major tradeoff: a paternalistic legal protection creates the need for even more protection in the future and leads to overinvestment. People are not afraid to take risks because they know that there is a government safety net protecting them and compensating bad investments and imprudent impulsive behavior. However, “under-protection” can also lead to underinvestment, undermining market confidence and financial stability. Even the most efficient market should function under the shadow of the law. Otherwise individual investors will be overdeterred by the fear that they can fall prey to opportunistic institutional investors without access to legal recourse. 8. Are there any economic justifications for such soft paternalism, especially in financial markets? Such application of soft paternalism has indeed economic justifications because there are a number of theories developed in both economics and psychology advocating a more paternalistic protection of the economic agents, particularly consumers. This body of work is called behavioral economics. Under that rubric one can find considerable contributions on behavioral Law & Economics and on behavioral finance. Behavioral economists have argued that humans are not always rational regarding their ability to make correct decisions and judgments (Simon 1987; Kahneman and al. 1979; 1982; 1986; 1991; 2000; Thaler 1999; Ariely 2008; 2010). According to this literature, people tend to make various mistakes while processing the available information or while estimating the short or long-term outcomes of their choices. Certain intuitive processes, which are called “heuristics,” generate errors in judgment so that individuals tend to succumb to certain cognitive biases, such as over-confidence or risk- and loss-aversion.

20  However one could argue that this should not apply to insurance industry. 21  Moral hazard occurs when the insured party doesn’t have enough motives to act in order to avoid the event that triggers payment (Pindyck and Rubinfeld 1995: 604–607).

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They also seem to make systematic mistakes when assigning probabilities to outcomes. Behavioral economics have relatively recently expanded into the finance market. Behavioral finance examines the cases where individuals under or over-estimate certain outcomes that eventually affect prices and market trends that can lead to bubbles and crises (Sewell 2010). In particular, planning for future retirement is a case that interests behavioral finance. People wish to secure a comfortable future, at a time when they will be much older and no longer working but, to achieve this, they should carefully plan and maintain a long-term savings and investment program in the present. This, of course, requires a lot of successful and especially difficult forecasting on behalf of the stakeholders. They need to predict a number of long-term rates and costs concerning taxes, inflation, income, health, longevity, etc. Additionally, they must be determined to maintain and continually sustain any plan they choose to follow. According to many behavioral economists, individuals very often fail to fulfill some or all of these expectations and save enough for retirement. A number of cognitive and behavioral constraints have been identified which are believed to make people bounded rationally and self-controlled. For instance, cognitive biases, like over-confidence, will drive them to underestimate certain risk factors. Young persons tend to think that their retirement age will be higher than it actually ends up being or people in general assume that bad luck or any accidents have a much lower probability of reaching them than they have in reality. They will also tend to “follow the herd” by opting to do what they hear others do, without any checking of their own.22 Or they will make their choices anchored by irrelevant information and sometimes influenced by the way a choice is presented to them rather than by the content of it. Also, people are apt to procrastinate a lot and often show a weakness of will when it concerns demanding and long-term plans of action, as in quitting smoking, losing weight, buying an insurance policy or build a retirement strategy. This means that they may not stick to the original plan, fall back on installments or crucially delay starting off with any retirement plan. Furthermore, when people reach retirement, they might not be able to appropriately manage their savings and end up spending everything too soon. Behavioral economists study all 22  Herding behaviour is the tendency to follow instinctively the majority. In finance, herd behaviour leads to similar investments by individuals who are afraid that any other choice is more risky. This behaviour is not always irrational. Some times collective decisions or majority decisions incorporate an amount of information unavailable to individual decision-makers (the wisdom of the crowds). See a classic treatment by Hayek (1945).

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these problems and propose various solutions, e.g. the “Save More Tomorrow” program (see Thaler and Bernatzi 2004 for further details). Thaler and Sunstein (2008) famously developed the notion of “libertarian paternalism” in their attempt to justify policy suggestions that aim to promote healthier, more qualitative and longer lives for individuals. Their theory rests on the practice of “nudging” people to make the best choice by framing it appropriately, while guaranteeing that they could opt-out of it effortlessly if they have a different preference or change of mind. This is supposed to be a kind of “soft” paternalism where freedom of choice is not violated since no available option is excluded and no actual coercion is taking place. Of course this theory has been criticized by both hard-liners in the behavioral economics camp but also by libertarians arguing that libertarian paternalism is an oxymoron. 9. What can soft law offer under such a framework? One of the major contributions of the economic analysis of institutions is the highlighting of the importance of informal rules as the necessary infrastructure for any formal institutional framework (Posner 2000). In addition, efficient social norms (as cost-saving devices) are considered pivotal for economic development (Platteau 2000). Soft law is a body of rules, standards and regulations that lies in between formal and informal legal rules (Brummer 2011; Grnchalla-Wesierski 1984). It is formal in the sense that it has been developed mostly by formal institutions and professional networks and it did not emerge spontaneously. It is informal in the sense that it is not legally binding, it develops to foster cooperation and encourage self-regulation and it is based on broader consensus – non legal fiat. In the case of international financial markets soft-law has some obvious advantages (Brummer 2011). The most important of them is international law’s authority deficit. When it is difficult to force compliance with the legal rules, then, self-regulation, codes of ethics and soft law are quite useful replacements for formal legal rules. A second advantage of soft-law is that it is more flexible, more open to legal innovation and more sensitive to the needs of particular markets but also of a continuously transforming global financial market. These advantages make cooperation easier and harmonization more feasible. The recent experience in financial markets and the dominance of soft law23 is

23  According to Brummer (2011), international financial law is often bolstered by a range of reputational, market, and institutional mechanisms that make it more coercive than classical theories of international law predict.

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evidence of its usefulness as a coordination mechanism despite the nonbinding character of most of its rules. However, soft law has its disadvantages too: there is an obvious lack of legitimization since its sources are often controversial. Public interest is not always the main concern when soft law rules are created but mostly the interests of a particular industry. Moreover, it is a polycentric kind of law, fragmented and sometimes self-contradictory as a body of rules. It is not a coincidence that it failed during the global financial crisis of 2008. 10. According to many pundits, the financial crisis of 2008 discredited ­economics as a science. Did the financial crisis undermine any economic approach to these problems – including the Law & Economics approach to (financial) regulation? This is a gross oversimplification usually made by people who are unfamiliar with economics but also by economists who are unfairly critical of the mainstream neoclassical school. The financial crisis was the result of a number of factors we examined here (such as informational asymmetries, regulatory capture, collective action problems or rent-seeking) and of political action and inaction. Everybody agrees that in order for a new financial crisis to be averted governments and international bodies should regulate the financial markets more efficiently (Claessens and Kodres 2014). The only way to do this is by using economic theory. Even the fiercest critics of economics do not offer any alternative and/or they are still using the same analytical tools which they consider discredited. This does not mean that economic theory was not wounded by the crisis. Economists, as always, are trying to learn from their mistakes and failures by incorporating insights from institutional theory, psychology, neuroscience and other social sciences. The same goes for Law & Economics. This approach is now more sophisticated, interdisciplinary, cautious and value-free than ever. Law & Economics has an additional advantage: it is not only one of the most successful applications of economics to the real world. It offers a new perspective to economics and regulation. A perspective informed by institutional theory and an approach where institutions are not constraints, i.e. kind of obstacles, but tools for correcting market failures and an essential framework for economic development and wealth maximization. However these tools should not be used as tools for social engineering – a futile attempt, historically failed. They should be used to regulate, i.e. normalize the market, the only mechanism that can create wealth by efficiently allocating scarce resources.

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Mises, Ludwig von. 1922. Socialism: An Economic and Sociological Analysis. Auburn, AL: Ludwig von Mises Institute. Reprint. 1981. Niskanen, William. 1971. Bureaucracy and Representative Government. Chicago-New York: Aldine-Atherton. Papandreou, Andreas A. 1994. Externality and Institutions. Oxford: Oxford University Press. Peltzman, Sam. 1976. “Towards a More General Theory of Regulation.” Journal of Law and Economics 19: 211–240. Peltzman, Sam. 1993. “George Stigler’s Contribution to the Economics of Regulation.” Journal of Political Economy 101: 818–832. Pindyck, Robert S. and Daniel L. Rubinfeld. 1995. Microeconomics, 3rd ed. Englewood Cliffs, NJ: Prentice-Hall. Platteau, Jean-Philippe. 2000. Institutions, Social Norms, and Economic Development. London: Routledge. Posner, Eric A. 2000. Law and Social Norms. Cambridge, MA: Harvard University Press. Posner, Richard A. 1971. “Taxation by Regulation.” Bell Journal of Economics and Management Science 2: 22–50. Posner, Richard A. 1974. “Theories of Economic Regulation.” Bell Journal of Economics and Management Science 5: 335–358. Posner, Richard A. 1975. “The Social Cost of Monopoly and Regulation.” Journal of Political Economy 83: 807–827. Posner, Richard A. 1976. Antitrust Law: An Economic Perspective. Chicago: University of Chicago Press. Posner, Richard A. 2003. Economic Analysis of Law. New York: Aspen. 6th ed. Posner, Richard A. 2014. Economic Analysis of Law. New York: Aspen. 9th ed. Radaelli, Claudio M. and Fabrizio de Francesco. 2010. “Regulatory Impact Assessment.” In The Oxford Handbook of Regulation. Robert Baldwin, Martin Cave, and Martin Lodge, eds. Oxford: Oxford University Press. Pp. 279–301. Rajan, Raghuram G. and Luigi Zingales. 2003. Saving Capitalism from the Capitalists: Unleashing the Power of Financial Markets to Create Wealth and Spread Opportunity. New York: Crown Business. Samuels, Warren J. 1993. The Chicago School of Political Economy. New Brunswick, NJ: Transaction Publishers, 2nd. ed. Shavell, Steven. 1980. “Damage Measures for Breach of Contract.” Bell Journal of Economics 11: 466–490. Shavell, Steven. 2003. Foundations of Economic Analysis of Law. Cambridge, MA: Harvard University Press. Simon, Herbert A. 1987. “Bounded Rationality.” In Utility and Probability. John Eatwell, Murray Milgate and Peter Newman, eds. New York: Norton, 1990. Pp. 15–18.

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Smith, Adam. 1776. An Inquiry into the Nature and Causes of the Wealth of Nations, R.H. Campbell, A.S. Skinner and W.B. Todd., eds. Oxford: Oxford University Press, 1979. Stigler, George J. 1971. “The Theory of Economic Regulation.” Bell Journal of Economics and Management Science 2: 3–21. Stigler, George J. 1975. The Citizen and the State: Essays on Regulation. Chicago: University of Chicago Press. Stigler, George J. and Claire Friedland. 1962. “What Can Regulators Regulate? The Case of Electricity.” Journal of Law and Economics 5: 1–16. Stigler. 1988. Chicago Studies in Political Economy. Chicago: University of Chicago Press. Thaler, Richard H. 1999. “Mental Accounting Matters.” Journal of Behavioral Decision Making 12: 183–206. Thaler, Richard H. and Shlomo Benartzi. 2004. “Same More Tomorrow: Using Behavioral Economics to Increase Employee Saving.” Journal of Political Economy 112: s164–s187. Thaler, Richard H. and Cass R. Sunstein. 2009. Nudge: Improving Decisions About Health, Wealth and Happiness. London: Penguin, 2nd ed. Viscusi, W. Kip, Joseph E. HarringtonJr., and John M. Vernon. 2005. Economics of Regulation and Antitrust. Cambridge, MA: MIT Press. 4th ed.

chapter 3

The Device of Soft Law: Some Theoretical Underpinnings Friedl Weiss* I Introduction Where there is money, there is regulation, of its creation, value, markets. And financial regulatory governance is global governance, in fact governance by soft law, to a considerable extent,1 or even governance without government.2 As there is ample and much debated soft law “practice” – state as well as non-state – in dealing with the consequences of the financial and economic crises triggered by the bankruptcy of Lehman Brothers, it is appropriate to revisit some broader theoretical legal underpinnings of this ongoing debate, alongside Chris Brummer’s theoretical reflections focused on international financial law in the preceding chapter. 1 Contextual Setting In the field of legal science, “multiculturalism” for want of a better term, is a relatively recent, generally accepted but still controversially discussed phenomenon. Another, undoubtedly related to it, is that of the much lamented “fragmentation” of international law, itself the result of normative differentiation in specialized areas of international law. The former, “multiculturalism,” though a somewhat fuzzy concept, embraces both diversified yet co-existing and overlapping levels of governance and a variety of rule-making actors.3

* Friedl Weiss is Professor at the Department of European, International Law and Comparative Law, University of Vienna. 1 Friedl Weiss, Finanzkrise und internationales öffentliches Recht, in Fassbender et al (Hrsg.), Paradigmen im internationalen Recht. Implikationen der Weltfinanzkrise für das internationale Recht, C.F. Müller, 2012, pp. 335–367. 2  Larry Cata Backer, Governance without Government: An Overview, in G. Handl, J. Zekoll, P. Zumbansen (eds.), Beyond Territoriality. Transnational Legal Authority in an Age of Globalization, Martinus Nijhoff, 2012, 87–123; see also P. Zumbansen, The Regulatory Landscape of Global Governance and Transnational Legal Authority, ibid., pp. 551–558. 3 On a proposed framework on transnational legal pluralism and for additional literature, see P. Zumbansen, Defining the space of transnational law, ibid., pp. 53–86. © koninklijke brill nv, leiden, 2015 | doi 10.1163/9789004280328_004

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The latter, “fragmentation,” the latest buzz-word featuring in official reports4 as well as in legal literature and academic discourse, has attained legal significance, especially when accompanied by the emergence of specialized and (relatively) autonomous rules or rule-complexes, legal institutions and spheres of legal practice. Thus, “general international law” comprising treaties and customary law, has become interspersed with such notoriously specialized areas as “trade law,” “human rights law,”5 “environmental law,” “law of the sea,” “international space law,” “European law”6 and even such exotic and highly specialized knowledge as “investment law”7 etc. – each possessing their own principles and institutions, and indeed soft law (soft rights and obligations).8 2 Emergence of Soft Law Before examining the term, concept and functions of soft law a brief summary sketch of its emergence and historical evolution might be in order. For some time we have come to realize that sovereign states no longer enjoy a monopoly of law-making as well as law enforcement and that they share and/ or pool such authority with other actors.9 In domestic law, with a variety of 4 International Law Commission (ILC), Report of the Study Group of the ILC: ‘Fragmentation of International Law: Difficulties arising from the diversification and expansion of international law’, finalized by Martti Koskenniemi, A/CN.4/L.682, 13 April 2006; 61 UN GAOR Supp.No.10, 400, UN Doc.A/61/10 (2006); Martti Koskenniemi & Paivi Leino, Fragmentation of International Law? Postmodern Anxieties, 15 Leiden Journal of International Law (2002), p. 553. 5  D. Shelton, Compliance with International Human Rights Soft Law, in E.B. Weiss, International Compliance with Non-Binding Accords, ASIL, 1998, p. 119, at 120. 6 Report of the European Parliament’s Committee on Legal Affairs on institutional and legal implications of the use of “soft law” instruments of 28 June 2007: … “soft law,” inter alia: recommendations, green and white books or Council conclusions, ….have no legal value or binding force, but can be used as interpretative or preparatory tools for binding legislative acts (2007/2028(INI)). 7  Andrea K. Bjorklund, August Reinisch, International Investment Law and Soft Law, Edward Elgar, 2012. 8 See e.g. Jürgen Schwarze, Soft Law im Recht der Europäischen Union, EuR 2011, issue 1, p. 3ff; Wolfgang Benedek, Die Rechtsordnung des GATT aus völkerrechtlicher Sicht, Springer, 1990, pp. 123–125, 153ff; Irmgard Marboe (ed.), Soft Law in Outer Space. The Function of Non-binding Norms in International law, Böhlau, 2012; Gerhard Hafner, The Effect of Soft Law on International Economic Relations, in S. Griller (ed.), International Economic Governance and Non-Economic Concerns: New Challenges for the International Legal Order 149–167 (2003); J. Gold, Strengthening the soft international law of exchange arrangements, in Id., Legal and Institutional Aspects of the International Monetary System: Selected Essays, vol.2 (1984), 515ff. 9 Oscar Schachter, The erosion of state authority and ist implications for equitable development, in Friedl Weiss, Erik Denters, Paul de Waart (eds.), International Economic Law with a Human Face, Kluwer Law International, 1998, pp. 31–44.

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self-regulating autonomous or semi-autonomous entities, stakeholders and formations of civil society; in international law, with international governmental (IGOs) and non-governmental organizations (NGOs) and other transnational actors.10 Contemporary state practice and hence international relations are characterized by systems of overlapping governance authority and multiple loyalty, held together by a duality of competing universalist11 claims, that of global markets and global civil society-states.12 In the matrix of municipal legal systems – occasionally also in systems of multilevel governance such as that of the EU – the public goods13 of money, regulatory integration and stability of financial markets are more or less attuned to one another. But public international law, still largely deemed a consensual system of state practice relying on the agreed sources of law listed in four sub-paragraphs of Article 38(1) of the post-war Statute of the International Court of Justice (ICJ), lags behind the practice of states and of international organs. In view of numerous examples of authoritative acts emanating from them which do not

10  See generally on legal status of NGOs, W. Hummer, Internationale nichtstaatliche Organisationen im Zeitalter der Globalisierung, in K. Dicke, W. Hummer et al, Völkerrecht und Internationales Privatrecht in einem sich globalisierenden internationalen System, C.F. Müller Verlag, Heidelberg, 2000, p. 45ff. 11 According to some cosmologists, the term “multiverse” – a universe filled with many ­universes – might one day have to be substituted for the current “universe,” see Andrei Linde, Inflationary Cosmology after Planck 2013, arXiv:1402.0526v2 [hep-th] 9 Mar 2014. 12  See Jörg Friedrich, The Meaning of New Medievalism, vol.74/4 European Journal of International Relations (2001), 475–502. 13 A public good is a term used by economists to refer to a product (i.e., a good or service) of which anyone can consume as much as desired without reducing the amount available for others. E.g. for the UNDP a clean environment, peace, security, justice and stable financial markets; see Scott Barrett, Why Cooperate? The Incentive to Supply Global Public Goods, OUP, 2007; Inge Kaul et al (eds.), Providing Global Public Goods, OUP 2003; critical David Long, Frances Woolley, Global Public Goods. Critique of a UN Discourse, 15 Global Governance (2009), 107–122; Peter Behrens, Economic Law Between Harmonization and Competition: The Law and Economics Approach, in Karl M. Meessen (ed.), Economic Law as an Economic Good. Its Rule Function and its Tool Function in the Competition of Systems, Sellier, 2009, 45, 49–50; see also e.g Keith Maskus and Jerome H. Reichman, International Public Goods and Transfer of Technology under A Globalized Intellectual Property Regime, CUP, 2005; Ernst-Ulrich Petersmann, Why does International Economic Law fail to protect “Global Public Goods?” in Aldo Ligustro e Giorgio Sacerdoti (eds.), Problemi e Tendenze del Diritto Internazionale dell’Economia,Liber Amicorum in onore di Paolo Picone, Editoriale Scientifica, Napoli, MMXI, pp. 112–125.

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feature in that list, Article 38 can no longer be considered a closed system of law-making.14 Similarly, EU decision-making is not limited to the types of acts expressly listed in Article 288 TFEU. Other acts not mentioned in that catalogue but in other sections of the Treaty are also available to EU decision-­ makers, generally referred to as atypical or non-standard acts.15 Historically, soft law has been linked with the ultimately abortive New International Economic Order (NIEO)16 adumbrated in the 1970s,17 but has since then gained much broader currency in state practice, both within and outside international organizations. In fact, soft law has come to embrace a heterogeneous array of many types of non-binding instruments as yet embodying normative commitments with some kind of legal effect, unless this is expressly excluded.18 Besides resolutions of international organizations, these include statements made in legally non-binding political instruments such as declarations,19 resolutions of international conferences, programs of action, as well as guidelines, codes of conduct (e.g. on transnational corporations, TNCs), conclusions of the presidency of the EU etc. While debates continue as to whether these have as yet the 14

Friedl Weiss, op. cit., fn 1 supra, pp. 336, 345–346; Karl Zemanek, Is the term “soft law” convenient? in G. Hafner, G. Loibl, A. Rest, L. Sucharipa-Behrmann and K. Zemanek (eds.), Liber Amicorum Seidl-Hohenveldern –in honour of his 80th birthday, Kluwer Law International, 1998, pp. 843–862, at 844. 15  Henning Grosse Ruse-Khan, Thomas Jaeger and Robert Kordic, The role of atypical acts in EU external trade and intellectual property policy, 21 EJIL (2011) nr.4, pp. 901–939. 16 The term was derived from the Declaration for the Establishment of a New International Economic Order, adopted by the United Nations General Assembly (1 May 1974, A/RES/ S-6/3201); it referred to a wide range of trade, financial, commodity, and debt-related issues, resulting from discussions between industrial and developing countries, focusing on restructuring of the world’s economy to permit greater participation by and benefits to developing countries (also known as the “North–south Dialogue”) and accompanied by the Declaration, a Programme of Action and a Charter of Economic Rights and Duties of States (12 December 1974, A/RES/29/3281). 17 See from abundant literature, S. Bhuiyan, P. Sand and N. Schrijver (eds.), International Law and Developing Countries, Essays in Honour of Kamal Hossain, Brill, 2014, particularly Chapters 2 and 3; Jagdish Bhagwati (ed.), The NIEO: The North–south debate, MIT Press; Robert Cox, Ideologies and the NIEO: Reflections on some recent literature, 33 International Organization (1979), nr.2, pp. 257–302. 18  For example, recommendations by EU institutions, “shall have no binding force,” Art.288 TFEU; see generally L. Senden, Soft Law in European Community Law, Hart, 2004. 19 Declarations contained in the minutes of the EU Council of ministers may be used by the ECJ as an aid in the interpretation of a legal provision, cf.e.g. Case 136/78, Ministère public v Vincent Auer.

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status of law in certain circumstances (e.g. the 1948 Universal Declaration of Human Rights) or could at least lead to law, there is no denying that such instruments have come to play a significant part in dealing with the aftermath of the global financial and economic crisis. In fact the crisis has shown that sovereign states have abandoned their traditional central command and control function and have replaced it by a system of “regulatory capitalism”20 consisting of decentralized hybrid forms of public and private regulation with transnational dimensions, with the participation of NGOs, interest groups, transnational networks, “think-tanks” committed to good scientific practice and the like.21 II

Soft Law

1 Concept At first sight, the concept of international “soft law,” invented in the 1960s22 and since then used in the practice of International organizations, particularly the United Nations,23 is neither fish nor fowl, so to speak, a kind of oxymoron, if it exists at all as a distinct source of law.24 Concept and phenomenon of soft law have also made their appearance in municipal legal systems where “state practice” of course originates.25 As one writer on EU law put it, there is general agreement that the term “soft law” denotes “rules of conduct which, in principle, have no legally binding 20  Tony Porter, Why International Institutions Matter in the Global Credit Crisis, 15 Global Governance (January-March 2009), No.1, 3. 21  Friedl Weiss, op. cit., fn. 1 supra, 347. 22 Creation of the concept has often been attributed to McNair’s The Law of Treaties (1961), though disputed by others, e.g. J. d’Aspremont, Softness in International Law: A SelfServing Quest for New Legal Materials, 19 EJIL, Nr.5, 2008, p. 1075, at 1081. 23  See I. Seidl-Hohenveldern, International Economic “Soft Law,” RdC 163 (1979 II), 165ff; id., International Economic Law, Kluwer Law International, 1999, 3rd. ed., pp. 35–41. 24 W. Graf Vitzthum, in id. (ed.), Völkerrecht, 4 ed., 2007, Nrs., 14ff, 68, 148ff; Anthony Aust, Modern Treaty Law and Practice, CUP, 2000, p. 44; Gerhard Hafner, The effect of soft law on international economic relations in S. Griller (ed.), International Economic Governance and Non-Economic Concerns: New Challenges for the International Legal Order 149–167 (2003); P. Weil, Towards Relative Normativity in International Law, 77 AJIL (1983), p. 416; J. Klabbers, The undesirability of soft law, 67 Nordic Journal of International Law (1998), nr.4, pp. 381–391. 25 Clemens Jabloner, Wolf Okresek, Theoretische und praktische Anmerkungen zu Phänomenen des “soft law,” 34 Österr. Zeitschrift für Öffentl. Recht und Völkerrecht (1983), pp. 217–241.

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force but which, nevertheless, may have practical effects.”26 Another referred to “soft law as ‘rules of conduct’ which are ‘located’ between “law” and “politics”…used by state authorities and international organizations to express commitments which are more than policy statements but less than law in its strict sense.”27 In fact, perspicaciously observed, as soft law consists of “norms in the twilight between law and politics” it occupies a place between “hard law” and “no law.”28 Adherents of Kelsen’s pure theory of law school of legal thinking, however, will only concede that soft law, though merely consisting of legally relevant facts, may entail legal consequences if so determined by a proper legal norm.29 As for the reception of soft law and related discourses amongst contemporary legal scholars, suffice it to note that a broad picture of many diverse positions, of “enthusiasts” and “radical critics,” has emerged representative of the diversity inherent in the international legal community itself.30 While some welcome soft law instruments as appropriate means to produce more effective global governance promoting economic openness, environmental enhancement and social cohesion,31 others do not use the term at all.32 Soft law critics on the other hand raise doubt as to their real efficacy and/or draw attention to their ideological implications, including the disappearance of the public/private law distinction and the threat of the privatization of legal regimes that soft law instruments entail.33 Other critics go even further and darkly warn that soft law is “yet another pattern of reception of American categories poorly fitting the fabric of European law.”34 Be that as it may, international law 26  Francis Snyder, Soft Law and Institutional Practice in the European Community in S. Martin (ed.), The construction of Europe: Essays in Honour of Emile Noel, 1994, p. 197, 198. 27 Daniel Thürer, The Role of Soft Law in the Actual Process of European Integration, in O. Jacot-Guillarmod (ed.), L’avenir du libre-échange en Europe: vers un Espace économique européen, 1990, p. 131 ff; see also G. Borchardt/C. Wellens, Soft Law in European Community Law, ELRev.1989, p. 267, 285; L. Senden, op. cit. fn. 18 supra, p. 112. 28  Daniel Thürer, Soft Law in R. Wolfrum (ed.), The Max Planck Encyclopedia of Public International Law, 2008. 29  Jabloner, Okresek, op. cit. fn. 25 supra, p. 221. 30  Anna Di Robilant, Genealogies of soft law, 54 American Journal of Comparative Law (2006), 499–554. 31 John J. Kirton and Michael J. Trebilcock (eds.), Hard choices, soft law: Voluntary standards in global trade, environment and social governance, Ashgate, 2004, 7. 32  See e.g., Andreas F. Lowenfeld, International Economic Law, OUP, 2008; Peter-Tobias Stoll, Frank Schorkopf, WTO – World Economic Order, World Trade Law, Martinus Nijhoff, 2006. 33  See e.g. J. Klabbers, op. cit. fn. 24 supra. 34  Di Robilant, op. cit., fn. 25 supra, 509.

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scholars have in particular articulated two major concerns, both referring to a functional “means to ends relation.”35 The first already mentioned theoretical concern raises the question whether soft law is law at all, rather than non-law. It is the kind of question that is persistently hurled at international law, a “jurisprudential insult that arises when influential persons continue to raise the question as to whether international law is really law at all, or in its more moderate form, is a species of primitive law that deserves only qualified respect,”36 or as “soft law.”37 The metaphor of a “spectrum of authority” appears to constitute an adequate answer to this kind of qualms. The second more practical concern of scholars relates to the effectiveness of soft law. Again as discussed below, to counter this argument, soft law is habitually complied with without reliance on enforcement through institutions and legal processes of legally ordained instruments. Instead, a variety of typically soft law “enforcement” mechanisms are available, including social or peer pressure, persuasion, selfinterest and imitation. From an alternative anthropological perspective, however, both currents of thought fail to appreciate that, “in spite of its apparently technical and/or ideological dimension, soft law – despite its international, transnational, or global range – is always the product of concrete social and historical arrangements taking place by means of individual, collective, and institutional practices in specific localities and temporalities.”38 2 Distinction from Hard Law National laws, made by a single legislature and source of administrative law, are generally classified into “black letter” – type law, including constitutions, statutes and regulations which are arranged in hierarchical order and into less clearly articulated norms of common or judge-made law and even customary law. International law, made by a multitude of norm makers, differs in that it is evidently based, as mentioned above, on many different types of instruments, 35

Annelise Riles, A new agenda for the cultural study of law: Taking on the technicalities, 53 Buffalo Law Review (2005), 973–1033. 36  Richard A. Falk, Re-framing the legal agenda of world order in the course of a turbulent century, in Michael Likosky (ed.), Transnational legal processes. Globalisation and power disparities, Butterworths, 2002. 355. 37 Jeremy Rabkin, Law Without Nations? Why Constitutional Government Requires Sovereign States, Princeton University Press, 2005, cited by Matthew Parish, Mirages of International Justice. The elusive Pursuit of a Transnational Legal Order, Edward Elgar, 2011, p. 13. 38  Filippo M. Zerilli, The rule of soft law: An introduction, 56 Focaal – Journal of Global and Historical Anthropology (2010), 3–18, 12.

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treaties, nonbinding agreements, declarations and decisions of international organs. Evidently, international law lacks the rather more clear-cut relations of processes and products established in domestic law. Instead, all sorts of processes can lead, directly or indirectly as by-products, to various types of hard and soft law, written and unwritten law.39 International law, then, comes in different flavors: as hard law, binding by definition at least on some international actors (states, IGOs); soft law, not binding yet habitually complied with by international entities, hence also referred to as law;40 and “non-law” not having the force of law – model laws41 and guidelines42 – compliance with which is deemed convenient or desirable but not due to a sense of obligation owed other international entities. As far as bi-or multilateral instruments are concerned the distinction between hard and soft law instruments is relatively straight forward. Only hard law in form of a treaty to be effective must be based on consent formally expressed by means stipulated in Article 11 of the Vienna Convention on the Law of Treaties though the determination of the legal nature of particular instruments may still be somewhat controversial.43 Likewise, only treaties must strictly be complied with. The effectiveness of, i.e. the compliance with non-legal instruments is less certain as it depends on a great number of different factors. Since the authority of soft law instruments largely depends on the quality of the texts involved as well as on the number and reputation of entities which had contributed to their drafting and had accepted them, compliance is not enforced by institutionalized bodies and formal procedures such as judges or courts, but by moral suasion and self-regulation together, possibly, 39

Paul Szasz, General law-making processes, in Oscar Schachter, Christopher C. Joyner (eds.), United Nations Legal Order, American Society of International Law, Cambridge University Press, 1995, Vol. I, pp. 35–36. 40  Ibid., 46 and literature cited there. 41  E.g. UNCITRAL Model Law on International Commercial Arbitration 1985, as amended 2006; UNCTAD Model Law on Competition. 42 E.g. FAO Voluntary Guidelines on Responsible Governance of Tenure of land, fisheries and forests in the context of national food security; OECD Guidelines for Multinational Enterprises; EU Commission Communication – Implementation of Article 260(3) TFEU (lump sum or penalty payments for failure to fulfil an obligation under the Treaties), OJ L 12/1, 15.11.2011. 43  See for example the Brussels Agreement of 21 December 2001, a text relating to the Nuclear Power Station Temelin, which was signed by the heads of government of Austria, the Czech Republic accompanied by a Member of the Commission of the EU, but was neither submitted to the respective parliaments nor ratified by the Heads of state, cited in G. Hafner, op. cit. fn. 24 supra.

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with fear of marginalization or more drastically of being excluded from a particular process or development. Despite their voluntary (non-binding) quality, therefore, they do not lack a coercive dimension, since institutional actors as well as individuals often perceive soft law as hard regulation and behave accordingly, due to a number of effective soft law mechanisms, including persuasion, social pressure, self-interest, imitation, conformity, shaming, opportunity etc.44 One anthropologist even argued that “the implementation of international laws bears some similarity to that of customary village law,”45 referring to gossip and scandal as mechanisms of international law.46 Hard law and soft law differ also in some other respects. Binding rules require, to a certain extent, parliamentary participation in decision making. Non-legally binding instruments, by contrast, fall within the competence of the executive power, of governments or individual ministers. 3 Characteristics Shared with Hard Law However, the delimitation between soft and hard law is neither tight nor necessarily lasting, let alone permanent. In fact, it has become increasingly blurred. Thus, even after an initial choice of the appropriate type of law has been made – depending e.g. on policy considerations or the subject matter or the characteristics of actors whose participation is essential for compliance – a certain osmosis or mutation between them can occur.47 Indeed, soft law often does not remain “soft.” It can harden as a precursor of hard law. But it need not necessarily lead to new or a conspicuous change in existing rules of law. It might merely serve in a subsidiary role in construing “hard” law, that is in interpreting treaties and elucidating customary law.48 Conversely, hard law, for example treaties, can become unenforceable or not enforced.49 Thus, as suggested above, on a “broad band” – spectrum both hard law and soft law are invested with respective degrees of “authority,” a term that better conveys their quality as norms than those of “legally binding” or “legally non-binding” instruments. In fact “normative standards articulated through soft forms are relied upon by a variety of actors in both domestic and international fora,” with the 44 Filippo M. Zerilli, op. cit., fn. 38 supra, 5. 45  Ibid., 6. 46  Sally Engle Merry, Anthropology and international law, 35 Annual Review of Anthropology (2006), 99–116, 101. 47  Jean Pierre Dobbert, Food and Agriculture, in Oscar Schachter et al, op. cit. fn. 39 supra, vol. II, p. 907, at 991. 48  K. Zemanek, op. cit. fn. 14 supra, 860. 49 Jean Pierre Dobbert, op. cit, p. 987.

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proponents not always differentiating between hard and soft obligations but drawing upon “all available instruments across the continuum of legality to present as full a picture as possible of appropriate expectations.”50 As Lowe rightly pointed out, “in terms of the strength of expectation of compliance, there is not necessarily a distinction between the categories of ‘hard’ and ‘soft’ law”: rather the “real difference between hard and soft law lies in the processes by which the rule is articulated and in the consequences of its breach.”51 4 Convergence in Transnational Legal Space “Hardening” of soft law can occur in one of two ways. Firstly, by complying with it states may eventually create customary law or take account of it as raw material when codifying or developing norms thereby transforming soft law into standard-setting – or reflecting – or authorizing treaty law.52 Secondly, international soft law standards are also hardened by being transposed into domestic law. In addition to the shared quality of embodying different degrees of authority, both hard and soft law also have other features in common. In fact both types of instrument, though invariably couched in language appropriate for the differential obligations involved53 – hortatory (“should”) or obligatory (“shall”) – must always be interpreted and judged in accordance with the standard of good faith. Soft law also results from painstakingly negotiated textual formulations which are scarcely different from complex treaty negotiations carried out by the same IGO organs. Likewise, both types of texts carry an expectancy of compliance among states, possibly other entities, which have declared their adherence, including as the case may be to some institutional mechanisms for monitoring, reporting, surveillance and to some support measures designed to provide incentives for or otherwise facilitate compliance.54 As was said in the Report “An Agenda for Development” of the Secretary 50  Roda Mushkat, The Principle of Public Participation, in Nico Schrijver and Friedl Weiss (eds.), International Law and Sustainable Development. Principles and Practice, Martinus Nijhoff, 2004, p. 607, 612–613. 51  V. Lowe, Sustainable Development and Unsustainable Arguments, in Alan Boyle and David Freestone (eds.), International Law and Sustainable Development. Past Achievements and Future Challenges, OUP, 1999, p. 30. 52 Paul Szasz, op. cit. fn. 39 supra, 46. See also the EU Charter of Fundamental Rights, a text which prior to becoming primary law by virtue of the Treaty of Lisbon AG Colomer described as “a provision of soft law,” Opinion of 22.12.2008 in Rs C-553/07, Rijkeboer, fn.23. 53  Some obligations may themselves be vague: e.g. to consult, to negotiate before taking action, Szasz, ibid. 54  Jean Pierre Dobbert, op. cit. fn.47 supra, p. 987.

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General of the United Nations “forging multilateral agreement is the essence of international law, whether embodied in the form of non-binding norms, internationally recognized standards or binding obligations.”55 Globalization and the concomitant shift from government to governance56 opened up vast and unprecedented transnational legal space between institutional frameworks comprising sets of legal competences in which state law is but one of multiple public and private agencies participating in the regulatory process. In many fields of law traditional domestic law-makers (policymakers, politicians, academics, interest groups, judicial systems) reciprocally interact with an increasing number of actors beyond national jurisdictions.57 Helped by the relative fuzziness of soft law instruments, this burgeoning of decentralized rule making sites from which actors and institutions produce and perceive normativity has broken the monopoly of the nation-state of law and policy-making for its citizens.58 In fact, softness as Teubner reminded us, is a “typical characteristic of global law.”59 III Conclusion The above selective survey of scholarly opinions on soft law has clearly shown that many have joined a vibrant but hitherto polarized debate, not to say religious war, taking up theoretically dogmatic or pragmatic positions on the merits or otherwise of soft law instruments. Few if any, however, seem to question the proliferation of such instruments in international relations and practice. Indeed, due to its inherent flexibility, soft law, the phenomenon of soft law, has obviously spread to practically all areas and disciplines of international law while preserving its main characteristic as a part of the toolkit or agent of change.60 55  UNGA Doc. A/48/935 of 6 May 1994, 48th session, para. 173. 56  Daniele Archibugi, The global commonwealth of citizens: Toward cosmopolitan democracy, 2008, Princeton University Press. Rhodes distinguished six separate uses of governance: as the minimal state, as corporate governance, as the new public management, as “good governance,” as a socio-cybernetic system, and as self-organizing networks., cf. RAW Rhodes, The New Governance: governing without government (1996), cited in Larry Cata Backer, op. cit. fn. 2 supra, at 92. 57  Cf. Filippo M. Zerilli, op. cit. fn. 38 supra, 6. 58  Ibid., 7. 59  Günther Teubner, Global Bukowina: Legal pluralism in the world society, in Global Law without a state, 1997, Brookfield: Dartmouth, pp. 3–28. 60  Mar Campins-Eritja, Joyeeta Gupta, The Role of “Sustainability Labelling” in the International Law of Sustainable Development, in Nico Schrijver and Friedl Weiss (eds.), International Law and Sustainable Development. Principles and Practice, Martinus Nijhoff, 2004, p. 251, at 261.

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And soft law instruments have played and continue to play a particularly salient role in standard setting by international and transnational public as well as private governance institutions of world financial markets.61 At the time of the Austrian State bankruptcy 1811 no financial regulatory system existed. Sovereign debt was subject to rules of domestic not international law, a situation which continued throughout the troubled twentieth century. A first step towards some kind of transnational “governmentality” for greater stability of the international financial system was only made with the establishment of the Basel Committee on Banking Supervision in 1974. Since then a new era of ever increasingly dense transnational governance systems has been ushered in challenging traditional patterns of state-based governance through international legal instruments. Instead regulatory standard setting has been “out-sourced,” so to speak. Indeed a whole panoply of hybrid public/private, official, semi-official, private and self-regulatory bodies, groups, “think-tanks,” arrangements and networks, acting globally or at regional levels, and using different soft law instruments, has come to change, possibly sustainably, the landscape of global financial governance. Debates continue, of course, as to the nature of the new and still changing governance architecture which has emerged, its adequacy and efficacy in dealing with crises, some influential voices even advocating a return to a model of regulatory autarky.62 Ultimately, of course, it is change itself which is at stake, soft law instruments being but one means of engineering change. States, together with other actors, are merely instruments for the achievement of communal goals and objectives, including repairs and re-modelling of the crisis-ridden system of global financial governance. It is in relation to the possibilities of post-crisis change that one is reminded, however, of a wistful observation by the economist Harry Gordon Johnson made in relation to post-war periods: “Periods immediately after wars appeared at the time to be periods of great intellectual ferment (…) but in retrospect one is struck by the tameness of the actual retreat into scientific modes of thought and conceptions of problems of the pre-war period.”63 61  Friedl Weiss, op. cit., fn.1, 348ff. Rolf H. Weber & Douglas W. Arner, Toward a new design for international financial regulation, 29 University of Pennsylvania Journal of International Law (2007) issue 2, pp. 391–453. 62  Charles H. Dallara, Revitalizing Economic and financial Cooperation: Observations on the Global Financial Architecture, conference paper, INET Conference, Cambridge, April 2010, p. 3. 63  Harry G. Johnson, Individual and Collective Choice, in W. Robson (ed.), Man and the Social Sciences, L.S.E., George Allen & Unwin, London, 1972, pp. 1, 13 cited in Friedl Weiss, The GATT 1994: environmental sustainability of trade or environmental protection sustainable by trade? in Konrad Ginther, Erik Denters and Paul J.I.M.de Waart (eds.), Sustainable Development and Good Governance, Martinus Nijhoff, 1995, pp. 382–401, at 386.

chapter 4

The Dogma of Capital Regulation as a Response to the Financial Crisis Heidi Mandanis Schooner* The reason I raise the capital issue so often is that, in a sense, it solves every problem. Alan Greenspan1 1 Introduction Leverage is like uranium. Under perfect conditions both leverage and uranium create opportunities for economic growth and prosperity. Leverage creates profit when the cost of borrowing is lower than the return on investment. Uranium fuels nuclear power plants which support modern life without warming the planet. Under less than perfect conditions, both leverage and uranium can destroy economic gains and undermine welfare. Leverage can lead to insolvency when the cost of debt exceeds the return on investments. Uranium can end lives and destroy communities when nuclear power plants fail. Leverage is both the life blood and the death knell of large financial institutions. Such institutions use leverage to grow, but their leverage can also lead to their demise. Reliance on financial institutions as a mechanism of economic growth is like relying on nuclear power to solve global warming. Leveraged institutions can power our recovery, like nuclear power plants could slow global warming. Yet, the risks of such solutions are very high and rely heavily on effective regulation. While recent developments, both domestically and internationally, display serious attention to the threat of highly-leveraged institutions, past experience suggests that increasingly complex regulation will lead to even more complex financial innovations designed to avoid such regulation. * Heidi Mandanis Schooner is Professor of law at Columbus School of Law, The Catholic University of America. The author wishes to thank Hilary Allen, José Gabilondo, Jennifer Taub, and the participants at Tulane Law School’s International Financial Regulation Roundtable for insightful comments and Krystle Taylor for her excellent research assistance. 1 Alan Greenspan, Testimony before the U.S. Financial Crisis Inquiry Commission (April 7, 2010) available at http://www.c-spanvideo.org/program/ReserveD at 0:55:15.

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The negative externalities2 in financial services are significant. Among other things, the operations of the financial service industry can lead to systemic instability. Systemic instability can be described in various ways but in very general terms involves the risk of domino-like collapse and/or the risk of asset price spirals.3 Domino-like collapse arises when financial distress in one financial institution is communicated to other institutions. Such contagious distress may occur when the failure of one institution to settle its obligations may cause the failure of other, fundamentally sound, institutions. Alternatively, problems in one institution trigger a crisis of confidence in other institutions. More recently, attention has focused on asset price spirals. Such downward spirals can begin when one bank’s need for liquidity forces it to sell assets at fire-sale prices. Such action puts downward pressure on the value of assets of other similarly situated banks which in turn reduces the capital of those other banks. If in response, for example, those banks reduce their lending, then their borrowers (i.e., other banks) will face more liquidity pressure and be forced to sell more assets at fire-sale prices, and so on. Regulation of financial institutions is the government’s primary response to the negative externalities in financial services.4 Concerns of systemic risk dominate the so-called prudential regulation of financial institutions which seeks to minimize the threat of systemic collapse. Such concern is understandable given the costs of systemic crisis, both in terms of lost economic output and the public funds expended in bailing out failing institutions. According to a recent report by the Federal Reserve Bank of Dallas, the Financial Crisis of 2008 (“Financial Crisis”) resulted in an output loss of somewhere between $6 and $14 trillion,5 reminding us again of the link between the financial sector and the real economy. Capital regulation, which, among other things, places upper limits on financial institutions’ debt, is the primary international mechanism for regulating 2 A negative externality arises when an economic activity generates a cost for which those engaged in the activity have not been charged. A common example of a negative externality is a factory that dumps waste into a river thereby destroying the livelihood of the downstream fishermen. 3 For further discussion on domino-like collapse and asset spirals, see Heidi Mandanis Schooner and Michael W. Taylor, Global Bank Regulation: Principles and Policies (Academic Press, 2010) at 35–49. 4 Governments also respond to externalities by providing lender of last resort liquidity (through the central bank), deposit insurance, and other fiscal support. 5 David Luttrell, Tyler Atkinson, and Harvey Rosenblum, Assessing the Costs and Consequences of the 2007–09 Financial Crisis and its Aftermath, Dallas Fed Economic Letter, Vol. 8 No. 7 (September 2013).

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banks. Since the late 1980s, the Basel Committee on Bank Supervision (Basel Committee)6 has established an increasingly complex framework of capital regulation which has been embraced worldwide. Ironically, however, the story of the evolving Basel capital rules is a microcosm of the major policy missteps that contributed to the Financial Crisis: underpricing the risks of mortgage assets and sovereign debt; heavy reliance on credit rating agencies; hidden leverage through off-balance sheet exposures; and, reliance on flawed internal risk modeling. Given the failure of capital regulation to deliver the benefits of financial stability and the significant resources devoted to such regulation at both the international and domestic levels, consideration of the usefulness of this relatively new regulatory tool is appropriate. This chapter proceeds as follows: Part I overviews financial leverage generally; the leverage of financial institutions more specifically; and the basis for regulating the leverage of financial institutions. Part II discusses how regulators have attempted to limit leverage. In particular, Part II examines the evolution of capital regulation as formulated by the Basel Committee. Part III examines capital regulation as a response to the Financial Crisis. Part IV examines whether capital regulation is an appropriate response to the Financial Crisis and concludes with concerns regarding regulators’ continued heavy reliance on this regulatory tool. 2

The Problem with Leverage

A Defining Leverage Traditionally, leverage describes the use of debt as opposed to equity to purchase an asset, finance operations, or, even, to pay shareholder dividends. Leverage is evident from a firm’s balance sheet by comparing the size of assets with the amount of equity.7 While this chapter focuses on traditional balance sheet leverage, other types of leverage are not evident from a balance sheet. Economic leverage identifies a firm that is exposed to a change in value of a position by more than the amount the firm paid for the position. The common 6 The Basel Committee was established in 1974 by the central bank governors of the G-10 countries. Following the Financial Crisis, membership was expanded to include Argentina, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, United Kingdom, and United States. For information on the history of the Basel Committee, see http://www.bis.org/bcbs/history.htm. 7 See Part II for discussion of various measures of leverage.

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example of economic leverage is a loan guaranty which is off-balance sheet and yet could involve a significant commitment of funds in the future. Finally, embedded leverage involves a position with an exposure that is greater than the underlying market factor. For example, embedded leverage exists when an investor owns an investment that is leveraged (e.g., collateralized-debt obligations). Leverage’s link to balance sheet insolvency is obvious. Higher leverage means more debt versus equity. Particularly when debts are short-term, like bank deposits and overnight wholesale loans, depositors and other creditors can threaten the solvency of the firm by making unanticipated demands for repayment. In the traditional bank run, depositors panic (sometimes based on news that has nothing or little to do with their own bank’s financial condition) and withdraw their funds simultaneously. The demands of creditors deplete the bank’s liquid assets and would plunge the bank into insolvency, but for deposit insurance. Moreover, leverage can also lead to other problems. Leverage is linked to liquidity of firms and markets. If many firms are leveraged and are called upon at the same time to pay, they will liquidate their assets, flooding the market with supply that taxes demand for these assets. As the price of these assets drops, the firms recover less on their sales, intensifying their own liquidity problems and leading to more hasty asset sales. These liquidity spirals create a crisis. B Leverage of Financial Institutions In general, not just prior to the Financial Crisis, financial institutions are more highly leveraged than other firms.8 In addition to the advantages of debt over equity that are desirable for any firm (e.g., tax advantages), banks may gravitate to higher levels of leverage because such increased leverage encourages prudence by bank managers who may wish to avoid insolvency triggered by a run on deposits. In a somewhat perverse way, the fragility of the balance sheet (i.e., relatively higher leverage) might encourage more conservative management.9 More important to this discussion, however, banks are more highly leveraged 8 According to a recent New York Federal Reserve Bank staff report: “A typical non-financial firm has equity that exceeds 50% of its assets. By contrast, in mid-2010, the median capital ratio of commercial banks was about 8.5%.” Viral Acharay, Hamid Merhan, Til Schuermann, and Anjan Thakor, Robust Capital Regulation, Federal Reserve Bank of New York Staff Reports, no. 490 (June 2011) at 2. 9 Creditors might demand such conservatism under such circumstances. In contrast, very low levels of firm debt leave creditors complacent because their loans are safe. For a fuller discussion of this point, see Viral Acharay, Hamid Mehran and Anjan Thakor, Caught Between Scylla and Charybdis? Regulating Bank Leverage When There is Rent Seeking and Risk Shifting, Working Paper, Federal Reserve Bank of New York (2010).

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than other firms because they can borrow money more cheaply than other firms. Banks’ ability to borrow at low rates derives from governments’ explicit (e.g., deposit insurance) or implicit (e.g., bailouts) guarantees of their solvency.10 This means that a bank’s lenders demand smaller returns (than they would from comparable nonbank firms) based on the expected subsidy. Nevertheless, as retail customers have shifted their deposits out of banks and into other kinds of financial firms and investment products like money market funds, banks have faced challenges in replacing the lost deposits with funding from rate-sensitive wholesale lenders. Perhaps more importantly, financial institution’s leverage feeds itself. Financial institutions rely heavily on leverage because of the suppressed price of their borrowing based on both explicit and implicit subsidies. Leverage allows financial institutions to grow – expanding their balance sheets. As financial institutions become larger, the expected implicit government subsidy expands allowing the financial institutions to take on more and more leverage and grow still larger. The financial services industry has become even more leveraged in recent years. A recent report by the U.S. Government Accountability Office (GAO) identified several sources of increased leverage: [T]he studies we reviewed generally identified a range of sources that aided in the buildup of leverage before the crisis. One such source was the reliance on short-term funding by financial institutions, which made them vulnerable to a decline in the availability of such credit. Another source of leverage was special purpose entities (SPE), which some banks created to buy and hold mortgage-related and other assets that the banks did not want to hold on their balance sheets. SPEs often borrowed by issuing shorter-term instruments, exposing them to the risk of not being able to renew their debt. Other sources of leverage included collateralized debt obligations (CDOs) and credit default swaps, a type of OTC derivative.11 Very high leverage was an important contributor to the Financial Crisis. The U.S. Financial Crisis Inquiry Commission concluded: “In the years leading up to the 10

Viral Acharay, Hamid Merhan, Til Schuermann, and Anjan Thakor, Robust Capital Reg­ ulation, Federal Reserve Bank of New York Staff Reports, no. 490 (June 2011) at 8. Banks’ preference for debt represents a deviation from the ideal Modigliani and Miller model. For further discussion on this point, see Heidi Mandanis Schooner and Michael W. Taylor, Global Bank Regulation: Principles and Policies (Academic Press, 2010) at 133–134. 11 GAO, Financial Crisis Highlights Need to Improve Oversight of Leverage of Financial Institutions and across System, GAO-10-555T (May 6, 2010).

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crisis, too many financial institutions, as well as too many households, borrowed to the hilt, leaving them vulnerable to financial distress or ruin if the value of their investments declined even modestly…. To make matters worse, much of their borrowing was short-term, in the overnight market – meaning the borrowing had to be renewed each and every day.”12 Thus, as discussed further in Part III, the regulation of leverage has been a center piece of the response to the Financial Crisis. 3

Regulating Leverage

The problems associated with leverage are not new. U.S. regulators have monitored the leverage of financial institutions for at least 100 years.13 Until recent years, however, the regulation of leverage was not the primary focus of the regulation of banks.14 Prudential, or sometimes called “safety and soundness,” regulation traditionally has sought to protect banks from failure primarily by restricting entry into the banking business and by regulating banks’ activities.15 Thus, significant barriers have been erected around the business of banking in the form of licensing and other entry restrictions. Bank managers must meet fit and proper standards and comply with other standards of corporate governance aimed at protecting the solvency of the bank.16 Finally, traditional prudential regulation focuses on many forms of activities restrictions from limitations on loans to one borrower to prohibitions on certain investments. 12 13

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Financial Crisis Inquiry Commission Report, at xix (January 2011). According to Federal Reserve Board Member Dan Tarullo: “Regulatory monitoring of capital levels at operating banks has existed in the United States since at least the early years of the 20th century. The relative sophistication of that monitoring evolved fairly steadily thereafter, particularly following World War II.” Daniel Tarullo, Banking on Basel: The Future of International Financial Regulation (Peterson Institute for International Eco­ nomics, 2008) at 29. This chapter focuses on the regulation of bank capital. For a broader discussion which also includes examination of broker-dealer capital and insurance company capital, see José Gabilondo, The Rise of Risk-Based Regulatory Capital: Liquidity and Solvency Standards for Financial Intermediaries, in Research Handbook on Corporate Law and Governance, Jerry W. Markham & Rigers Gjyshi eds., Edward Elgar, forthcoming (2014). For a complete discussion of the foundation for the prudential regulation of banks, see Heidi Mandanis Schooner and Michael W. Taylor, Global Bank Regulation: Principles and Policies (Academic Press, 2010), xii–xxi. For a complete discussion of bank licensing and corporate governance rules, see Heidi Mandanis Schooner and Michael W. Taylor, Global Bank Regulation: Principles and Policies (Academic Press, 2010), at 89–110.

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Regulators use the leverage ratio to measure leverage.17 In very general terms the leverage ratio is calculated by dividing the bank’s equity by its assets. The lower the ratio of equity to assets (or debt), the higher is the bank’s leverage because there is a smaller capital cushion (equity) to bear unexpected losses. Similarly, a leverage multiplier is calculated by dividing the bank’s assets by its equity. In the United States, FDIC-insured banks have long been required to maintain a ratio of capital to total assets of 4% or greater to be considered adequately capitalized.18 Canadian regulators have used a leverage multiplier which requires that assets should be no more than 20 times equity.19 The problem with the simple leverage ratio (or leverage multiplier), however, is that is does not account for the relative riskiness of banks’ assets. By treating all assets the same, the leverage ratio encourages banks to hold relatively more risky assets (i.e., those with a higher rate of return) which increases risk in the bank’s overall balance sheet. Thus, in 1988, the Basel Committee endorsed Basel I’s risk-weighted capital requirements which are designed to account for the riskiness of banks’ assets when determining the level of required capital. Under Basel I, the ratio of capital to risk-weighted assets (generally referred to as the “capital ratio”) must be greater than or equal to 8%. With respect to the denominator of the capital ratio, Basel I has four riskweight buckets which, in effect, discount the value of an asset according to the degree of risk. For example, cash carries a zero risk weight which, in effect, allows a bank to hold no capital against its cash assets. Basel I relies on membership in the Organization for Economic Development and Cooperation (OECD) to determine certain risk weights. For example, a loan to an OECD bank with a maturity of greater than a year carries a 20% risk-weight, whereas the same loan to a non-OECD bank country carries a 100% risk weight. Residential mortgages are weighted under Basel I at 50 percent. With respect to the numerator of the capital ratio, capital has two components: core capital and supplementary capital. Core capital (Tier 1) comprises, primarily, paid-up capital and reserves, i.e., equity as determined by the difference between assets 17

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This chapter focuses on the regulation – as opposed to supervision – of leverage. In other words, this discussion covers the rules/regulations that restrict leverage and not the examination and monitoring practices of bank supervisors that might also address leverage. A well-capitalized bank must have a 5% or greater leverage ratio. 12 C.F.R. § 325.103 (b)(1) (iii). A bank with a 3% leverage ratio would also be considered adequately capitalized if the bank maintained the highest possible composite supervisory rating. 12 C.F. R. § 325.103(b)(2)(iii). Katia D’Hulster, The Leverage Ratio: A New Binding Limit on Banks, Crisis Response, The World Bank Group Note Number 11 (December 2009). This equates to a leverage ratio of 5%.

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and liabilities. Supplementary capital (Tier 2) includes, among other things, various forms of subordinated debt and hybrid debt/capital instruments. Thus, the capital ratio not only adjusts assets for their risk (the denominator) but also allows certain types of debt to count at capital (the numerator). Soon after Basel I was adopted, its limitations became evident. Basel I encouraged regulatory arbitrage through financial innovation and through cherry-picking assets with equal risk-weights.20 For example, neither securitization nor credit derivatives (both off-balance sheet) are accurately captured within the Basel I framework. The four risk buckets are crude in that, for example, all commercial loans are weighted at 100% regardless of the creditworthiness of the borrower. Moreover, the use of OECD designations to determine risk weighting is arbitrary and both politically derived and politically incorrect (from the vantage point of non-OECD countries). Finally, Basel I fails to recognize (and encourage) diversification of assets but treats every asset in isolation for purposes of the capital ratio. These criticisms of Basel I led to Basel II, completed in 2004, which attempts further refinement of the risk-weighting categories and introduced the use of risk management tools for regulatory purposes. The hope was that such reforms would reduce opportunities for arbitrage. Basel II offered banks the option of either using risk weighting as determined by external credit rating agencies’ risk assessments (the standard approach) or by using the banks’ own internally generated assessments of risk (the internal ratings based approaches or IRB). Basel II is also broader in scope. The methodology for setting bank capital requirement (the focus of this discussion) forms only the first pillar of Basel II. The second pillar addresses the supervisory review process, which aims at a comprehensive review of banks’ internal capital adequacy assessment, including an assessment of risk management processes, controls, and risk profile. The third pillar deals with public disclosures by banks. With regard to the numerator of the capital to risk-weighted assets ratio, Basel II retains the same standards of Tier 1 and Tier 2 capital as under Basel I. Basel II makes significant changes, however, to the denominator. Basel II eliminates the OECD/non-OECD distinction and thereby addressed one of the major criticisms of Basel I. Under Basel II’s standard approach, a sovereign debt, regardless of OECD membership, can be assigned as high as a 150% risk weight if that government’s debt received the lowest credit rating. The same is 20

For a comprehensive discussion of banks’ incentives to arbitrage regulatory capital requirements, see Erik F. Gerding, Law, Bubbles, and Financial Regulation (Routeledge 2014) at 236–275; see also Hilary Allen, Let’s Talk About Tax: Fixing Bank Incentives to Sabotage Stability, 18 Fordham J. Corp. and Fin. L. 821, 833–844 (2013).

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true for commercial borrowers. Under Basel I, all commercial loans are weighted 100%. Under Basel II, a commercial loan to a firm with the highest credit rating is weighted at only 20%. Under Basel II’s standard approach, loans fully secured by residential mortgages receive a risk weight of 35% (subject to the supervisor’s discretion). Loans secured by commercial real estate receive a risk weighting of 100%. The internal ratings-based (IRB) approaches were a much more radical departure from Basel I than the standardized approach. While the standardized approach refined the Basel I risk buckets, the IRB framework relies on banks’ internal estimates of the key risk elements that determine their required capital. Fundamental to the IRB framework is that it requires bank supervisors to assess the adequacy of a bank’s risk management processes as opposed to compliance with preset rules for calculating regulatory capital (as reflected in Basel I and Basel II’s standardized approach). Thus, the implementation of Basel II’s IRB requires the exercise of far more subjective supervisory discretion in determining capital adequacy than under Basel I. Before both the Financial Crisis and the full implementation of Basel II, its limitations were observed. Most of the debate centered on the IRB framework and whether or not it would increase or decrease capital requirements. The Quantitative Impact Studies conducted by the Basel Committee showed that large internationally active banks would have lower capital requirements under Basel II than under Basel I.21 This lead to objections of an uneven playing field in which the largest banks with the most sophisticated risk management systems would enjoy the lower capital requirements afforded by the IRB, while smaller institutions would not. Moreover, even among the largest banks there was concern regarding the inconsistency among internal rating systems which could not be easily verified through comparison to external sources. Of course, the Financial Crisis brought these concerns and others into greater focus. 4

Capital Regulation as a Response to the Financial Crisis

As discussed above, high levels of leverage were certainly an important contributing factor in the Financial Crisis. Therefore, it comes as no surprise that policymakers would focus on improving the regulation of leverage in response to the Crisis. Yet, the increased focus on capital regulation predates the Crisis. 21

Basel Committee on Bank Supervision, Quantitative Impact Study 3 – Overview of Global Results (2003) (the study showed some increases in capital requirements for banks using the standardized approach).

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In 2008, current Federal Reserve Member, then law professor, Daniel Tarullo identified three factors that contributed to the growing focus on capital as a basis for bank regulation: “first, a decline in capital ratios; second, the upheaval in the financial services industry; and third, the modification or outright abandonment of many traditional regulatory devices for assuring bank safety and soundness.”22 Tarullo’s observations continue in the aftermath of the Financial Crisis such that capital adequacy continues to occupy much of the attention in debates regarding regulatory reform. This is despite the fact that the Financial Crisis highlighted many of the limitations of the Basel rules. One of the most immediate responses to the Financial Crisis came in the form of modifications to Basel II, known as Basel II.5.23 Basel II.5 was designed to discourage exploitation of the designation of bank assets into the banking book versus the trading book. The banking book is comprised of assets that are held to maturity and are therefore accounted for at their original book value. In contrast, the trading book is comprised of assets held for the short term and with the intention to resell. Trading book assets are valued according to the current market price, such that the mark-to-market volatility is reflected in the bank’s reported earnings. Basel II.5 attempts to avoid the inappropriate designation of assets into the banking or trading book for the purpose of avoiding capital requirements. It does so by introducing an incremental risk capital charge for certain trading book assets. The Financial Crisis highlighted other shortcomings of both the Basel I and Basel II frameworks. The credibility of external credit rating agencies’ ratings was shattered, especially after the coveted AAA-rating was assigned to structured financial products that suffered much higher default rates than the rating implied. The same was true for the high ratings given to sovereign debt which proved quite optimistic given the ensuing European debt crisis. The fact that Basel II lowered the risk weight for residential mortgage loans from 50% to 35% seemed in the rear view mirror, unwise given the huge role of mortgage assets in the Crisis. The Financial Crisis also brought the IRB under Basel II 22

23

Daniel K. Tarullo, Banking on Basel: The Future of International Financial Regulation (Peterson Institute for International Economics, August 2008) at 30. With regard to Tarullo’s third point, in the United States, for example, the passage of the Gramm-Leach-Bliley Act of 1999, Pub. L. No. 106–102, 113 Stat. 1338, repealed many of the rules that separated commercial from investment banking. See Basel Committee on Banking Supervision, Revisions to the Basel II Market Risk Framework (March 2009) and Basel Committee on Banking Supervision, Guidelines for Computing Capital for Incremental Risk in the Trading Book (July 2009).

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under scrutiny. Not only is IRB procyclical (just as all capital regulation),24 it also employs an inexact science. An internal, or external for that matter, assessment of a bank’s capital needs is fundamentally a prediction. Given that several of the banks that were bailed out in the Financial Crisis were well capitalized under Basel II shortly before the crisis suggests that the IRB did not do a very good job of predicting their capital needs. Fundamentally, as discussed earlier, the Financial Crisis provided evidence that banks had simply become too leveraged and that regulatory capital requirements had not prevented the accumulation of dangerous levels of leverage. In the United States, because of concerns primarily raised by the Federal Deposit Insurance Corporation (FDIC), the implementation of Basel II was delayed. The FDIC was concerned that the IRB would allow banks to hold too little capital. The FDIC insisted on maintaining a leverage ratio, without risk weighted assets, as a back-stop to the Basel II approach.25 Many believe that the FDIC’s insistence on maintaining a leverage ratio left U.S. banks in a slightly better financial condition than their European counterparts in the face of the Financial Crisis.26 The United States was quick to respond legislatively to the Crisis. In 2010, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA).27 DFA includes some important changes to the capital adequacy framework. Section 171 of DFA, known as the Collins Amendment,28 requires federal regulators to establish minimum leverage and capital requirements for banks, bank holding companies and nonbank financial companies supervised by the Federal Reserve.29 Such minimum requirements cannot be less than 24

25 26

27 28 29

Capital requirements are by their nature pro-cyclical, i.e., they operate to reduce capital requirements during boom times and raise them during a downturn. This is because the calculation of capital is based on the value of the bank’s assets. The value of such assets will be greater during a boom allowing a bank to hold less capital relative to liabilities. FDIC-insured banks must maintain a ratio of capital to total assets of 5% to be considered well-capitalized, 4% to be considered adequately capitalized. 12 C.F.R. § 325.103(b)(2). Canada also maintained a leverage ratio and Switzerland adopted a leverage ratio effective 2013. See generally The World Bank, The Leverage Ratio: A New Binding Limit on Banks (December 2009). Pub. L. No. 111–203 (2010). 12 U.S.C. §5371. DFA gave the Federal Reserve the authority to supervise certain U.S. nonbank financial companies if the Financial Stability Oversight Council determines that “material financial distress at the U.S. no-bank financial company, or the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the U.S. nonbank financial company, could pose a threat to the financial stability of the United States.” 12 U.S.C. § 5323(a)(1).

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generally applicable risk-based capital and leverage requirements that were in effect at the time DFA was enacted.30 Section 165 of DFA requires the Federal Reserve to impose more stringent prudential standards on bank holding companies with assets of USD 50 billion or more and systemically important nonbank financial companies.31 More stringent standards include risk-based capital requirements and leverage limits.32 In addition, DFA requires annual stress testing of such companies to determine whether they have adequate capital to absorb losses during adverse conditions.33 Upon finding by the Financial Stability Oversight Council that a bank holding company or nonbank financial company supervised by the Federal Reserve poses a grave threat to U.S. financial stability, the Federal Reserve must require such company to maintain a debt-to-equity ratio of no more than 15 to 134 (which translates to a leverage ratio of 6.25%). Finally, Section 939A of DFA mandated the removal of all references to external credit ratings for regulatory purposes. Obviously, this has a direct impact on the Basel II risk-weighting framework, but it also affected other safety and soundness rules.35 In 2010, the Basel Committee offered its comprehensive response to the Financial Crisis in the form of Basel III. Basel III places strong emphasis on common equity as the source of capital. Minimum capital has been raised significantly. While the ratio of capital to risk-weighted assets remains, as it has since Basel I, at 8%, the composition of capital (the numerator) requires much more pure equity or high-quality capital. Basel II set common equity (the highest quality capital) to risk-weighted assets at 2% and Basel III increases that ratio to 4.5%. Basel II set Tier 1 capital to risk-weighted assets at 4% and Basel III increases that ratio to 6%. Basel III includes additional capital requirements in the form of conservation and countercyclical buffers. The conservation buffer requires an additional 2.5% of common equity Tier 1 capital to risk-weighted assets to be built 30 31 32 33 34 35

12 U.S.C. § 5371(b). 12 U.S.C. § 5365(a). 12 U.S.C. § 5365(b)(1)(A)(i). 12 U.S.C. § 5365(i). 12 U.S.C. § 5365(j). For example, the Office of the Comptroller of the Currency, regulator of federally chartered U.S. banks, maintains rules that allow such banks to hold certain types of investment securities. The Comptroller’s rules had relied on external credit ratings for determining whether securities were “investment grade.” Since the passage of DFA, reference to credit ratings for this purpose has been replaced by a requirement that in order for securities to be deemed investment grade, the bank must determine that the probability of default is low and the full payment upon maturity is expected. 12 C.F.R. § 1.2(d).

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up during good times and available for draw down during times of stress. The countercyclical buffer requires an additional 1–2.5% of common equity Tier 1 or other loss absorbing capital to risk-weighted assets during times of excess aggregate credit growth. Basel III also includes an additional capital charge for global systemically important banks. For the first time, Basel III adopts an international non-risk based leverage ratio of 3% (discussed further below). Basel III also includes liquidity standards and additional capital requirements for securitizations and other off-balance sheet activities. With regard to the use of external credit ratings, Basel III incorporates the International Organization of Securities Commissions’ (IOSCO)36 Code of Conduct Fundamentals for Credit Rating Agencies and requires banks to internally assess both their rated and unrated exposures. While the immediate response to the Financial Crisis was to focus on the numerator of the capital ratio by working to improve the quality of capital, since then the denominator has been subject to scrutiny. Since Basel III, evidence of considerable variation among banks in risk weighting of assets has raised concern. As part of its broader Regulatory Consistency Assessment Program, the Basel Committee has studied risk-weighting assets by major banks. While the Basel Committee found a high degree of consistency in some elements of risk-weighting, the Committee found significant variation in others.37 In a study by the International Monetary Fund (IMF) on this issue, the IMF found that variations can be explained by differences in banks’ business models, risk profiles and risk-weighting methodologies and also by differences in supervisory practices.38 Certainly, variation in risk-weighting is troubling because it undermines the reliability of the risk assessment. Yet, a complete lack of 36

37

38

IOSCO was created to promote high standard of regulation, to facilitate exchange of information, to establish standards for international securities transactions, and to promote enforcement standards. Over 120 securities regulators and 80 other securities market participants are included in its membership. See http://www.iosco.org/about/. For example, in its study of risk-weighting in the banking book, the Basel Committee “found a high degree of consistency in banks’ assessment of the relative riskiness of obligors…. Differences exist, however, in the levels of estimated risk, as expressed in probability of default (PD) and loss-given-default (LGD).” Basel Committee on Bank Supervision, Report on the regulatory consistency of risk-weighted assets in the banking book (July 2013). In its study of risk-weighting for market risk, the Basel Committee found considerable variation. Basel Committee on Bank Supervision, Report on the regulatory consistency of risk-weighted assets for market risk (January 2013). Vanessa Le Leslé and Safiya Avramova, Revisiting Risk-Weighted Assets: “Why Do RWAs Differ Across Countries and What Can Be Done About It?” IMF Working Paper, WP/12/90 (March 2012).

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variability can have negative consequences as well if it leads to herding among institutions toward particular assets. Growing unease with heavy reliance on risk-asset weighted capital ratios lead to a renewed focus on the leverage ratio. The un-weighted leverage ratio is seen as a counter weight to the limitations of the capital ratio. While Basel III included the first international leverage ratio, the Basel Committee revived discussions with the publication of a consultative document that includes important revisions to the framework.39 The numerator of the leverage ratio remains defined as Tier 1 capital as in the original proposal and the ratio itself remains at 3%. The further developments to the leverage ratio framework are in the denominator. The denominator of the leverage ratio is the “Exposure Measure” and includes un-weighted on-balance sheet assets as well as derivative exposures, securities financing transactions (e.g., repurchase agreements), and other off-balance sheet exposures. Meanwhile, US bank regulators adopted a supplemental leverage ratio for large banks that exceeds the Basel standard. Under the new rule, certain large bank holding companies must maintain a leverage ratio of 5% to avoid restrictions on dividend and discretionary bonus payments.40 The Basel Committee continues to evaluate the effectiveness of Basel III. Recently, the Committee released a discussion paper on risk sensitivity, simplicity and comparability.41 In this paper, the Committee addresses the complexity of a risk-based regulatory regime and states: The Committee believes that a risk-based capital regime should remain at the core of the regulatory framework for banks, supported by liquidity and funding metrics as well as other measures such as a leverage ratio. That said, the pursuit of increased risk sensitivity has considerably increased the complexity of the capital adequacy framework in some areas – particularly the calculation methodology for risk-weighted assets. As a result, there is a risk that the framework may not always strike an appropriate balance between the complementary goals of risk sensitivity, simplicity and comparability.42

39 40 41 42

So Basel Committee on Bank Supervision, Revised Basel III leverage ratio framework and disclosure requirements (June 2013). 79 Federal Register 24,528 (May 1, 2014). Basel Committee on Bank Supervision, The regulatory framework: balancing risk sensitiv­ ity, simplicity and comparability (July 2013). Id.

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Finally, the Basel Committee’s focus on setting capital standards has not failed to recognize the supervisory process as distinct from and important to regulation. Since the Financial Crisis, stress testing has drawn considerable attention as a necessary part of bank supervision. A stress test is an evaluation of a bank’s financial condition under extreme but plausible scenarios. Stress testing is not new. Basel II included stress testing as part of a bank’s determination of certain risks for purposes of capital adequacy. Yet, the Basel Committee found that stress testing practices were inadequate during the Financial Crisis. The Basel Committee has made recommendations for improvement in both banks’ stress testing and their supervisors’ review of such testing.43 5

Evaluating Capital Regulation as an Effective Response to the Financial Crisis

As discussed above, to the extent that leverage was a contributing factor in the Financial Crisis, the regulation of leverage through capital and leverage ratios seems a natural response. And yet, many other regulatory and supervisory tools can be (and sometimes are) used to address excess leverage.44 Therefore, it is important to consider whether the significant attention and reliance placed on capital regulation is appropriate. The discussion below considers both the advantages and disadvantages of capital regulation and observes that while big banks have strong incentives to support capital regulation frameworks, little evidence suggests that such frameworks should prevail as the primary mechanism for avoiding financial crises. The conventional narrative is that banks resist regulatory capital requirements because they prefer to fund their activities with subsidized (cheap) debt as opposed to equity. While banks may maintain a preference for debt, it does not necessarily mean that large banks oppose capital regulation. Consider the fact that the growth of capital regulation coincided with a period of deregulation. Capital regulation, in particular Basel II, is part of that deregulatory story and thus should be viewed in that light – i.e., capital regulation is the type of regulation that banks should love not loath. Given the political power of the large banks, it is hard to imagine that the Basel rules came into being without 43 44

Basel Committee on Bank Supervision, Principles for sound stress testing practices and supervision (May 2009). For example, to the extent that excess leverage is a by-product of the implicit too-bigto-fail (TBTF) subsidy (which allows banks to borrow cheaply), then efforts to reduce TBTF policies should lower leverage.

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their implicit blessing. A more cynical way of stating the same point is that we have capital regulation because the large, powerful banks are willing to tolerate capital regulation.45 So, why would or should banks favor capital regulation (despite their complaints about the high cost of equity, etc.)? Large banks must assure the public and regulators that they are not too big to regulate, because, if they are, then they must be dismantled (or, in some way fundamentally altered as institutions). Capital regulation would seem to suit the needs of large banks to prove that they are regulate-able for many reasons. First, like any form of regulation, capital adequacy regulation is subject to arbitrage. Moreover, the opportunities for arbitrage have only increased as capital regulation has become more and more complex.46 Endless opportunities to skirt capital regulation, and the time to do so, can be found in the definitions of capital (Tier 1 and 2), weighting of assets, positioning of assets off-balance sheet, long implementation schedules, and so on.47 Second, perhaps most importantly, capital regulation provides the basis for arguing that other forms of regulation are unnecessary. For example, if a bank convinces regulators that it is well capitalized, then the justifications for activities restrictions diminish. This is the framework by which Glass-Steagall restrictions on the combination of commercial and investment banking were dismantled in the United States under Gramm-Leach-Bliley of 1999 (GLB). Under GLB, certain bank holding companies are allowed to engage in broader activities if they establish, among other things, that their subsidiary banks are “well capitalized.”48 This coincides with Greenspan’s observation that capital “solves every problem.”49 Third, the international forum for capital adequacy negotiations is a very receptive forum for objections based on competitive inequality.50 So, for example, existing capital levels across jurisdictions can be used as a basis for arguing that ratios 45

46

47

48 49 50

For an extensive discussion of the political power of large banks in the context of regulatory reform, see Arthur E. Wilmarth, Jr., Turning a Blind Eye: Why Washington Keeps Giving in to Wall Street, 81 Univ. Cincinnati L. R. 1283 (2013). A simple measure of complexity: Basel I was a mere 25 pages long. The original Basel II document was 10 times that at 251 pages. The original Basel III document is double that at 568 pages. Jamie Dimon, JPMorgan’s chief executive said, regarding Basel III, that the bank would “manage the hell out of [risk weighted assets].” Tom Braithwaite, Banks turn to financial alchemy in search for capital, Financial Times (Oct. 24, 2011). 12 U.S.C. § 1843(l)(1). See supra note 1. For extensive discussion of competitive interests, see Chris Brummer, Soft law and the Global Financial System: Rule Making in the 21st Century (Cambridge University Press, 2012) at 256–259.

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remain low: if it is impossible for some banks to meet higher ratios then no banks should be so required. Fourth, the rhetoric of capital regulation provides reassuring public soundbites – capital ensures a buffer/safeguard against loss, etc. References to balance sheets generally sound so safe – after all, they balance. What could be more reasonable?51 While capital is often fallaciously described as something like a “rainy day fund” (which confuses regulatory capital with reserve requirements),52 the idea (even if misleading) of a rainy day fund is tremendously appealing. The observation that large banks might (or should) favor capital regulation does not necessarily lead to the conclusion that capital regulation is bad. Many factors point to the importance of capital adequacy in the overall regulatory framework. Perhaps the most important arguments in favor of capital adequacy regulation rest on the advantages associated with strong balance sheets. An IMF study found that banks with higher and better-quality capital were able to continue lending during the Financial Crisis.53 This is not only good news for those particular institutions, but also has positive impact on crisis recovery. The fact that the most important conversations regarding capital adequacy regulation have occurred at the international level is beneficial for several reasons. Common international standards can avoid race to the bottom regulations and afford national regulators with a common language.54 And, yet, the limitations of capital regulation are all too clear. First, the international regulation of capital, which began formally in the late 1980s, did not prevent the most serious financial crisis since the 1930s. In this sense, capital regulation was tested and failed. Efforts to improve capital regulation given 51

52

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Jamie Dimon, CEO of JP Morgan Chase refers to his bank’s “fortress balance sheet.” William D. Cohan, The One Thing Jamie Dimon Got Right This Week, Bloomberg.com (May 11, 2012). For discussion of such mischaracterizations of capital, see Anat Admati and Martin Hellwig, The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about it (Princeton University Press, 2013) at 97. Tümer Kapan and Camelia Minoiu, Balance Sheet Strength and Bank Lending During the Global Financial Crisis, IMF Working Paper, WP/13/102 (May 2012). Furthermore, an assessment by the Basel Committee affirms the net benefits of capital regulation in terms of reducing the probability of banking crises. Basel Committee on Banking Supervision, An assessment of the long-term economic impact of stronger capital and liquidity require­ ments (August 2010). This chapter does not attempt to address the broader impact of international financial architecture on the development of capital rules. That topic is covered extensively in: Chris Brummer, Soft law and the Global Financial System: Rule Making in the 21st Century (Cambridge University Press, 2012).

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our experience with the Financial Crisis appear a bit like throwing good money after bad. Certainly, the Basel Committee has been quick to identify solutions to limitations in the capital frameworks. The Basel Committee’s emphasis on the leverage ratio, as discussed above, came after identification of serious limitations in risk-weighting. Yet, as Gelpern and Scott note, the revival of the leverage ratio “is more an indictment of the Basel methodology than grounds for endorsing crude leverage ratios. Indeed, it was dissatisfaction with the leverage ratio as a measure of capital adequacy that was a major impetus in the development by Basel of a risk-weighted approach.”55 Another way of saying this is that it might not be wise to respond to the flaws in one ratio by adopting another flawed ratio. Similarly, the post-crisis debate over the optimum level of capital might serve to undermine the entire capital framework. As discussed in Part III, Basel III sets required capital to risk-weighted assets at 8% with an additional 2.5% or more in conservation buffers (and the potential for extra charges for counter-cycle buffers and against systemically important financial institutions). Several authoritative commentators suggest that these levels are far too low. Eminent economists, Admati and Hellwig argue for levels in the 20 to 30 percent range.56 Researchers at the Bank of England and Bank for Inter­ national Settlements (BIS), David Miles, Jing Yang, and Gilberto Marcheggiano suggest doubling the requirements set by Basel III. Calls for much higher capital levels are based on the premise that capital requirements – when set high enough – are an effective form of regulation. Yet, it is possible that such severely qualified support of capital regulation actually undermines viability of international capital standards. It seems unlikely that the Basel Committee would amend Basel III to incorporate such recommendations. Yet, if the advocates of much higher capital are correct, then the current capital requirements are not an effective form of regulation. Thus, to the extent that it is politically unimaginable for capital requirements to reach the levels recommended (e.g., no less politically fraught than dismantling large banks), then capital regulation should take a back seat to other regulatory and supervisory tools. 55 56

Hal S. Scott and Anna Gelpern, International Finance: Transactions, Policy, and Regulation (Foundation Press, 19th ed., 2012) at 589 (citations omitted). Anat Admati and Martin Hellwig, The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about it (Princeton University Press, 2013) at 182. See also Anat R. Admati, Peter M. DeMarzo, Martin F. Hellwig, and Paul Pfleiderer, Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive (March 23, 2011).

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The Financial Times’ chief economics commentator Martin Wolf has written that the Basel III standards are woefully inadequate. At the same time, he recognized the good faith, incremental efforts of regulators: The regulators are trying to make the existing financial system less unsafe, incrementally. That is better than nothing. But it will not create a safe system. The world cannot afford another such crisis for at least a generation. By these standards what is emerging is simply insufficient. This mouse will never roar loudly enough.57 But, it may not be true that current (low) capital requirements are better than nothing. Basel III may not be better than nothing if it takes scarce resources away from other regulatory and supervisory tools that have a better chance of being effective. Martin Wolf’s “better than nothing” observation does seem to support emphasis on the simple leverage ratio – even if the ratio is set too low, its simplicity does not hog resources in the way that risk-based capital measures do – making it potentially better than nothing. In the end, it may be that the attempt to determine the riskiness of assets is simply too difficult. One of the justifications of higher capital requirements is that the larger buffer reduces the potential impact of errors in valuation and risk-weighting of assets. Even so, capital ratios have never been more than an estimate.58 Moreover, the estimate uses information about the past to predict the future – an inherently flawed exercise. Vice Chairman of the U.S. Federal Deposit Insurance Corporation Thomas Hoenig observes: If risk weights could be assigned that anticipate and calibrate risks with perfect foresight, adjusted on a daily basis, then perhaps risk-weighted capital standards would be the preferred method for determining how to deploy capital. However, they cannot. To believe they can is a fallacy that puts the entire economic system at risk.59 Even placing a value on an asset (apart from the weighting of that value) is a fraught exercise. Recently, Bank of America announced that had overstated its 57 58 59

Martin Wolf, Basel: the mouse that did not roar, The Financial Times (September 14, 2010). Roger B. Myerson, Rethinking the Principles of Bank Regulation: A Review of Admati and Hellwig’s Bankers’ New Clothes (October 2013) (on file with author). Thomas Hoenig, Vice Chairman, FDIC, Basel III Capital: A Well-Intended Illusion, Remarks to the International Association of Deposit Insurers 2013 Research Conference in Basel, Switzerland (April 9, 2013).

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regulatory capital by USD 4 billion because of its treatment of certain assets acquired as part of its 2009 acquisition of Merrill Lynch.60 The fact that such an accounting error could remain undetected for so many years raises serious concerns over the effectiveness of the bank’s management. It also provides another illustration of the vulnerability of capital calculations. A glimmer of hope in what might otherwise feature the failure of capital regulation may be found in developing supervisory practices. As discussed in Part III, the Basel Committee has emphasized improvements to stress testing methodologies. In the U.S., DFA mandates annual stress testing for large financial institutions to assess the adequacy of capital levels. In addition, the Federal Reserve’s recent “Capital Planning at Large Bank Holding Companies: Supervisory Expectations and Range of Current Practices” sets forth principles of an effective capital adequacy process.61 While an evaluation of supervisory practices in relation to capital adequacy is outside the scope of this discussion, it may be an area worth of future study to determine whether such practices can act as an effective backstop against the significant deficiencies in capital regulation. 6 Conclusion Regulating capital affords a tantalizing solution to the risks of over-leverage. As Alan Greenspan observed: “in a sense, [capital] solves every problem.” In a sense, on its face, in our dreams, capital does just that. For that reason, the topic of capital regulation attracts great attention, resources, and debate. Yet, the effectiveness of capital regulation has very likely been oversold. Regulat­ ing capital may be a zero sum game – one that the industry should be happy to play, but one in which the chances of achieving enduring improvements to financial stability may prove elusive.

60 61

Camilla Hall and Stephen Foley, BofA faces voter backlash over error, The Financial Times (May 7, 2014). Board of Governors of the Federal Reserve System, Capital Planning at Large Bank Holding Companies: Supervisory Expectations and Range of Current Practice (August 2013).

Part 2 Specific Legal and Policy Responses

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chapter 5

The Politics of International Financial Law in the Aftermath of the Global Financial Crisis of 2008 Douglas W. Arner* Introduction The global financial crisis of 2008 and the subsequent Eurozone debt crisis of 2010 have had a profound impact not only on global finance and international financial regulation but also on the political context in which both operate. This chapter begins by reviewing the evolution of the political context of international financial law prior to the global financial crisis. From this basis, the chapter then discusses major developments during the main period of the crisis (2008–2013), particularly highlighting the emergence of the Group of 20 (G20). Finally, the chapter discusses the evolving political context of international financial law in the aftermath of the global financial crisis, focusing on the emergence of China.

International Financial Law: The Pre-Crisis Evolution

International financial law has evolved through a variety of economic, financial and political contexts over the century preceding the global financial crisis of 2008 and it is necessary to have some understanding of this development in order to understand the changes emerging in the years since 2008. The First Great Financial Globalisation During the previous period of financial globalisation commencing in the final decades of the 19th century and ending with World War I, international financial law was comprised of two main elements. The first was private law relating to transactions, most often English contract law which is interestingly still the most important framework for international financial transactions

* Douglas W. Arner is Professor and Head of the Department of Law at the University of Hong Kong. The research underlying this chapter was supported by the Hong Kong Research Grants Council Theme-based Research Scheme Project, Enhancing Hong Kong’s Future as a Leading International Centre.

© koninklijke brill nv, leiden, 2015 | doi 10.1163/9789004280328_006

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today. The second was the gold standard, the dominant domestic and international monetary system until the establishment of the Bretton Woods system at the end of World War II. During that period, international institutional arrangements supporting economic and financial globalisation were essentially non-existent. In the political context, this was the period of great power struggles emanating from Europe. As in the political sphere, in the financial sphere international cooperation and coordination were largely a matter of occasional discussions among great power central bankers, particularly focused on efforts to maintain the gold standard and also to occasionally deal with cross-border financial crises, most often resulting from periodic sovereign defaults.1 In the context of the frequent financial crises of the time, resolution tended to focus on great power intervention into the economic (and sometimes political and/ or territorial) affairs of the country experiencing problems (and potentially causing losses to great power creditors).2 World War I signalled a break but not a fundamental change in character. In the aftermath of World War I, great powers worked to build a new international system to address political issues through the League of Nations.3 However, this framework largely ignored financial issues. At the same time, however, the first formal international institution to support finance was established: the Bank for International Settlements (BIS).4 The BIS had a twofold purpose: first and foremost to assist the flow of international payments (particularly reparations payments) among the great powers and second to support financial coordination, particularly in relation to cross-border financial crises and issues surrounding the international operation of the gold standard. We thus see in the period between the first and second World Wars the emergence of one of the major forums for international financial cooperation and one which continues to play a central role today.5 Despite these developments, the Great Depression and World War II finally ended the first great period of financial globalisation and signalled the end of the dominance of the European great powers in finance as well as politics. 1 See L. Ahamed, Lords of Finance: The Bankers who Broke the World (Penguin 2009). 2 See C. Kindleberger, A Financial History of Western Europe (Oxford University Press 1984). 3  See M. Mazower, Governing the World: The History of an Idea (Allen Lane 2012). 4  See www.bis.org. 5  See D. Arner, M. Panton & P. Lejot, “Central Banks and Central Bank Cooperation in the Global Financial System,” 23 Pacific McGeorge Global Business & Development Law Journal 1 (2010).

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Bretton Woods By the end of World War II, a new paradigm emerged in global financial law, formalised through the Bretton Woods system established in 1944. As at the end of World War I, the victorious powers sought to put in place a new framework for international political, economic and financial affairs.6 This framework centred on the United Nations (UN) and related institutions. Unlike the League of Nations, the UN was designed to have a central focus on economic and financial matters, formalised in the Economic and Social Council. Likewise unlike the League system, the new international order included two new treaty-based international institutions which formed the basis of a new public international financial law: the International Monetary Fund (IMF), and the International Bank for Reconstruction and Development (IBRD, World Bank). At the same time, the BIS was meant to be wound up but clearly this did not actually take place, primarily because it continued to prove a useful forum for discussion in Europe.7 Under the Bretton Woods system, international financial law was characterised by three main elements. In terms of international monetary arrangements, the gold standard was replaced by a US dollar standard, with the US dollar linked to gold and other currencies linked to the US dollar. Changes in fixed exchange rates took place via the IMF. Likewise, the IMF was the central mechanism to address monetary crises to the extent they existed – and they were far fewer during this period than in the previous or subsequent periods. In terms of international financial transactions, these were to be limited through capital controls, as were cross-border operations of financial institutions. At the same time, the World Bank was to support cross-border lending.8 In terms of the political context, the central change which then occurred was a fundamental shift from the previous dominance of the European great powers to the dominance of the United States and the US dollar. At the same time, finance was largely de-globalised albeit by formal international institutional arrangements. Neither of these characterisations was to continue for very long. In terms of de-globalisation of finance at the end of World War II, this began to unravel almost immediately. In fact, today’s second financial globalisation is 6 See D. Arner, Financial Stability, Economic Growth and the Role of Law (Cambridge University Press 2007). 7  See H. James, International Monetary Cooperation since Bretton Woods (Oxford University Press 1996). 8  J. Head, Losing the Global Development War: A Contemporary Critique of the IMF, the World Bank, and the WTO (Brill 2008).

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largely the result of ad hoc re-emergence of cross-border finance through the 1970s followed by an important change in policy to support globalisation of finance from the 1980s up to the 2008 crisis. Likewise, the political dominance of the United States was likewise almost immediately challenged by the Soviet Union and the Cold War. At the same time, particularly in the West, the US dollar and the IMF played central roles internationally until the unilateral decision by the US to end the link between the US dollar and gold in 1974, marking the end of the Bretton Woods period. Internationalisation of Finance and Financial Law It is this period of US dollar instability from the late 1960s that marks the emergence of new approaches to international financial law. In particular, the Group of Six (subsequently Seven and Eight) and the Basel Commit­tee on Banking Supervision (as it is now known)9 were established in this period as mechanisms for international financial cooperation and coordination, particularly in the context of increased cross-border financial activities and linkages. It is also in this period that important steps begin to be taken in the context of Europe towards greater monetary and financial cooperation, eventually resulting in the Single Currency and the Single Financial Market. Unlike the Bretton Woods period, international finance during the 1970s and 1980s was being allowed to internationalise at an increasing rate and fixed exchange rates were giving way to floating exchange rates, bringing new challenges to financial regulation. In this environment, once again, unlike in the Bretton Woods system, the approach was secretive and non-binding discussions and agreements among financial active nations, dominated by the US but extending to the full G7. This pattern of G7 dominance of international monetary and financial affairs would continue until 2008, as would the ever increasing interactions of domestic financial officials through an ever increasing variety of regulatory organisations (highlighted by Slaughter).10 The Washington Consensus By the mid-1980s, the dominant paradigm for international finance had changed to one supporting globalisation of finance, with a preeminent role for the US and the US dollar. At the same time, this period is characterised by 9

See http://www.bis.org/bcbs/index.htm?ql=1. For the development of the Basel Com­ mittee, see J. Norton, Devising International Bank Supervisory Standards (Kluwer 1995). 10  See A. Slaughter, A New World Order (Princeton University Press 2004).

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increasing frequency and severity of financial crises, albeit usually centred on developing / emerging market countries (1980s debt crisis, 1994 Mexican peso crisis, 1997 Asian financial crisis, 1998 Russian financial crisis).11 While the political context of US ideological and financial dominance did not change, the G7 did seek to build new arrangements to address the challenges of the second great financial globalisation, particularly in the wake of the 1997 Asian financial crisis. At the same time, Europe began to focus seriously on developing both a single financial market and a single currency – a reaction to the dominance of the US and US dollar but also an attempt to compete with the financial advantages of the US. The New International Financial Architecture In the wake of the Asian financial crisis, the G7 agreed to establish a new framework to support financial globalisation and financial stability. Under this framework, overall policy was coordinated through the G7 finance ministers and central bank governors, with key aspects disseminated through a new G20 (encompassing major emerging markets in addition to the G7/10), and soft law international financial regulatory standards developed by the main regulatory organisations (the Basel Committee, International Organisation of Securities Commissions (IOSCO),12 International Association of Insurance Supervisors (IAIS)13) and coordinated through a new Financial Stability Forum (FSF, now the Financial Stability Board (FSB)14). These standards were to be implemented by individual countries but with support and monitoring from the IMF and World Bank (particularly through the Financial Sector Assessment Program – FSAP). Likewise, Europe focused on ever deeper integration, particularly following the creation of the single currency.15 Thus, by the time of the 2008 global financial crisis, international financial law was largely a matter of soft law standards lead by G7 financial regulators combined with private law contracts (with English law once again dominant), with the US dollar and floating exchange rates dominant, although with rapidly increasing use of the Euro and interest in regional fixed exchange rate and single market arrangements. 11  See D. Arner, M. Yokoi-Arai & Z. Zhou (eds), Financial Crises in the 1990s: A Global Perspective (British Institute of International and Comparative Law 2001). 12 See www.iosco.org. 13  See www.iaisweb.org 14  See www.financialstabilityboard.org. 15  R. Weber & D. Arner, “Toward a New Design for International Financial Regulation,” 29 University of Pennsylvania Journal of International Law 391, 391–453 (2007).

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The Politics of International Financial Law in the Context of the Crisis By the initial stages of the global financial crisis in 2007, the international consensus relating to global finance can largely be summed up as a G7 (particularly US and UK) – led efficient markets paradigm supporting globalisation floating exchange rates and free movement of capital and financial services, with regulation seeking to address market failures and in particular to minimise transactions costs through expert-led soft law mechanisms. The rest of the world was viewed by the global financial elites as students in need of tutelage. In the early stages of the crisis, issues were seen largely in this context and to be limited to rather esoteric areas of US and UK finance. As the crisis moved into its acute phase during 2008, this consensus rapidly shifted, most specifically in the autumn of 2008 following the nationalisation of Fannie Mae and Freddie Mac, the collapse of Lehman Brothers and the bailout of AIG. During this period, it rapidly became clear beyond any doubt that, while emanating from complex transactions among large institutions previously thought to be sophisticated, the crisis in fact was spreading to all corners of the global financial system and directly impacting the global economy.16 However, by the end of the global financial crisis (in this author’s estimation, 2013), the context had once again began to change. The following sections consider the evolution of the political context in the main areas of the international financial architecture.17

Coordination and the G20

In November 2008, then US President George Bush signalled the most highprofile change in the political context of global finance with the first G20 heads of government summit in Washington DC. This was an important landmark in the evolution of the politics of global financial regulation. First, it expanded the core group of countries involved to include the major emerging markets in addition to the developed Western economies of the G7. Second, it brought finance and financial regulation out of its previous technocratic home with finance ministers, central bankers and financial regulators and placed it firmly 16

See D. Arner, “The Global Credit Crisis of 2008: Causes and Consequences,” 43 The International Lawyer 91 (2009). 17  This framework is based on R. Buckley & D. Arner, From Crisis to Crisis: The Global Financial System and Regulatory Failure (Kluwer 2011).

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in the context of the global political arena, with the direct involvement of all the leaders of major economies. In addition, since the advent of the G20 heads of government annual summit, other summits (in particular the G7/G8) largely fell into the shadows of the G20, becoming points to build consensus among the various groups concerned in preparation for each annual summit. During the period of the crisis (2008–2013), G20 summits tended to place very high emphasis on financial regulation and related arrangements such as the FSB, and in fact, these summits (particularly those of 2008–2011) achieved a tremendous amount of change in global financial regulation.18 This was largely the result of the continuing evolution of the crisis, first in the US and UK then the Eurozone with the Greek crisis, with periodic reinvigoration of efforts as a result of developments such as the emergence of scandals relating to manipulation of global interest rate and foreign exchange markets. At the same time, by the later stages of the crisis, as the sense of urgency waned, the G20 became less effective in developing consensus, though it remains the most important body in international financial cooperation and coordination. Monetary Affairs: The IMF, the Federal Reserve and the European Central Bank In the realm of monetary affairs, throughout the crisis, the IMF has played at most a supporting role. Moreover, even the annual World Bank-IMF meetings have largely become subsidiary to the annual G20 leaders summits. At the same time, the political environment in which the IMF operates has changed dramatically, with four frequently diverging groups most active: the US, Western Europe, other developed countries, and emerging markets. In the context of the crisis, the IMF quickly became a political focus, with major emerging market seeking to use the crisis and the rise of the G20 to support an increase in their influence in the organisation. However, IMF ownership and control is a zero sum game: if one group gains, others must lose. In this case, given that the US share is below the size of its economy (albeit bolstered by the fact that its stake is sufficient to block major decisions requiring an 85 per cent majority of votes), that the share of Western Europe in particular is larger than its relative economic weight and that the share of emerging markets was below their economic weight, the trade-off would have to be one 18  See D. Arner, “Adaptation and Resilience in Global Financial Regulation,” 89:5 North Carolina Law Review 1579, 1579–1626 (2011).

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in which Western Europe saw its influence reduced in order to allow an increase in influence of the major emerging markets. Despite the difficulties, an agreement was reached to adjust ownership and control via the G20 process. Unfortunately, four years following this agreement, the US Congress continues to block the changes required to the US contribution to the IMF in order to make this happen, showing that the US is increasingly focusing inward rather than outside – a major contraction to its role in the original Bretton Woods process and an issue discussed further below. In addition, the G20 also agreed that previous allocations of leadership roles in the IMF and other international organisations would be replaced by an open and transparent recruitment process. Despite this, since the agreement, while appointment processes have been made to look more transparent, leadership roles in the IMF, World Bank and ADB have all gone to EU, US, Japanese nationals, respectively, following previous practice. In terms of monetary affairs, the floating exchange rate paradigm continues. At the same time, however, there has been a major shift in consensus on capital controls, with a general acceptance in some circumstances, marking a major political change reflected in IMF policy. Further, somewhat surprisingly given increasing concerns regarding US debt levels, the dominance of the dollar has increased at the expense of the Euro, reflecting instabilities in the Eurozone.19

International Financial Regulation

In the context of international financial regulation, the crisis has not apparently triggered a major rethinking of the system. Just below the surface, however, important aspects of financial globalisation do appear to be changing. With the central focus of the G20 leaders on financial regulation, it is not surprising to see that there have been significant agreements in major areas, including capital and over-the-counter (OTC) derivatives, though major hurdles remain particularly in relation to resolution.20 Similar to the aftermath of the Asian financial crisis of 1997, there have also been changes to structure, with the creation of the Financial Stability Board (FSB) in place of the FSF. 19

See E. Prasad, The Dollar Trap: How the US Dollar Tightened its Grip on Global Finance (Princeton University Press 2014). 20  For a full analysis, see D. Arner, “Adaptation and Resilience in Global Financial Regulation,” 89:5 North Carolina Law Review 1579 (2011).

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Despite initial enthusiasm, the FSB seems to face many of the same limitations as the FSF, its predecessor.21 Outside of the EU, there continues to be very limited interest in moving from soft law to hard law approaches to international financial regulation. In addition to the FSB, the various international regulatory bodies such as the Basel Committee, IOSCO, and IAIS have all expanded their membership to include the full G20 and FSB membership. In this author’s view, this has been an important development. In particular, regulators from a number of non-G7 economies are now playing much larger roles in these organisations than before the crisis, suggesting there is greater scope for their participation in the G20 and FSB as well, in which they nonetheless continue to play largely passive roles. The area in which the most interesting developments are taking place at the moment relate to enforcement: how to make sure that soft law standards are implemented and enforced and how to address conflicts between G20/FSB members arising in the context of implementation.22 The highest profile example relates to OTC derivatives clearing and the application of the post-crisis financial regulatory reforms of the US Dodd-Frank Act provisions to activities and institutions outside the US. While initially US regulators largely ignored concerns from non-US regulators, when faced with significant coalitions of G20/FSB members, the US has been forced to take into account external considerations. This was most pronounced in discussions between the US and EU, with Asia-Pacific economies only being heard when they finally managed to come together as a group to express concerns. Going forward, this issue of dispute resolution among differing approaches to financial regulation is likely to continue to be one of the most challenging and also interesting intersections of politics and international financial regulation.23

The Politics of International Financial Law: Looking Forward

Looking forward, a number of trends are discernible in the politics of international financial law. 21  See D. Arner & M. Taylor, “The Global Credit Crisis and the Financial Stability Board: Hardening the Soft Law of International Financial Regulation?” 32 University of New South Wales Law Journal 488 (2009). 22 See Atlantic Council, The Danger of Divergence: Transatlantic Financial Reform and the G20 Agenda (Nov. 2013). 23  See Atlantic Council, The Danger of Divergence: Transatlantic Financial Regulatory Reform and the G20 Agenda (Dec. 2013).

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The Role of Regional Monetary and Financial Arrangements Prior to the global financial crisis, the single currency and single market project of the EU were seem as very appealing models for other regions to pursue, particularly as a means of both enhancing growth within the region concerned and also balancing against the financial weight of the US and EU.24 Regional currencies were frequently discussed and plans were being developed in a variety of other regions, including East and Southeast Asia. As a result of the Eurozone debt crisis of 2010, this is no longer the case: The crisis has very clearly demonstrated the risks and challenges in building a regional currency. It has also shown that such arrangements are not suitable in the context of most regions, particularly in light of the surrender of sovereignty necessary to make them work.25 At the same time, however, regional financial integration continues to be pursued in a number of regions. In this context, despite the crisis, the EU experience in building the single market should still prove extremely valuable in informing others in seeking to build the architecture necessary to support regional financial markets. While the EU’s passport structure and the concurrent need for centralisation of regulatory standards setting and in many cases enforcement and resolution may not be suitable in most cases, the EU experience of harmonisation of regulatory standards as a prerequisite to market access certainly is. This is the case not only in the regional context but in the international context, as regulators struggle with concepts of mutual recognition and regulatory equivalence. Further, the EU’s implementation of the de Laroisiere structure of European regulatory structures provides a potentially attractive model for hardening global financial regulation and particularly dealing with disputes between regulatory organisations. Financial Globalisation: Still the Paradigm? While there has been limited official interest in G20 / FSB circles for de-­ globalising the Bretton Woods-finance, there are increasing questions about whether or not domestic decisions are in fact moving in this direction as a matter of fact, if not of rhetoric. It is in fact surprising how little discussion there has been of changing the overall policy direction in this respect. Nonetheless, that has in fact been the case. 24  See D. Arner, P. Lejot & W. Wang, “Assessing East Asian Financial Cooperation and Integration,” 12 Singapore Yearbook of International Law 1 (2010). 25  See E. Avgouleas & D. Arner, “The Eurozone Debt Crisis and the European Banking Union: A Cautionary Tale of Failure and Reform,” University of Hong Kong Faculty of Law Research Paper No. 2013/037 (Oct. 2013).

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Regulatory approaches of the US, EU and UK are often cited in support of the proposition that de-globalisation is taking place. In the US, the adoption of the so-called Volcker Rule, requirements for domestically capitalised subsidiaries of foreign financial institutions operating in the US, and derivatives clearing and reporting requirements arguably seek to separate the US financial markets from pre-crisis global markets. Likewise, EU treatment of compensation and derivatives clearing may serve as evidence of the same as may UK changes to ring-fence banking activities from other financial activities. At the international level, while there has been agreement in large areas of the post-crisis financial regulatory response, divergence domestically in terms of detailed implementation is increasingly raising issues and conflicts between jurisdictions. Capital, leverage, liquidity, derivatives regulation, and accounting standards all fall into this category. Beyond these, certain jurisdictions have gone beyond international consensus in financial regulation in their domestic regulatory systems and these divergences are likewise raising issues and conflicts. The Volcker Rule, ring-fencing and compensation practices all fall into this category. At this point, it is probably too early to say whether or not these sorts of issues and conflicts herald a new world of a global financial system comprised of a series of bridged domestic / regional financial systems. On the one hand, such a structure may have benefits for financial stability – not the least in that it may be easier to understand. On the other hand, such a system may limit the allocation of capital across jurisdictions, thereby hindering economic growth and innovation. Regardless, however, this situation highlights the complexity of the politics of international financial law in the aftermath of the global financial crisis, with inter-linkages between domestic, regional and international approaches and potential conflicts and divergences at and across each level. This is particularly the case in the absence of a global leader in this area – a major change from the pre-crisis period in which the US and EU were largely able to lead the rest of the world towards eventual adoption of their approaches. With the leadership credentials of both the US and EU in the area of financial regulation decidedly weakened by the crisis, others have begun to take higher profile roles in standard setting, with Australia, Canada and Hong Kong being leading examples. At the same time, the major emerging markets have in most cases not yet shown any real interest in taking greater roles in setting the regulatory agenda. The situation in the area of monetary affairs however appears different. Regulatory Capture and the Role of the Financial Industry Prior to the global financial crisis, international financial regulation was almost a perfect picture of regulatory capture, with a close partnership between the financial industry and financial regulators leading to outcomes advantageous

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to the industry and eventually almost disastrous for the global financial system. The clearest examples can be seen in the development of the Basel II framework, particularly internal models approaches, and in the development of the OTC derivatives industry, with regulation largely being outsourced to the International Swaps and Derivatives Association (ISAD)26 in the pre-eminent example of the pre-crisis success of private ordering. During the crisis, not surprisingly, the reputation of the financial services industry collapsed, among the public, among politicians and among regulators. As a result, the close trusting relationship which had previously existed between regulators and politicians and the financial industry pre-crisis changed almost overnight. This was most pronounced in the industry-regulator relationship, with regulators in the context of the crisis viewing everything coming from the financial services industry as dissembling and self-serving. Very high levels of confidence, trust and reliance (particularly between the banking industry and banking regulators) were replaced by very high levels of mistrust, even suspicion. At each stage where the industry showed some sign of rebuilding influence, new issues would arise, with the LIBOR rigging scandal undoubtedly being the most damaging, particularly given the very heavy belief in the effectiveness of market developed mechanisms and the discovery of systematic manipulation. In general, this shift was an important one and one that is likely to be for the long-term benefit of financial stability and the global economy. Nonetheless, it does have the potential to go too far. Self-regulation has a very long history in finance and many benefits, not least in terms of resources and expertise. The key is to have a balanced relationship with the financial industry, neither overtrusting nor over-suspicious. In practice, this is difficult, and the change is a major shift in the politics of international financial law.

The Role of China

Perhaps the most significant change in the politics of international financial law compared with the period prior to 2008 is the emergence of China. While China’s re-emergence as one of the world’s major economies and major powers has not been sudden, the global financial crisis has seen its presence being felt much more greatly. Going forward, the role of China is likely to be one of the most important aspects of the global economy and financial system in the aftermath of the global financial crisis. 26  See www.isda.org

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The G20 and Global Economic and Financial Cooperation and Coordination In many ways, the most important aspect of the rise of the G20 to pre-eminence in global economic and financial cooperation and coordination is the inclusion of China. During the crisis, China became the world’s second largest eco­ nomy and also the world’s largest exporter – the result of decades of opening and reform. As a result, the role of China in the global economy is now a first order political as well as economic issue. At the same time, its role in financial and monetary matters remains below its economic weight – issues discussed in more detail below. In the context of the G20, China has so far taken a rather low profile, although it has been a major focus of attention in questions relating to global imbalances, exchange rates, and climate change. At the same time, China is an active participant in discussions, albeit more reactive than leading at present. Assuming China hosts the G20 in 2016 as has been proposed, this is likely to present a major opportunity for China to highlight issues on which it places the highest priority, in the same way that other chairs have done previously. In terms of its approach, like other members and other groupings (such as the G7 and EU), China seeks to build coalitions with other members. Unlike the G7 and EU, though, China has fewer historically close relationships. In the context of East Asia, the relationship with Japan is difficult and the relationship with the other Asia-Pacific members carefully balanced. Probably the highest profile forum to emerge is that of the BRICS (Brazil, Russia, India, China and South Africa) which now meets annually. Similar to relations in the Asia-Pacific, BRICS members are economically self-interested and politically wary of one another. Nonetheless, the BRICS forum does provide an opportunity for potential G20 coalition building outside the G7 and EU and has taken some notable steps, including a decision to establish a development bank.27 The relationship most prioritised by China however is that with the US. While China-EU relations were an important focus pre-crisis, the crisis has shown that the EU is mainly an economic partner for China and that political relations must focus on the individual major European states, particularly Germany.28 Thus, the China-US relationship has become even more significant for China. Nonetheless, US domestic politics have made this relationship 27  See A. Soto, “BRICS emerging nations close to launching bank; to start lending in 2016,” Reuters (30 May 2014) (http://in.reuters.com/article/2014/05/29/brics-bankingidINKBN0E92DI20140529). 28  This is in many ways similar to China’s relationship with the Association of Southeast Asian Nations (ASEAN): www.asean.org.

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particularly challenging, especially as the US in all likelihood turns increasingly inward. If US pre-eminence continues to wane, as China’s economic significance rises, it will need to take an ever higher profile role in order to secure and advance its own interests. As this occurs over the coming decades, this will be the most significant political change in the global economy since the emergence of the US as the world’s major power in the aftermath of the First World War. Financial Law and Regulation In the area of financial law and regulation, given that China still operates a largely closed financial system, it has so far taken a relatively low-key role. Instead, it has preferred to leave leadership in this area to other more open and financially developed G20/FSB members. Viewing itself very much as a developing country in the context of finance, China continues to feel that it has more to learn than to lead in this area. At the same time, the global financial crisis brought into stark question the desirability of Anglo-American financial models and has led to new questioning in China of the best approach to financial development going forward. One could say that in the aftermath of the global financial crisis, China no longer sees itself as a developing country looking to developed countries for guidance but rather an emerging market country, seeking solutions which will best suit its own developmental needs and objectives. China has thus gained confidence in this area. However, given the importance of its economy, China’s financial system is now globally systemically significant in a way which it has never been before. As a result, the approaches taken by China in respect of domestic financial regulation are now globally politically significant as well. At the same time, China has been very supportive of Hong Kong’s increasing stature and influence in global financial regulation. Hong Kong after all is part of China and China’s major international financial centre. It is also one of the jurisdictions which came through the global financial crisis with very few major problems.29 Hong Kong’s success is thus a matter of pride and also benefit for China. While Hong Kong has long played a leading role in IOSCO, with its inclusion in the Basel Committee, it is also playing an important role there too. Likewise, although Hong Kong is an original member of both the FSF and the FSB, it maintained a low profile in the context of the FSF, perhaps as a result of the Asian financial crisis. Following the global financial crisis, Hong Kong has taken a far higher profile role in the FSB and is now seen as one of the 29  See D. Arner, B. Hsu & A. Da Roza, “Financial Regulation in Hong Kong: Time for a Change,” 5 Asian Journal of Comparative Law 71 (2010).

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leading centres of expertise in international regulatory matters. Finally, while pre-crisis, Hong Kong (along with Singapore) was an important international financial centre, post-crisis with the continuing emergence of China, Hong Kong is now seen as one of the world’s leading international financial centres – and a major concern when G7/EU regulators consider regulatory approaches, as Hong Kong (as well as Singapore) now are true competitors with New York, London, Frankfurt and Tokyo. International Investment and Finance The global financial crisis arguably has forced China to come to terms with the need to restructure its economic model away from overreliance on exporting to the US and EU. This has taken a number of forms, first focusing on diversifying exports to other markets, particularly Asia and emerging markets and developing countries around the world. Today, for almost every country in the world, China is one of the top trading partners (import and export). Second, the focus is on restructuring the domestic economy towards greater consumption and also increased innovation (moving up the value chain). Third is the focus on reducing the role of domestic investment in driving the economy. In order to balance exports and to deploy savings outside the country, China is focusing on increasing outgoing investment (a policy of “going out” which applies to exporters, to companies and to finance). The “going out” policy is rapidly changing China into a major investor and exporter of capital to the rest of the world. As one aspect, China and Germany now trade places frequently as the countries with the greatest number of international investment treaties. This “going out” policy over time will have very important implications for the role of China in the global economy and financial system, as it moves towards the role of major international investor and creditor. As this takes place, not only its companies but its financial institutions and eventually its currency will find themselves in ever more places and contexts around the world. China, as with previous major power creditor nations, will need to adjust its approach to international political and economic relations in order to protect its interests overseas. International Monetary Affairs As the global financial crisis highlighted to China the dangers of overreliance on G7/EU markets for export and finance, the global financial crisis has also highlighted the dangers of overreliance on G7/EU currencies. This has driven the decision to increase the use of China’s currency, the yuan. Importantly, this at present is not a drive to replace the dollar as the world’s major currency. Rather, it is a drive to increase the use of the yuan in order to better support

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and protect China’s interests, in much the same way as the euro was developed and has evolved into a (but not “the”) major international currency. This decision has also certainly been reinforced by the failure of IMF reforms to date to rebalance power in that institution and by the difficulties of regional currency arrangements demonstrated by the Eurozone debt crisis. What would this take and is it reasonable? In terms of increasing the use of the yuan, this is clearly already taking place, albeit from a very low level. The first stage relates to confidence of others outside (and also inside) China in using the currency: Is the currency an effective store of value? Is it useful for making cross-border payments? In respect of effectiveness as a store of value, the yuan has remained stable through both the Asian and the global financial crises, increasing confidence and trust among potential users. In respect of payments, as China is now the largest or at least one of the largest bilateral trading partners of every economy in the world, the currency is clearly useful for making payments both in receipt for exports and for imports. China since the 1990s has maintained an open current account, albeit with limitations. As a way around these, there are now payment systems for offshore yuan transactions in an increasing number of major centres, beginning with Hong Kong, followed by Singapore, Taiwan, the UK and Australia, with more to follow, each supported by central bank swaps lines between the Chinese central bank (the People’s Bank of China) and partner jurisdiction central banks. The confidence, rationale and infrastructure for use of the currency for trade now all exist, with use increasing rapidly. Second, there must be mechanisms to manage the yuan in between transactions, namely deposit accounts. As is the case with payments, yuan deposit services are now widely available and the pool of offshore yuan deposits in jurisdictions such as Hong Kong, Singapore, Taiwan, Australia and the UK continues to increase. The corollary of deposits are loans, and likewise, loan markets (both for trade finance and also term and syndicated lending) are increasing, not unlike the early stages of the Euromarkets in the late 1950s and early 1960s. Third, as cash balances increase, there are requirements for investments, particularly to support international treasury operations of corporations and financial institutions. In addition to deposits and loans, offshore yuan bonds are now widely available from an ever-increasing range of issues, once again not unlike the development of the Euromarkets in the mid 1960s and early 1970s. Fourth, as financial activities increase, risk management tools become necessary. In this respect, yuan swaps are being increasingly used to manage risks – an important intersection between a key element of the G20/FSB post-crisis regulatory agenda and the internationalisation of the yuan.

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Thus, one can say that the main elements are in place for increasing the internationalisation of the yuan and that its use is in fact increasing in all these aspects rapidly. At the same time, one aspect which is widely seen as essential is not yet in place: full convertibility on the capital account. In my view, this is not strictly essential (many major currencies have experienced significant periods of capital controls and still been widely used, for exactly the reasons highlight in the preceding analysis). However, for the yuan to join the dollar and euro as major international currencies, for instance with the euro and yuan taking up approximately similar shares of transactions and with the dollar still the leading international currency, convertibility is probably essential. This poses a challenge for China. On the one hand, China is in the process of increasing convertibility and probably intends to have the currency largely convertible within five years. At the same time, China is likely to continue to maintain certain capital controls. However, as noted above, the global consensus now accepts a range of capital controls as useful (a major change from the Washington consensus period), and the end result is likely to be sufficient to see the yuan emerge as a major international currency, not replacing the dollar but rather joining the euro as the second tier.

Looking Forward

Looking back, the global financial crisis has had significant impact on the politics of global financial law but at least at present has not resulted in fundamental change to global finance. At the same time, looking forward, the global financial crisis has served as an important milestone in the rise of China in the context of global financial law. Going forward, the changes this rise will bring are likely to be ever greater, with China taking an ever more influential role in all aspects of international economic governance and international economic law, including international financial law. In the context of trade, China prior to the global financial crisis largely focused its efforts on multilateral arrangements through the WTO. However, the global financial crisis has highlighted the need for greater diversification for China in respect of trading relationships and legal arrangements. This has accelerated as China has begun to perceive the US as looking to develop arrangements which exclude China (such as the Trans-Pacific Partnership [TPP]). The most recent example of China’s emerging strategy to take a more leading role is the proposal to commence discussions on an Asia-Pacific Free Trade Agreement through APEC. In the context of development, China already provides a larger volume of lending to developing countries than the World Bank, a result of a perception that the existing

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framework did not appropriately serve its interests. In this respect, China is now pursuing a formal policy of supporting the creation of multilateral development banks such as the BRICS development bank mentioned above. In the context of investment, China is now looking to multilateralise discussions on international arrangements, to build on its own approach already embedded in bilateral trade and investment agreements. In the context of monetary affairs, the drive to internationalise the yuan is very much a reaction to the dominance of the US dollar. Finally, in the context of finance, Hong Kong has now emerged as one of the world’s leading financial centres and China very much has similar ambitions for Shanghai. As a result, as China expands as a financial power, it will likewise seek to strengthen its influence in international arrangements such as the FSB, and if not successful, to develop alternatives, an outcome which this author would perceive as to the detriment of global financial stability and economic development.

chapter 6

The Changing Landscape of European Financial Supervision from an Institutional Perspective Alfred Schramm* 1 Introduction Until 2008 it seemed supervision of financial markets – then undeniably a competency of the member states (MS) of the European Union (EU) – would remain subject to national administrations. Specialists only discussed involvement of the EU in the effective day-to-day supervision of financial markets as a possible concept for the future improvement of the supervisory architecture in the EU.1 Against the background of increased unification of supervisory law through EU legislation and in particular the so-called Lamfalussy2 regime which had been implemented at the EU level in 2003, any change in the institutional and administrative setup of financial supervision was at first considered a predominantly European task. Consequently, EU financial market legislation primarily channelled financial supervision legislation of MS towards common European standards while the Lamfalussy framework contributed to the coordination and implementation of common financial supervisory standards among MS.3

* Alfred Schramm is Lecturer at Danube University Krems in Austria and expert in international affairs with the Financial Market Authority (FMA) in Austria. The views expressed here are solely those of the author and do not express the views of the FMA. 1 See among others, Kammel, A Proposal for the Governance of Financial Regulation and Supervision in Europe, Vierteljahresschrift zur Wirtschaftsforschung 74 (2006), 167. 2 See for further details regarding the Lamfalussy framework Committee of Wise Men on the Regulation of European Securities Markets, Final Report (2001), available at: http:// ec.europa.eu/finance/securities/docs/lamfalussy/wisemen/final-report-wise-men_en .pdf. 3  Regarding the shortcomings of this environment, see The High Level Group on Financial Supervision in the EU, chaired by Jacques de Larosière, Report (2009) 27, available at http://ec.europa.eu/internal_market/finances/docs/de_larosiere_report_en.pdf.

© koninklijke brill nv, leiden, 2015 | doi 10.1163/9789004280328_007

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The global financial crisis considerably changed this situation.4 As a consequence of the De Larosière Report5 2009 the EU realized that it would not only have to improve its capacity to create and coordinate necessary legislation on financial supervision, but also that it would need to play an improved and stronger role in the institutional setup of such a framework. Thus, in 2011 three European Supervisory Authorities (ESAs) were established: the European Banking Authority (EBA), the European Securities and Markets Authority (ESMA) and the European Insurance and Occupational Pensions Authority (EIOPA). These were entrusted with limited but specific supervisory powers at the EU-level within the framework of the European System of Financial Super­ vision (ESFS). Their predecessors, the former Level 3 Committees – the Com­ mittee of European Banking Supervisors (CEBS), the Committee of Euro­pean Insurance and Occupational Pensions Supervisory (CEIOPS) and the Commit­ tee of European Securities Regulators (CESR) – only had a coordinating role. The ESAs are involved in the making of legally binding secondary supervisory legislation (i.e., Regulatory Technical Standards (RTS) and Implementing Technical Standards (ITS)6 which have to be endorsed by the European Com­ mission). They also adopt guidelines and issue guiding interpretations. In all but three limited cases, they are also entrusted with the making of administrative supervisory decisions, which are binding on the MS or the respective financial institutions in the specific cases of breaches of EU law, disagreements between MS and in emergency situations. These arrangements underscore the evolutionary changes in the landscape of European financial supervision from integration through legal instruments to integration based on legal instruments and institutional arrangements. Given these developments, this chapter has three parts. It deals firstly with the reasoning that led to the establishment of the current ESFS and ESAs based on the De Larosière Report (the “Report”). The second part provides a detailed 4 See in this respect, among others, Kammel, Eine Konsequenz der Finanzkrise: die neuen ESAs, Aufsichtsrat aktuell 3/2011 or official documents such as European Commission, Public Consultation ESFS Review, Background Document, available at http://ec.europa.eu/internal _market/consultations/2013/esfs/docs/background-document_en.pdf or European Parliament, Review of the new System of Financial Supervision (ESFS), Part 1: The Work of the European Supervisory Authorites (EBA, EIOPA, and ESMA) STUDY (2013) 11 and 13, available at www.europarl.europa.eu/RegData/etudes/etudes/join/2013/507446/IPOL-ECON _ET(2013)507446_EN.pdf. 5  See The High Level Group on Financial Supervision in the EU, chaired by Jacques de Larosière, Report (2009), available at http://ec.europa.eu/internal_market/finances/docs/de_larosiere _report_en.pdf. 6  These legal instruments will be explained in Part 3.2.of this chapter.

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description of the institutional setup of the ESAs and the third an overview of the most important competencies of the ESAs. Concluding remarks focus on a study of the European Parliament on the institutional setup of the ESFS. 2

De Larosière Report and Its Aftermath

While supervision of financial markets through a European supervisory architecture is still evolving, financial supervisory law is one of the most harmonized parts of EU legislation. With the introduction of Lamfalussy’s four-level-approach in 2003, the EU began to establish a more effective way of coordinating various levels of financial legislation.7 According to this approach, a so-called framework regulation (of the European Parliament and the Council of the European Union) will at first be enacted leaving room for implementation by more detailed secondary legislation by the Commission (first level). The Commission then adopts more detailed technical implementing measures in cooperation with four specialist Committees8 (second level). The technical development of these implementing measures by the Commission is carried out with the advice of committees of experts, the so-called Level 3 Committees9 (third level). Finally, the Commission – in close cooperation with the MS – checks whether EU-legislation is appropriately applied in the MS (fourth level). However, this type of cooperation proved insufficient, not strong enough in support of national supervisors to enable them effectively to react to the financial crisis.10 7

For a description of the Committees within the Lamfalussy process see Ferran, Under­ standing the Institutional Architecture of EU Financial Market Supervision in Wymeersch, Hopt, Ferrarini [Eds] Financial Regulation and Supervision. A Post-Crisis Analysis (2012). 8 These are the European Banking Committee (EBC), the European Securities Committee (ESC), the European Insurance and Occupational Pensions Committee (EIOPC) and the Financial Conglomerates Committee (FCC). These Committees are composed of highranking representatives from the MS. 9  They are CEBS, CEIOPS and CESR. The Committees were composed of experts, which were representatives of the respective NCAs. 10 The de Larosière Report states that the Lamfalussy framework was ill-equipped which explains the institutions’ inability to take urgent decisions. See De Larosière Report, 39–42. Literature has been critical in this respect as well. Examples are Kammel, Eine Konsequenz der Finanzkrise: die neuen ESAs, Aufsichtsrat aktuell 3/2011, 3; Karpf, Lamfalussy-Verfahren – Quo vadis? ZFR 2008, 35f; Kalss, Lamfalussy – Segen oder Fluch für den Kapitalnarkt? ÖBA 2007, 419; Schädle, Exekutive Normsetzung in der Finanzmarktaufsicht (2006) 120 et seq; Schramm, Bankenaufsicht durch die Europäische Union? in Jabloner/Lucius/ Schramm, Theorie und Praxis des Wirtschaftsrechts, Festschrift für H. René Laurer (2009)

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In November 2008 the Commission mandated a High-Level Group chaired by Jacques de Larosière to make recommendations on how to strengthen European supervisory arrangements with a view to better protecting the citizens and to rebuilding trust in the financial system. This report firstly listed the many deficiencies of the supervisory system: • In the pre-crisis era of European financial legislation, special emphasis was given to micro-prudential supervision.11 However, macro-prudential supervision was not sufficiently observed in the EU.12 In an increasingly internationalized market, as the Report outlined, the system of home state control, relying solely on national supervision, was becoming increasingly ineffective.13 • National supervisors were not sufficiently coordinated in order to enable swift coordinated action in certain cross-border crisis situations.14 Further­ more, the crisis has shown that the current system of cooperation between national authorities whose jurisdictional powers are limited to individual MS was insufficient as regards financial institutions that operate across borders. Since host supervisors were more or less compelled to accept the action or non-action of the home supervisor, early and coordinated reaction to crisis situations on either side was not possible. The crisis exposed shortcomings in the areas of cooperation, coordination, consistent application of Union law and trust between national supervisors.15 439; Commission of the European Communities, COM (2007)727 final, Communication of the Commission, Review of the Lamfalussy Process. Strengthening supervisory convergence; Raptis, European Financial Regulation: ESMA and the Lamfalussy Process, the Renewed European Legislative Process in the Field of Securities Regulation, Columbia Journal of European Law Online (2012) 62, available at www.cjel.net/wp-content/uploads/ 2012/09/Raptis_61-68.pdf; Chaher, Is Lamfalussy Falling from the Third Floor (Level)? (2005), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=966705. 11  Typical for this legislation is the distinction between nearly omnipotent home-supervisors and the respective host supervisors which only display very limited supervisory functions. Also the (Single) European Passport for financial institutions was a typical enactment of this era. 12  See de Larosière Report, 39 et seq. 13 See European Parliament, Review of the new System of Financial Supervision (ESFS), Part 1: The Work of the European Supervisory Authorites (EBA, EIOPA, and ESMA) STUDY (2013) 11 and 13 available at www.europarl.europa.eu/RegData/etudes/etudes/join/2013/ 507446/IPOL-ECON_ET(2013)507446_EN.pdf. 14 See Commission of the European Communities (2009), European Financial Supervision Impact Assessment, available at http://ec.europa.eu/internal_market/finances/docs/ committees/supervision/communication_may2009/impact_assessment_fulltext-en.pdf. See also De Larosière Report, 27 et seq. 15  See de Larosière Report, 40.

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• The way EU legislation was applied in MS was far from coherent.16 The Report made out several spheres of legislation where sanctions and administration were incoherent among the MS the sanctioning regimes in particular being both weak and heterogeneous.17 • The powers of the Level 3 Committees CEIOPS, CESR and CEBS under the Lamfalussy regime were limited by procedures based on consensus. They were neither invested with the power to take decisions binding on national authorities or individual financial institutions, nor were they entrusted with any powers to adopt or to contribute to the adoption of any other kind of binding legal norms. The result of the work of those Committees was non-binding interpretations, standards and recommendations concerning EU financial legislation. • As the Commission stated in 2009,18 whilst the Lamfalussy process has since 2001 contributed to a closer co-operation between national supervisors, the EU was still in a situation where the supervision of the EU markets and financial groups was fragmented and exercised at the national level, both with respect to prudential and conduct of business supervision.19 As a result, the Report recommended the following changes: • A fundamental amendment of the Basel 2 rules was needed.20 According to the Report the crisis had shown that there should be more capital and more high-level capital. The goal should be to increase minimum capital requirements gradually. Moreover, the Report identified strong pro-cyclical effects of Basel 2 and, inter alia, changes in the regulatory framework with a view to reduce pro-cyclicality by (e.g.) encouraging dynamic capital provisioning or capital buffers. • CESR should be in charge of the supervision of credit rating agencies (CRAs). Because of their pivotal and quasi-regulatory role in the financial markets, the Report points out as especially important that the CRAs should be regulated effectively to ensure that their ratings are independent, objective and of high quality. Since the allocation of work between home and host authorities was likely to lack effectiveness and efficiency, the Report recommended 16  So de Larosière Report, 28. 17  See de Larosière Report, 23. 18  See Commission of the European Communities (2009), European Financial Supervision Impact Assessment, available at http://ec.europa.eu/internal_market/finances/docs/ committees/supervision/communication_may2009/impact_assessment_fulltext-en.pdf. 19 See de Larosière Report, 27. 20  See de Larosière Report, 19.

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that a strengthened CESR should be in charge of registering and supervising the CRAs.21 The Report recommended that the supervisory framework be strengthened to reduce the risk and severity of future financial crises as well as reforms to the structure of supervision of the financial sector in the Union. The group also concluded that a European System of Financial Supervisors should be created, comprising three European Supervisory Authorities – one for the banking sector, one for the securities sector and one for the insurance and occupational pensions sector – and recommended the creation of a Euro­ pean Systemic Risk Council.22 A macro-prudential Risk Board should be installed at the Union level, mandated to analyse macroeconomic trends and to publish recommendations and warnings.23 The Report also recommended that financial legislation should be more effectively coordinated between European and national legislators. The supervisory and sanctioning regime in MS should be sound and have sufficient powers to sanction non-compliance of the financial institutions with applicable rules.24 A European System of Financial Supervision should be set up, in which general supervisory power and the day-to-day supervision would remain the competence of MS. At the EU level, the existing Level 3 Committees should be transformed into supervisory authorities. These should be equipped with certain but limited powers in respect of the drafting of secondary legislation, adopting guidelines and recommendations. Furthermore, in a limited number of situations – such as the already mentioned cases of breach of Union law, differences among national supervisors and emergency situations – they should also possess the power to adopt directly applicable decisions addressed to the MS and to financial institutions.25

The Report was completed by a roadmap26 depicting how this system of European Supervision should be set up in the years 2009 to 2012.27 Three years 21  So de Larosière Report, 20. 22  See in more details de Larosière Report, 43 et seq. 23  See in details de Larosière Report, 46, Recommendations 16 and 17. 24  See de Larosière Report, 23. 25  So in details de Larosière Report, 47 and 48, Recommendation 18. 26 de Larosière Report, 48 et seq. 27  For further details see de Larosière Report, 78 et seq, showing where the listed supervisory competencies should be allocated between national supervisors and EU authorities.

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after its implementation the ESFS, according to the Report, should be placed under a review. Depending on the result of this review, the ESAs could end up being integrated into two ESAs, by a merger of banking and insurance supervision into one authority while leaving the securities and markets supervision untouched. The European Commission in 2009 relied on this Report to draft its legislative proposals for the installation of the European Systematic Risk Board (ESRB) and the European System of Financial Supervisors (ESFS) which was composed of the ESAs, the Joint Committee and the National Competent Authorities (NCAs) and were required to act together in this new system. Following a Commission Communication in May 200928 announcing major changes in the European financial supervision architecture, the legislative proposals for ESRB and ESFS were published in September 2009.29 The new regulations were enacted in 2010.30 Since 1 January 2011 a two-fold system, combining macro-prudential supervision and micro-prudential supervision is established: • At the level of macro-prudential supervision, the ESRB was installed, which is responsible for identifying and assessing potential threats to financial stability arising from macro-economic developments and from developments within the financial system as a whole. The Risk Board has simple advisory 28  See European Commission, Communication on European Financial Supervision, COM (2009) 252. 29 In more details, see Proposal COM (2009) 499 regarding the ESRB, Proposal COM (2009) 501 regarding EBA, Proposal COM (2009) 502 regarding EIOPA and Proposal COM (2009) 503 regarding ESMA. 30 The legal framework of the ESAs consists of EBA – Regulation (EU) No 1093/2010 of the European Parliament and the Council of 24 November 2010 establishing a European Supervisory Authority (European Banking Authority), amending Decision No 716/2009/EC and repealing Commission Decision 2009/78/EC (OJ EU, L 331/12); ESMA – Regulation (EU) No 1095/2010 of the European Parliament and the Council of 24 November 2010 establishing a European Supervisory Authority (European Securities and Markets Authority), amending Decision No 716/2009/EC and repealing Commission Decision 2009/78/EC (OJ EU, L 331/84); EIOPA – Regulation (EU) No 1094/2010 of the European Parliament and the Council of 24 November 2010 establishing a European Supervisory Authority (European Insurance Authority), amending Decision No 716/2009/EC and repealing Commission Decision 2009/78/EC (OJ EU, L 331/48); Regulation (EU) No 1092/2010 of the European Parliament and the Council of 24 November 2010 on European Union macro-prudential oversight of the financial system and establishing a European Supervisory Risk Board (OJ EU, L 331/1).

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competencies and may publish information in the form of warnings and recommendations.31 • At the level of micro-prudential supervision, the ESFS is established as a network, composed of NCAs – which retain their power in the day-to-day financial supervision –and the ESAs. This network is aimed at safeguarding the financial soundness at the level of individual financial institutions. According to the Report – which recommended that the ESFS should be independent from political influence, but accountable32 – the new European supervisory competencies were bundled together in three special authorities. Although labelled “authorities,” the EU adopted the ESAs on the basis of the (by then) already well-established agency-model as decentralised agencies and independent legal entities under European public law, to be distinguished from EU institutions.33 By 2009 it was reasonable to assume that the EU – backed by a new decision of the European Court of Justice (ECJ) – would base the legislative act establishing the agencies (authorities) on Art 95 TEC (now Art 114 TFEU).34 Until the so-called ENISA decision, the delegation of powers from one of the explicitly enumerated organs of the Union to an agency needed to be founded on one or more of the common market freedoms. Art 114 TFEU by contrast is – according to its clear wording – the EU-level competence for the unification of incoherent national legislation for common market purposes. In ENISA the ECJ accepted for the first time that the establishment of an agency, which had only consultative powers, was based on Art 114 TFEU. It held that nothing in the wording of Article 95 EC [Art 114 TFEU] implies that the addressees of the measures adopted by the Community legislature on the basis of that provision can only be the individual Member States. The legislature may deem it necessary to provide for the establishment of a Community body responsible for contributing to the implementation of a process of harmonisation in situations where, in order to facilitate the uniform implementation and application of acts based on that provision, the adoption of non-binding supporting and framework measures seems appropriate.35 31

In this respect see the website of the ESRB at www.esrb.europa.eu/about/tasks/html/ index.en.html. 32  See in details de Larosière Report, 48, Recommendation 18. 33  So European Parliament, Review of the New European System of Financial Supervision (ESFS) Study (2013) 21. 34 See already Schramm, Bankenaufsicht durch die Europäische Union? in Jabloner/Lucius/ Schramm [Eds.] Theorie und Praxis des Wirtschaftsrechts. Festschrift für H. René Laurer (2009) 435. 35  Case C-217/04, United Kingdom/European Parliament and Council, ECR 2006, I-03771, para 44.

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This leads to the conclusion that in case the power to adopt legally non-binding legislative decisions or guidance is transferred to an agency, Art 114 TFEU may be used as legal basis. In the case of the ESAs, the Commission also based the transfer of regulatory and supervisory power – including the power of the ESAs to enact legally binding administrative acts (Art 17 to 19 ESA Regulations) – on Art 114 TFEU. Therefore the Commission in the legislative proposal for establishing the ESAs, after quoting the above ENISA decision, added the following: The purpose and tasks of the ESAs – assisting competent national supervisory authorities in the consistent interpretation and application of Union rules and contributing to financial stability necessary for financial integration – are closely linked to the objectives of the Union acquis concerning the internal market for financial services. The Authority should therefore be established on the basis of Article 114 TFEU.36 It may be accepted as settled that the competencies of the Union to set up authorities, even if they have the power to enact directly applicable individual decisions, were correctly applied, since the “legislative” powers of the ESAs are limited to mere drafting, while the endorsement of secondary legislative acts (ITS and RTS) remains a competence of the Commission. A second issue repeatedly discussed in the event of powers being delegated to agencies is the so-called Meroni doctrine,37 mandating that such transfer may only take place if four preconditions are met: (i) there must be a clear legislative act saying exactly what kind of powers are delegated to the agency, (ii) the Union must retain comprehensive control over the agency, (iii) there must be the right to appeal against binding decisions of the agency, and (iv) the agency must not be invested with political (legislative) discretionary power.38 In short, the essential prerequisites of the doctrine are met in the case of the ESAs: the ESAs are implemented by legal acts exactly depicting their powers, their decisions (especially those directed to individual financial institutions) can be appealed according to Art 60 and 61 ESA Regulations, the Union can revoke the delegation at any time allowing to enact ITS and RTS and the Union must conduct a periodical review of their work.39 36  Cited from Regulation (EU) 1093/2010, Recital 17. 37  Case C-5/56, Meroni, ECR 1958, 133. 38 So Schramm, Bankenaufsicht durch die Europäische Union? in Jabloner/Lucius/Schramm, Theorie und Praxis des Wirtschaftsrechts (2009) 452. 39  See also for a different but in its effect equivalent analysis Ottow, The European Supervision of the Financial Markets, the Europe Institute of Utrecht, Working Paper No 2/2011, 7.

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ESAs: Tasks, Institutional Setup and Powers

ESAs are, in comparison to the Level 3 Committees, invested with legal personality. They have the same place of business as their respective predecessors: EIOPA is settled in Frankfurt, ESMA in Paris and EBA in London. In order to foster cooperation and coordination among the ESAs a Joint Committee has been established. Its responsibilities include the supervision of financial conglomerates, accounting, micro-prudential analysis, combating money laundering as well as information exchange with the ESRB. In order to guarantee their full autonomy and independence, ESAs have autonomous budgets mainly made up of revenues derived from obligatory contributions from national super­ visory authorities as well as from the general budget of the EU. Thus, ESAs, at least at the beginning, are financed from Union funds (40%) and through contributions from MS (60%), their accounts being audited by the Court of Auditors. According to Art 3 ESA Regulations, the ESAs are accountable to the European Parliament and the Council. In order to properly execute their supervisory and coordinating powers, ESAs retain extensive information gathering rights. According to Art 35 ESA Regulations, ESAs may request all necessary information. The national authorities are obliged to disclose any information needed by the ESAs for the purpose of carrying out their tasks. In addition and as a last resort, ESAs can address a duly justified and reasoned request for information directly to the respective financial institution if a NCA does not or cannot provide such information in a timely manner. Moreover, MS authorities are obliged to assist ESAs in enforcing such direct requests. Consequently, a regime of confidentiality and professional secrecy has been put in place. The confidentiality of information made available to the ESAs and exchanged in the network of ESFS is subject to stringent and effective confidentiality rules. According to Art 70 ESA Regulation, all members working for ESAs are bound by the obligation of professional secrecy. Beginning in January 2014, the results of general reviews of the ESA framework will be continuously published by the European Commission.40 3.1 The ESAs: Institutional Setup Since all the three ESAs are constructed in the same manner, their respective organs can readily be described. Each ESA has the following main 40

See Art 81 ESA Regulations. Moreover, it is worth seeing the remarks of the European Commission on the review of the ESFS, available at http://ec.europa.eu/finance/generalpolicy/committees/index_en.htm#maincontentSec2.

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decision-making bodies: the Board of Supervisors, the Management Board, the Chairperson and the Executive Director. Moreover, a Stakeholder Group is attached as an advisory body, which must be consulted in specific enumerated cases. Decisions of ESAs are subject to appeal to the Board of Appeal and ultimately to the ECJ. The Board of Supervisors The Board of Supervisors (BoS) is the main decision-making body of an ESA. Its main role is to take all relevant policy decisions, such as adopting draft technical standards, guidelines, opinions, providing advice, drafting the annual work programme and various reports. The BoS also nominates the Chairperson and the Management Board and takes the final decision regarding the ESA budget. The BoS is comprised of the Chairperson and representatives of 28 NCAs – which are all voting members, where applicable – accompanied by a representative of the national central bank. Membership of the BoS also includes observers from the European Commission, the ESRB, the European Central Bank (ECB), and the other two ESAs, all non-voting members. According to Art 43 of the ESA Regulations, the Chairperson and the voting members of the BoS shall act independently and objectively in the sole interest of the Union as a whole and shall neither seek nor take instructions from EU institutions or bodies from any government of a MS or from any other public or private body, when carrying out the tasks conferred upon it by the ESA Regulations. In addition, no MS, EU institutions or bodies or any other public or private body shall seek to influence the members of the BoS when performing their tasks. In general, the BoS takes its decisions by simple majority based on the principle of one member, one vote (Art 44 ESA Regulation). For acts of a general nature, including those relating to RTS and ITS, guidelines and recommendations, for budgetary matters as well as in respect of requests by a MS to reconsider a decision by an ESA to temporarily prohibit or restrict certain financial activities, the rules of qualified majority voting apply. The quorum for qualified majority voting resembles the quorum of the European Council when deciding in the legislative process.41 The various working groups installed by ESAs report directly to the BoS, which then takes decisions regarding their work and other preparatory papers

41  See Articles 16 (4) TEU, 238(2) TFEU and 3 (1) Protocol Nr.36 on Transitional Provisions.

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for BoS meetings, which are held at least five times per calendar year. Further­ more, the majority of decisions are taken by using a written procedure, where the same quorum has to be met as in voting. The Management Board The Management Board is composed of the ESA Chairperson and of six representatives of NCAs, drawn from the BoS and of the European Commission.42 Its role is to ensure that the relevant ESA carries out its mission and performs the tasks assigned to it in accordance with the ESA Regulations.43 The Management Board has the power, inter alia, to propose the annual and multiannual work programme, to exercise certain budgetary powers, to adopt the ESA staff policy plan, to adopt special provisions on the right to access to documents and to propose the annual report. The Management Board takes its decisions with simple majority.44 As with respect to BoS, its members are bound to act independently and in the sole interest of the Union (Art 46 ESA Regulation). The Chairperson The Chairperson45 represents the respective ESA and is responsible for the preparation of the tasks performed by the BoS. The Chairperson also has the duty to chair the meetings of the BoS as well as those of the Management Board. The term of office for the chairperson is five years; re-appointment is possible. The full-time Chairperson is appointed by the BoS based on merit, skills, knowledge of financial institutions and markets, and of experience relevant to financial supervision and regulation, following an open selection procedure organised and managed by the BoS assisted by the Commission. Before taking up its duties and within one month of selection by the BoS, the European Parliament is entitled, after a hearing with the selected candidate, to object to the appointment. Again, the Chairperson, like members of the BoS and of the Management Board, is mandated to act independently (Art 49 ESA Regulations). The Executive Director According to Art 52 ESA Regulations, the Executive Director is a full-time independent professional in charge of the day-to-day management of the respective ESA and prepares the work of the Management Board. In this respect, the 42 43  44  45 

See Art 45 ESA Regulations. See Art 47 ESA Regulations. See Art 47 (2) ESA Regulations. See Art 48 ESA Regulations.

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Executive Director is responsible for implementing the respective ESA’s annual work programme under the guidance of the BoS and under the control of the Management Board. Moreover, the Executive Director is responsible for preparing the internal administrative instructions, for drafting and implementing the budget and for the annual reporting to the Commission and to the European Parliament, as well as the management of the human resources of the ESA concerned. The Executive Director is nominated by the BoS for a five-year-term. The Executive Director has the right to participate in meetings of both the BoS and the Management Board without a vote. The Stakeholder Group Each ESA also comprises of a so-called Stakeholder Group. Its 30 members46 represent, based on balanced proportionality, financial institutions operating in the EU, employees’ representatives as well as consumers, users of financial services and representatives of SMEs. The Stakeholder Group’s role is to help facilitate consultations with stakeholders in areas relevant to the tasks of the respective ESA. The Stakeholder Group does not possess decision-making power but must be consulted on certain ESA decisions. It shall be consulted on actions concerning RTS and ITS as well as on guidelines and recommendations, to the extent that these do not concern individual financial institutions. The Stakeholder Group may also submit opinions and advice to the respective ESA on any issue related to its responsibilities with particular focus on common supervisory culture, peer reviews of competent authorities and the assessment of market developments. The Stakeholder Group can also submit a request to one or more ESAs, as appropriate, to investigate the alleged breach or non-application of EU law. The Board of Appeal The Board of Appeal is a joint body of the ESAs. Articles 58 and 59 of the ESA Regulations provide for the establishment of an independent and impartial Board of Appeal of the three ESAs because it is introduced to protect the rights of parties affected by decisions adopted by ESAs. The Joint Board of Appeal is responsible for deciding on appeals against decisions of ESAs.47

46  See Art 37 ESA Regulations. 47  See Art 60 ESA Regulations.

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The Board of Appeal is composed of six members and six alternates, two from each ESA. Members need to have a proven track record of professional experience in the fields of banking, insurance, occupational pensions and securities markets or other financial services, and with the necessary legal expertise to provide expert legal advice in relation to the activities of the ESAs. Current staff of NCAs, or other national or EU institutions involved in the activities of the ESAs are not eligible for service on the Board of Appeal which also has a term of office of five years. According to Art 59 ESA Regulations the Board members are independent in their decisions. The decisions of the Board of Appeal can then be appealed in front of the ECJ, as primarily set out under Article 61 of the ESA Regulations. Since its establishment, the Board of Appeal issued four decisions.48 The Joint Committee In order to ensure cross-sectoral consistency, a Joint Committee coordinates the activities of the ESAs in order to reach common positions, where appropriate. Thus, the Joint Committee coordinates the functions of ESAs in relation to financial conglomerates and other cross-sectoral matters. Moreover, acts also falling within the area of competence of ESAs are adopted in parallel by the respective ESA concerned. The Chairpersons of the three ESAs chair the Joint Committee for a twelve-month term, on an annual rotating basis. The Chairperson of the Joint Committee is the Vice-Chair of the ESRB. The Joint Committee has dedicated staff provided by ESAs to allow for informal information sharing and the development of a common supervisory culture approach across the ESAs. The Standing Committees ESAs primarily carry out their tasks through working groups, such as Standing Committees, Groups, Panels and Task Forces, which can be set up on a permanent basis or as ad-hoc groups. The working groups are involved in the preparation of papers, decisions, recommendations and other works and are composed primarily by NCA experts, ESA staff and in specific cases, representatives of other ESA staff, the European Commission, the ESRB, the ECB or even third country supervisors. However, the head or a senior official of a NCA typically chairs them. ESAs have also established Review Panels whose main task is the 48

These four decisions are (i) Global Private Rating Company “Standard Rating” Ltd v European Securities and Markets Authority (ESMA), decision taken on 10 January 2014 (BoA 2013–014), (ii) SV Capital v European Banking Authority (EBA), decision taken on 24 June 2013 (BoA 2013–008), (iii) SV Capital v European Banking Authority (EBA), decision taken on 14 July 2014 (BoA 2014-C1-02), and (iv) Investor Protection Europe sprl v European

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technical drafting or preparation of decisions of the BoS. When a specific report, recommendation or the like is debated in the Committee, it is channeled to the BoS for endorsement. Since their inception ESAs have set up various Committees. At the end of 2013, EBA had 11 Committees (including the Review panel) and 24 subgroups, EIOPA’s organizational setup included 14 Committees (including the Review panel) and ESMA’s comprised 13 Committees (including the Review Panel).49 Between 2011 and 2013, the Committees have adopted the following legislative acts and measures: • ESMA Committees have prepared 26 pieces of advice, 45 RTS, 8 ITS and 18 Guidelines regarding, inter alia, the European Market Infrastructure Regu­ lation (EMIR),50 Alternative Investment Fund Managers Directive (AIFMD),51 the Credit Rating Agency Regulation (CRA),52 the Market Abuse Directive (MAD),53 the Markets in Financial Instruments Directive (MIFID),54 and the Undertakings for Collective Investment in Transferable Securities (UCITS) Directive.55 ESMA has supervised 35 registered Credit Rating Agencies (CRAs). During this period of time, ESMA’s budget has been substantially increased from EUR 12,683,000 in 2011 to EUR 25,967,360 in 2013.56 • EIOPA Committees have provided advice to the European Commission in 8 instances, and further issued 1 Guideline and 4 opinions regarding the Securities and Markets Authority (ESMA), decision taken on 10 November 2014 (BoA 2014-05). 49  See European Parliament, Review of the New System of Financial Supervision (ESFS) Study (2013) 63, 80 and 94. 50 See Regulation (EU) 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories (OJ EU, L 201/1). 51  Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers and amending Directives 2003/41/EC and 2009/65/EC and Regulations (EC) No 1060/2009 and (EU) No 1095/2010 (OJ EU, L 174/1). 52  Regulation (EU) 1060(2009) of the European Parliament and of the Council of 16 September 2009 on credit rating agencies (OJ EU, L 302/1). 53 Directive 2003/6/EC of the European Parliament and of the Council of 28 January 2003 on insider dealing and market manipulation (market abuse) (OJ EU, L96/16); proposed recast COM (2011) 651 and COM (2011) 654. 54  Directive 2004/39/EC, of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments (OJ EU, L 45/18); proposed recast COM (2011) 656. 55 Directive 2009/65/EC of the European Parliament and of the Council of 13 July 2009 on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS) (OJ EU, L 302/32). 56  See European Parliament, Review of the New System of Financial Supervision (ESFS) Study (2013) 94.

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Solvency-II-Directive.57 EIOPA’s budget was increased from EUR 10,667,000 in 2011 to EUR 18,767,470 2013.58 • EBA Committees have provided advice on a delegated act, 19 RTS, 7 ITS, 8 Guidelines and 6 Recommendations regarding, among others, the Capital Requirements Directive III (CRD III),59 the Capital Requirements Direc­ tive IV (CRD IV)60 and the Capital Requirements Regulation (CRR),61 the Financial Conglomerates Directive (FICOD)62 and the EMIR. EBA’s budget was also increased significantly from EUR 16,962,000 in 2011 to EUR 28,235,000 in 2013.63 3.2 Legal Instruments of ESAs One major impact of the De Larosière Report was the decision of the EU to set up the ESAs equipped with considerably more powers than those of their predecessors. As will be explained below in more detail, ESAs are now involved in the drafting of secondary legislation (RTS and ITS) and, under special circumstances, may also direct decisions to NCAs or to financial institutions. ESAs’ increased powers are primarily a reflection of the general tasks assigned to them as are set out in Arts 8 (1) and 9 of the respective ESA Regulations. These state that ESAs shall, inter alia, contribute to the establishment of high-quality common regulatory and supervisory standards and practices, to the consistent application of legally binding EU legislative acts, to cooperate closely with the 57

Directive 2009/138/EC of the European Parliament and the Council of 25 November 2009 on the taking-up and pursuit of the business of Insurance and Reinsurance (OJ EU, L 335/1). 58  See European Parliament, Review of the New System of Financial Supervision (ESFS) Study (2013) 80. 59  Directive 2010/76/EU amending Directives 2006/48/EC and 2006/49/EC as regards capital requirements for the trading book and for re-securitizations, and the supervisory review of remuneration policies (OJ EU, L 329/3). 60 Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC (OJ L 208/73). 61  Regulation (EU) 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms (OJ EU, L 176/1). 62 Directive 2002/87/EC Directive 2002/87/EC of the European Parliament and of the Council of 16 December 2002 on the supplementary supervision of credit institutions, insurance undertakings and investment firms in a financial conglomerate (OJ EU, L 35/1). 63  See European Parliament, Review of the New System of Financial Supervision (ESFS) Study (2013) 63.

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ESRB, to organise and conduct peer review analyses of competent authorities, and to monitor and assess market developments. In order to achieve those tasks, ESAs are empowered to make use of a number of tools set out in Art 8 (2) of the respective ESA Regulation, namely: (a) draft regulatory technical standards, (b) draft implementing technical standards, (c ) guidelines and recommendations, (d) individual decisions addressed to competent authorities, (e) individual decisions addressed to individual financial institutions, (f) opinions to the European Parliament, the Council or the Commission, (g) collecting necessary information concerning financial institutions and (h) providing a centrally accessible database. These powers can be exercised either in the form of secondary legislation or of direct intervention. 3.2.1 ESAs Powers in Secondary Legislation: RTS and ITS According to Art 1 (2) of the respective ESA Regulation, an ESA has to act within the powers conferred by these Regulations and within the scope of the Direc­ tives and Regulations referred to such as EU legislation targeted at the three sectors of credit institutions, securities and markets and insurance supervision. In the case where such legislative acts delegate secondary legislative powers to the Commission, it can exercise these by adopting delegated acts either pursuant to Art 290 TFEU or implementing acts pursuant to Art 291 TFEU. The difference between delegated acts (Art 290 TFEU) and implementing acts (Art 291 TFEU) stems from the different degree of involvement in their adoption by the European Parliament. Regarding delegated acts it enjoys a veto right (Art 13 ESA Regulations) but not with respect to implementing acts (Art 15 ESA Regulations). The choice of act – delegated or implementing – is determined in the respective primary legislative act such as a EU Directive or EU Regulation. Furthermore, it is worth stressing that ESAs are only involved in the drafting of such delegated or implementing acts. This implies that it is up to the Euro­ pean Commission to endorse them. Making use of the expertise of ESAs allows NCAs to strongly influence secondary legislation. According to Art 37 ESA Regulations, aside of the national experts in the working groups, the Com­ mission is required to conduct open public consultations and to request the opinion of the Stakeholders Group, another body of national experts.64 According to recital 23 of the ESA Regulations, draft RTS are subject to amendment only in very restricted and extraordinary circumstances. This is because the respective ESA is deemed best suited to draft them for possessing the requisite knowledge and expertise. Moreover, draft RTS must be amended 64  See Art 10 (1) and 15 (1) ESA Regulations.

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if they are incompatible with EU law or fail to accord with the principle of proportionality or are in conflict with the fundamental principles of the internal market for financial services as reflected in the acquis of EU financial services legislation. According to Arts 11 and 12 ESA Regulations, the power to adopt RTS is transferred to the Commission for a period of four years beginning on 16 December 2010. This period will be extended automatically if the European Parliament does not revoke it, which it could at any time. The procedures for the adoption of RTS and ITS are regulated in Arts 10 to Art 15 ESA Regulations. The RTS/ITS have to be endorsed by the Commission within three months after receipt by the Commission of the draft RTS or ITS from the ESA. The Commission then notifies the European Parliament. If the Commission returns the draft RTS/ITS to the ESA accompanied with reasons, the ESA can amend and resubmit its draft to the Commission within six weeks. The Commission may adopt the RTS/ITS with amendments if the ESA does not make use of this period. If no draft is submitted by the ESA within the respective time limits set out in Art 10 (2) ESA Regulations, the competence to enact RTS/ITS reverts to the Commission.65 RTS and ITS are published in the Official Journal of the EU.66 According to Art 13 ESA Regulations, the European Parliament and the Council have the right to object to RTS within a period of three months after notification by the Commission. This period can be extended by another three months. In the case of an objection, the RTS may not enter into force. In the absence of an objection, the RTS will be published in the Official Journal of the EU. Guidelines and Recommendations Art 16 ESA Regulations enable ESAs to enact guidelines and recommendations. Their effect is to be secured by reliance on a comply-or-explain mechanism (Art 16 (3) ESA Regulations). Though guidelines and recommendations are not legally binding, ESA Regulations require NCAs to give notice within two months after the issuance of the respective guideline or recommendation, whether it complies or intends to comply with them. In the case where compliance is not intended, the NCA is required to notify the relevant ESA and to explain its reasons, which shall be published by the ESA. This mechanism can also be applied to individual financial institutions if this is required in regulations or guidelines. 65  See Art 10 (3) ESA Regulations. 66 See Art 10 (3) ESA Regulations.

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This so-called comply-or-explain-mechanism is designed to ensure transparency. This mechanism puts significant pressure on NCAs and individual financial institutions to adhere to non-binding ESA guidelines or recommendations when adopting legislation or when executing its legislation. Although it cannot, therefore, be reasonably argued that non-compliance constitutes a breach of EU law, it could still be argued that the non-application of guidance may indirectly induce a breach of law. Since guidelines are nothing more than an official announcement of how certain legal acts (primary or secondary legislation) are officially interpreted or understood by the respective ESA as an organ of the Union, and since the ECJ or the Board of Appeal may also use guidance for its own reasoning in their rulings, this procedure facilitates a certain understanding, interpretation and implementation of EU legislation. An interpretation not adhering to an interpretation displayed in the guidance may become indirectly a wrong interpretation of EU legislation and thus a breach of EU law. This is clearly reflected by the Board of Appeal’s 2013 Decision on EBA Guidelines.67 In clarifying the legal status of the Recommendations and Guidelines (regarding specific features of Directive 2006/48/EC) it ruled that they do not constitute binding acts, but that they address the matter from a practical perspective and assist in the interpretation of the scope of the provisions of Directive 2006/48/EC.68 As a result one must conclude that, compared with the predecessors of the ESAs, little has changed, except for the novel and important comply-or-explain-mechanism. 3.2.2 ESAs Powers of Direct Intervention The power of ESAs to directly implement legal acts binding on NCAs or individual financial institutions is regulated in Art 17–19 ESA Regulations. These powers have in common that it is not up to the Commission to enact them, but to the ESAs, which means that the ESAs are obliged to direct a decision to a certain financial institution mandating that institution to react in a certain way which is a way of direct implementation of EU law. Breach of Union Law According to recital 27 of the ESA Regulations, ESAs are dedicated to ensuring correct and full application of EU law and should therefore address instances 67  See Decision of the Joint Board of Appeal of the ESAs given under Article 60, Regulation (EU) 1093/2012 and the Board of Appeal’s Rule of Procedure (BOA 2012 02), BOA 2013-008, 24 June 2013. 68  See Joint Board of Appeal, Decision (BOA 2012 02), BOA 2013–008, Para 56; quoted after European Parliament, Review of the New European System of Financial Supervision (ESFS) Study (2013) 112.

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of non-application or incorrect application of EU law potentially leading to a breach thereof. The mechanism should apply in areas where EU law defines clear and unconditional obligations. The procedures provided for in Art 17 ESA Regulations set forth a threephased mechanism. In the first phase, the relevant ESA is empowered to investigate alleged incorrect or insufficient application of EU law obligations (including primary and secondary legislation) by national authorities in their supervisory practice, concluded by a recommendation. This investigative procedure is initiated by a request either of one or more NCAs, the European Parliament, the Council, the Commission or the Stakeholder Group, but can also be initiated upon an ESAs own initiative. The NCA concerned must provide the investigating ESA with all necessary information. No later than two months after commencement of the investigation, the ESA has to address a recommendation to the relevant authority setting out, if necessary, the action needed to comply with EU law. Within ten days of receipt of the recommendation, the respective NCA has to inform the ESA which legal or administrative steps it intends to take in order to ensure compliance with Union law. In the second phase, and if the NCA fails to follow the recommendation within one month after receipt, the Commission is empowered to issue a formal opinion taking into account the ESA’s recommendation, requiring the NCA to take the actions necessary to ensure compliance with EU law. This should not happen later than three months after the recommendation of the ESA. Again, within ten days after receipt of the formal opinion the NCA is obliged to indicate the steps to be taken in order to comply with it. In a possible third phase and in order to overcome exceptional situations of persistent inaction by a NCA, the ESA is empowered, as a last resort, to adopt decisions addressed to individual financial institutions. That power is limited to exceptional circumstances in which a NCA does not comply with the formal opinion addressed to it and in which EU law is directly applicable to financial institutions by virtue of existing or future EU regulations. The decision of the ESA should be in conformity with the formal opinion of the Commission. It prevails over any decision adopted by NCAs on the same matter.69 Even in the case of decisions taken under Art 17(6) ESA Regulations, the Commission still retains the right to initiate proceedings for infringement of EU law at the ECJ according to Art 258 TFEU. If one of the parties involved wishes to challenge the decision of the ESA, it can file an appeal against it to the Board of Appeal.70 The Board of Appeal’s decision, ultimately, is subject to an appeal to the ECJ.71 69 See Art 17 (6) and (7) ESA Regulations. 70  So Art 60 ESA Regulations. 71  See Art 61 ESA Regulations.

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Between 2011 and 2013, EBA carried out two investigations concerning national ring-fencing measures. One case was settled through non-binding mediation, the other is still pending.72 EIOPA has launched three investigations regarding the possible breach of the IMD Directive, but soon discontinued them since the NCAs cooperated by providing the requested necessary information.73 ESMA received 30 requests regarding activities of financial market participants but considered it unnecessary to open procedures in any of them.74 Mediation The mediation procedure set out in Art 19 ESA Regulations may be employed to settle disagreements on legal questions between two or more NCAs. In such cases, ESA may intervene to ensure compliance with EU law. Exercise of this power ensures efficient and effective supervision as well as balanced consideration of the positions of the NCAs. Art 19 ESA Regulations enables ESAs not only to settle disagreements with binding effect in cross-border situations between NCAs, but also within the colleges of supervisors.75 According to Art 19 (1) ESA Regulations, the ESA’s competence covers disagreements about the procedure or content of an action or inaction by a NCA in cases specified in the legally binding Union acts referred to in Art 1 (2) ESA Regulation. In such a situation, one or more of the supervisors involved is entitled to refer the issue to the relevant ESA. The procedure is divided into three phases. The first begins with a request by one or more interested NCAs. The requested ESA should first provide for a conciliation phase during which the NCAs may reach an agreement. The time frame for conciliation among the involved supervisors is set out by the respective ESA. 72  So European Parliament, Review of the New European System of Financial Supervision (ESFS) Study (2013) 63. 73  So European Parliament, Review of the New European System of Financial Supervision (ESFS) Study (2013) 82. 74 So European Parliament, Review of the New European System of Financial Supervision (ESFS) Study (2013) 101. 75 The Colleges of Supervisors provide a platform for the gathering and dissemination of relevant supervisory information, developing a common understanding of the risk profile of the groups, achieving coordination of supervisory review and risk assessment at a Group level as well as establishing supervisory plans for the mitigation of risks at Group level. In the European setting, Colleges of Supervisors provide a framework for the consolidating or home supervisor and the other competent authorities to carry out the tasks referred to under European financial supervisory legislation, ensuring appropriate coordination and cooperation with relevant competent authorities from nonEEA countries.

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If supervisors involved fail to reach agreement during the conciliation phase, the respective ESA may take a binding decision requiring the NCAs concerned to take specific action or to refrain from taking action in order to settle the matter in compliance with EU law (Art 19 (3) ESA Regulations). Failure of a NCA to comply with the settlement decision addressed to it by the ESA –according to Art 19 (3) ESA Regulations – triggers a third phase of the procedure in which the ESA, acting under Art 19 (4) ESA Regulations, may adopt decisions directly addressed to financial institutions in areas of EU law directly applicable to them. The power to adopt such decisions is one of last resort. It applies only to ensure the correct and consistent application of Union law. The ESA decides with simple majority of the members of its BoS (Art 44 (1) ESA Regulations).76 Such decisions prevail over any previous decision taken by a national supervisor in the same matter.77 ESAs have implemented relevant internal procedures. In case of decisions taken under Art 19(4) ESA Regulations the Commission still retains the right to initiate infringement procedures in the ECJ (Art 258 TFEU). Appeals against ESA decisions by involved parties can be filed to the Board of Appeal.78 Decisions of the Board of Appeal are subject to appeal to the ECJ.79 During the years 2011 to 2013, the EBA had received two formal requests for non-binding mediation (concerning home/host relationships in the event of unilateral measures of ring-fencing liquidity). One of these was successfully resolved through mediation, the other is still pending.80 No mediation requests were lodged by ESMA and EIOPA.81 Emergency Situations (Art 18 ESAs) In emergency situations ESAs can adopt decisions requiring NCAs to take specific action in a way the relevant ESA deems appropriate to remedy the emergency situation. The action of the ESA is bound by a decision adopted by the Council addressed to the ESA. By means of such a decision the Council 76  But see Art 44(1) third paragraph ESA Regulations in case that the decision is rejected by members representing a blocking minority as defined in Art 16(4) TEU and Art 3 of Protocol No 36 on transitional provisions. 77  See Art 19(5) ESA Regulations. 78  See Art 60 ESA Regulations. 79 See Art 61 ESA Regulations. 80  So European Parliament, Review of the New European System of Financial Supervision (ESFS) Study (2013) 67. 81  So European Parliament, Review of the New European System of Financial Supervision (ESFS) Study (2013) 83 and 101.

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determines the existence of an emergency situation, a determination that is subject to monthly review and expires if not renewed after a period of one month. According to recital 28 of the ESA Regulations, action undertaken by ESAs in this respect are without prejudice to the Commission’s powers pursuant to Article 258 TFEU to initiate infringement proceedings against the respective MS for its NCA’s failure to take such action. ESA actions are also without prejudice to the Commission’s right in such circumstances to seek interim measures in accordance with the rules of procedure of the ECJ. Between 2011 and 2013 no crisis situation has evolved. Participation in Colleges ESAs also perform an important role regarding the so-called colleges of supervisors. According to Art 21 ESA Regulations, they shall contribute to promoting and monitoring the efficient, effective and consistent functioning of the colleges of supervisors and, in that respect, have a leading role in ensuring the consistent and coherent functioning of colleges of supervisors for crossborder financial institutions across the EU. Therefore, ESAs enjoy full participation rights in colleges of supervisors as competent authorities. In this role the ESAs shall foster convergence and consistency across colleges in the application of EU law. As to their functions in the sphere of colleges of supervisors, the ESAs are not only considered as competent authorities, but are also involved in collecting and sharing relevant supervisory information, thereby facilitating the work of the college in initiating and coordinating EU-wide stress tests and in promoting effective and efficient supervisory activities.82 The ESAs are also explicitly entrusted with the task of developing draft RTS and ITS. In addition, they play a role in legally binding mediation to resolve disputes between NCAs. To that effect it may make directly applicable supervisory decisions.83 Between 2011 and 2013 EIOPA has participated in nearly all of the 91 colleges established in the insurance sector, EBA has established more than 80 colleges and participated in 40, while ESMA, due to different legal settings, did not experience colleges yet. The preparation of colleges for Central Counterparties (CCPs) under EMIR began in 2013.84

82  Art 21(2) (a) to (e) ESA Regulations. 83  Art 21(3) and (4) ESA Regulations. 84  European Parliament, Review of the New European System of Financial Supervision (ESFS) Study (2013) 64, 81 and 98.

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Peer Reviews ESAs are also involved in periodically organising and conducting peer reviews. As Art 30 ESA Regulations mandates, the relevant ESA shall develop the methodological framework for such reviews and conduct them on a regular basis. Reviews should focus not only on the convergence of supervisory practices, but also on the capacity of NCAs to achieve high-quality supervisory outcomes, as well as on the independence of those NCAs. The outcome of peer reviews is made public with the agreement of the relevant NCA subject to the review. Best practices should also be identified and made public. Between 2011 and 2013 EBA has conducted two peer reviews (one on stress testing, the other on the calculation of risks). EIOPA was engaged in four peer reviews on various topics (i.e., supervisory practices) in 2013, while six reviews are planned for 2013/14. ESMA has completed six peer reviews since 2011 addressing, inter alia, the actual use of sanctions under the Market Abuse Directive (MAD), and the conduct of business rules under MIFID.85 Supervision of Credit Rating Agencies (CRAs) Apart from the common organisational composition and the common powers, there is one important difference between EBA and EIOPA. According to Reg­ ulation (EU) 513/2011, ESMA has been entrusted with an additional power: the power of supervision of CRAs, previously the sole competence of the NCAs. This makes ESMA unique among the ESAs, as it is the only real Euro­ pean supervisor being involved in day-to-day supervision. Since 2012 ESMA has supervised 35 CRAs registered in the EU and, in addition, 2 Japanese CRAs have been certified.86 Coordination Function Finally, ESAs are entrusted with a general coordination role between NCAs. In this respect, ESAs shall facilitate the exchange of information between NCAs, identify the information and verify the reliability of the information. They shall notify ESRB of any potential emergency situations and centralise information received from NCAs.

85  European Parliament, Review of the New European System of Financial Supervision (ESFS) Study (2013) 67, 83 and 100. 86  European Parliament, Review of the New System of Financial Supervision (ESFS) Study (2013) 97.

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In the aftermath of the crisis and, based on the recommendations of the de Larosière Report, the EU has invested the ESAs with particular supervisory powers (as outlined in subsection 3.2). A European Parliament Review of the ESFS87 published in 2013 shows that the ESAs have already successfully contributed to the enactment of various binding and non-binding legal instruments. In addition, ESAs have conducted peer reviews and mediation panels between NCAs and they have investigated cases of alleged breach of law. It can be observed that the ESAs live up to the supranational supervisory tasks implemented in the ESAs Regulations. It is obvious that the legal framework, if consistently applied by ESAs, is an appropriate tool to implement European supervisory interests. Never­ theless, some changes in the institutional setup, as proposed by the European Parliament, may even further enhance the work of the ESAs. While the current tendency in legislation goes into the direction of harmonizing financial supervisory rules at the European level, the influence of the MS in the institutional setting of financial market supervision is still considerably strong.88 As outlined in subsection 3.1, the organs of the ESAs are largely dependent on the contribution of and on the cooperation with the NCAs. This fact has led the IMF to conclude that, in the ESAs, national interests are prevailing over European interests, especially when it comes to decision making in the Board of Supervisors.89 In its report, the European Parliament rejected this view as being too narrowly focussed. The mere fact that national interests may have impacted the BoS must be traced back to the fact that the ESAs started and evolved out of the financial crisis. Moreover, qualified majority voting proved to be an important improvement allowing national preferences to be overcome. It may well be concluded that the ESAs are continuously consolidating their supranational supervisory role. With regard to the institutional setup of the ESAs, some changes would seem appropriate. In general, cooperation between ESAs and the ESRB, the Council, the Commission, the European Parliament, as well as the NCAs developed considerably well from its beginning. On the other hand, in its review of the ESFS the European Parliament came to the conclusion that in the years 2011 to 2013 the three BoSs spent too much time deciding on ITS and RTS instead of discussing important policy issues. The European Parliament, 87  European Parliament, Review of the New System of Financial Supervision (ESFS) Study (2013). 88  So Ottow, The European Supervision of the Financial Markets, the Europe Institute of Utrecht, Working Paper No 2/2011. 89  IMF Country Report No. 13/65, March 2013, 11; See also IMF Country Report No. 11/186, July 2011, 33.

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therefore, recommends that in future the three BoS should rather be involved in the handling of important policy issues, while implementation issues (such as ITS and RTS) should be prepared as far away as possible in a special Panel, leaving only mere decision making to the BoS. In addition, in order to better supervise and promote the consistent implementation and application of EU primary and secondary legislation across Europe, the European Parliament, in its report, recommends the abolition of the Management Board in its current form and the creation of an Executive Board composed of five full-time professionals. Moreover, the positions of the Chairperson and of the Executive Director should be enhanced90 so as to promote the actual work of the Management Board necessary for promoting consistent implementation and application of EU financial market legislation. The reform of financial market supervision introduced in 2010 to overcome the financial crisis is just one step within a continuing process towards greater centralisation of financial market supervision at the EU level.91 According to advocates of European level supervision, the concept of the ESFS constitutes an improvement in supervision, yet represents just a half-way compromise.92 Once it had been recognised that European financial supervisory agencies at the EU level would make sense if based on an orderly prepared institutional setup,93 Art 127 TFEU provided ample competence for installing banking super­vision with the ECB.94 So the Union, supported by the necessary political reasoning,95 adopted legislation on the Banking Union.96 This step in the integration of European financial market supervision will surely not be the last. In November 2014, the ECB started supervising banks in cooperation with the NCAs, and the ESAs will continue to execute their competencies. Only time will tell which integration steps will be taken next, if any. 90  European Parliament, Review of the New System of Financial Supervision (ESFS) Study (2013) 14. 91  Ferran, Understanding the Institutional Architecture of EU Financial Market Supervision in Wymeersch, Hopt, Ferrarini [Eds] Financial Regulation and Supervision. A Post-Crisis Analysis (2012) 5.38. 92  Speyer, Financial supervision in the EU, Deutsche Bank Reseach (2011) 15. 93  Kammel, A Proposal for the Governance of Financial Regulation and Supervision in Europe, Vierteljahresschrift zur Wirtschaftsforschung 74 (2006) 176ff. 94  Schramm, Bankenaufsicht durch die Europäische Union? in Jabloner/Lucius/Schramm, Theorie und Praxis des Wirtschaftsrechts, Festschrift für H. René Laurer (2009) 439. 95  See the internet page of the Commission on the state of play of the Banking Union at: http://ec.europa.eu/internal_market/finances/banking-union/index_en.htm. 96  Regulation No 1024/2013 of 15 October 2013 conferring specific tasks on the European Central Bank concerning policies relating to the Prudential Supervision of Credit Institutions (OJ EU, L 287/63).

chapter 7

The Dodd-Frank Act Does Not Solve the Too-Big-to-Fail Problem Arthur E. Wilmarth, Jr.* Introduction In an article published in 2002, I warned that the too-big-to-fail (“TBTF”) policy was the “great unresolved problem of bank supervision” because it “undermine[d] both supervisory and market discipline.”1 I pointed out that Congress’ enactment of the Gramm-Leach-Bliley Act (“GLBA”) allowed financial conglomerates to span the entire range of our financial markets. I also cautioned against the emerging financial giants bringing “major segments of the securities and life insurance industries…within the scope of the TBTF doctrine, thereby expanding the scope and cost of federal ‘safety net’ subsidies.” I predicted that financial conglomerates would take advantage of their new powers under GLBA and their TBTF status by pursuing risky activities in the capital markets and by increasing their leverage through “capital arbitrage.”2 In a subsequent article published seven years later, I noted that the financial crisis had “confirmed” my earlier predictions. As I explained: [R]egulators in developed nations encouraged the expansion of large financial conglomerates and failed to restrain their pursuit of short-term profits through increased leverage and high-risk activities. As a result, [those institutions] were allowed to promote an enormous credit boom [that] precipitated a worldwide financial crisis. In order to avoid a complete collapse of global financial markets, central banks and governments [in the U.S. and Europe] have already provided almost $9 trillion of support…for major banks, securities firms and insurance companies. Those support measures – which are far from over – establish beyond * Arthur E. Wilmarth, Jr. is Professor of Law and Executive Director of the Center for Law, Economics & Finance at George Washington University Law School. 1 Arthur E. Wilmarth, Jr., “The Transformation of the U.S. Financial Services Industry: Competition, Consolidation, and Increased Risks,” 2002 University of Illinois Law Review 215, 475 [hereinafter Wilmarth, “Transformation”], available at http://ssrn.com/abstract=315345. 2  Id. at 444–476 (quotes at 447, 476).

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any doubt that the TBTF policy now embraces the entire financial services industry.3 The financial crisis has demonstrated that TBTF subsidies create dangerous distortions in our financial markets and our general economy. We must eliminate those subsidies in order to restore a less distorted playing field for smaller financial institutions and to encourage the voluntary breakup of inefficient, risky financial conglomerates.4 The financial crisis has also proven, beyond any reasonable doubt, that operations of large financial conglomerates are based on a hazardous business model that is riddled with conflicts of interest and prone to speculative risk-taking.5 The Dodd-Frank Wall Street Reform and Consumer Protection Act (“DoddFrank”) establishes a new regulatory regime for systemically important financial institutions (“SIFIs”). As discussed below, Dodd-Frank authorizes the Financial Stability Oversight Council (“FSOC”) and the Federal Reserve Board (“FRB”) to adopt more stringent capital requirements and other enhanced prudential standards for SIFIs. Dodd-Frank also establishes the Orderly Liquidation Authority (“OLA”), which provides a superior alternative to the “bailout or bankruptcy” choice that federal regulators confronted when they dealt with failing SIFIs during the financial crisis. However, Dodd-Frank does not completely close the door to future government bailouts for creditors of SIFIs. As shown below, the Federal Reserve System (“Fed”) can still provide emergency liquidity assistance to troubled financial conglomerates through the discount window and through group liquidity facilities (similar to the Primary Dealer Credit Facility) that are 3  Arthur E. Wilmarth,Jr., “The Dark Side of Universal Banking: Financial Conglomerates and the Origins of the Subprime Financial Crisis,” 41 Connecticut Law Review 963, 1049–50 (2009) [hereinafter Wilmarth, “Subprime Financial Crisis”], available at http://ssrn.com/abstract= 1403973. 4 Arthur E. Wilmarth, Jr., “The Dodd-Frank Act: A Flawed and Inadequate Response to the TooBig-To-Fail Problem,” 89 Oregon Law Review 951, 987 (2011) [hereinafter Wilmarth, “DoddFrank”], available at http://ssrn.com/abstract=1719126; Arthur E. Wilmarth, Jr., “Reforming Financial Regulation to Address the Too-Big-To-Fail Problem,” 35 Brooklyn Journal of International Law 707, 748–749 (2010) [hereinafter Wilmarth, “Reforming Financial Regulation”], available at http://ssrn.com/abstract=1645921. 5 Wilmarth, “Subprime Financial Crisis,” supra note 3, at 970–972, 994–1002, 1024–1050; Simon Johnson & James Kwak, 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown 74–87, 120–141, 193, 202–205 (2010); John Kay, Narrow Banking: The Reform of Financial Regulation 12–16, 41–44, 86–88 (Sept. 15, 2009) (unpublished manuscript), available at http:// www.johnkay.com/wp-content/uploads/2009/12/JK-Narrow-Banking.pdf.

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designed to help the largest financial institutions. Federal Home Loan Banks can still make collateralized advances to major banks. The FDIC can potentially use its Treasury borrowing authority as well as the “systemic risk exception” (“SRE”) to the Federal Deposit Insurance Act to protect uninsured creditors of failed SIFIs and their subsidiary banks. Dodd-Frank has made TBTF bailouts more difficult, but the continued existence of these avenues for financial assistance creates serious doubts about Dodd-Frank’s ability to prevent bailouts during future episodes of severe financial distress. In addition, Dodd-Frank relies heavily on the same supervisory tools – ­capital-based regulation and prudential supervision – that failed to prevent the banking and thrift crises of the 1980s and the recent financial crisis. DoddFrank’s reforms also depend for their effectiveness on many of the same federal regulatory agencies that failed to stop excessive risk-taking by financial institutions during the credit booms that preceded both crises. Federal regulators failed to complete more than 60% of the required rulemakings during the three years following Dodd-Frank’s enactment, creating serious doubts about the statute’s long-term efficacy. As an alternative to Dodd-Frank’s regulatory reforms, Congress could have tackled the TBTF problem directly by mandating a breakup of large financial conglomerates. That is the approach advocated by Simon Johnson and James Kwak, who have proposed maximum size limits of about $600 billion in assets for commercial banks and about $300 billion of assets for securities firms. Those size caps would require a significant reduction in size for all of the six largest U.S. banking organizations – viz., Bank of America (“BofA”), JP Morgan Chase (“Chase”), Citigroup, Wells Fargo, Goldman Sachs (“Goldman”) and Morgan Stanley.6 I am sympathetic to the maximum size limits proposed by Johnson and Kwak. However, it seems highly unlikely – especially in light of megabanks’ enormous political clout – that Congress could be persuaded to adopt such draconian limits, absent a future disaster comparable to the present financial crisis. A third possible approach – and the one I advocate – is to impose structural requirements and activity limitations that would (i) prevent SIFIs from using the federal safety net to subsidize their speculative activities in the capital markets, and (ii) make it easier for regulators to separate banks from their nonbank affiliates if a SIFI fails. As described below, my proposals for a pre-funded Orderly Liquidation Fund (“OLF”), a repeal of the SRE, and a two-tiered system of bank regulation based on the “narrow bank” concept would accomplish the goals of shrinking safety net subsidies and minimizing the need for government bailouts of SIFIs. 6  Johnson & Kwak, supra note 5, at 214–217.

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My approach is similar to the “ring-fencing” proposal issued by the U.K.’s Independent Commission on Banking (the “Vickers Commission”), which the U.K. government has recently enacted. The narrow bank concept provides a promising way for the U.S. and the U.K. to develop a common approach for regulating large financial conglomerates. If the host countries for the two most important financial centers – New York and London – establish consistent regimes for dealing with SIFIs, they would place great pressure on other developed nations to follow suit. In combination, the narrow bank concept and the other reforms I propose would strip away the primary safety net subsidies exploited by SIFIs and would subject SIFIs to the same type of market discipline that investors have applied in breaking up many commercial and industrial conglomerates during the past three decades. If (as I believe) SIFIs cannot produce favorable returns to investors without their current TBTF subsidies, my approach should enable market forces to compel SIFIs to break up voluntarily. TBTF Financial Institutions Received Extraordinary Governmental Assistance during the Financial Crisis The federal government provided massive amounts of financial assistance to large, complex financial institutions (“LCFIs”) during the financial crisis. The 19 largest U.S. banks (each with more than $100 billion of assets) and the largest U.S. insurance company, American International Group (“AIG”), received $290 billion of capital assistance from the Troubled Asset Relief Program (“TARP”). Federal regulators also enabled the same 19 banks and GE Capital (a huge finance company subsidiary of General Electric) to issue $290 billion of FDICguaranteed, low-interest debt. In contrast, smaller banks (with assets under $100 billion) received only $41 billion of TARP capital assistance and issued only $11 billion of FDIC-guaranteed debt.7 In addition, the Fed provided $16 trillion of liquidity assistance to financial institutions through a series of emergency lending programs. The Fed’s emergency credit reached a single-day peak of $1.2 trillion in December 2008. The Fed extended the vast majority of this emergency credit to large U.S. and European banks and provided very little help to smaller institutions.8 7  See Wilmarth, “Reforming Financial Regulation,” supra note 4, at 737–738. 8 Benjamin M. Blau, Central Bank Intervention and the Role of Political Connections (Geo. Mason Univ. Mercatus Center Working Paper No. 13–19, Oct. 2013), at 3, available at http:// mercatus.org/sites/default/files/Blau_CentralBankIntervention_v1.pdf; Bradley Keoun & Phil

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The Fed and the Treasury also supported financial institutions and financial markets by purchasing more than $1.5 trillion of direct obligations and mortgage-backed securities (“MBS”) issued by government-sponsored enterprises (including Fannie Mae and Freddie Mac) between 2008 and mid-2010. In combination, the federal government provided more than $6 trillion of support to financial institutions by mid-2010, when such support is measured by the peak amounts of outstanding assistance under the TARP capital assistance programs, Fed emergency lending programs, FDIC debt guarantees, and other asset purchase and guarantee programs.9 European countries similarly provided more than $4 trillion of financial support to their financial institutions by the end of 2009.10 Federal regulators acted most dramatically in rescuing LCFIs that were threatened with failure. U.S. authorities bailed out two of the three largest U.S. banks – BofA and Citigroup – as well as the largest U.S. insurance company, AIG. In addition, federal regulators provided financial support for emergency acquisitions of two other major banks (Wachovia and National City), the two largest thrifts (Washington Mutual (“WaMu”) and Countrywide), and two of the five largest securities firms (Bear Stearns and Merrill Lynch). Regulators also approved emergency conversions of two other leading securities firms (Goldman and Morgan Stanley) into bank holding companies (“BHCs”), thereby placing those institutions under the Fed’s protective umbrella.11

Kuntz, “Wall Street Aristocracy Got $1.2 Trillion in Secret Fed Loans,” Bloomberg.com, Aug. 22, 2011; Bob Ivry, Bradley Keoun & Phil Kuntz, “Secret Fed Loans Helped Banks Net $13 Billion,” Bloomberg.com, Nov. 27, 2011. 9 The “high-water mark” of the combined programs, based on the largest outstanding amount of each program at any one time, was $6.3 trillion. The federal government’s maximum potential exposure under those programs was $23.9 trillion. Office of the Special Inspector General for the Troubled Asset Relief Program (“SIGTARP”), Quarterly Report to Congress, July 21, 2010, at 116–119, 118 tbl. 3.1, available at: http://www.sigtarp.gov/Quarterly%20 Reports/July2010_Quarterly_Report_to_Congress.pdf. The Fed has also supported financial markets and the general economy by purchasing more than $3 trillion of MBS and Treasury bonds under its “quantitative easing” programs since 2009. John C. Williams, Economic Outlook: Moving in the Right Direction, FRBSF Economic Letter 2013–15, at 4 (May 20, 2013). 10 Adrian Blundell-Wignall et al., “The Elephant in the Room: The Need to Deal with What Banks Do,” 2 Organization for Economic Co-operation & Development Journal: Financial Market Trends, Vol. 2009, No. 2, at 1, 4–5, 14, 15 tbl.4, available at http://www.oecd.org/ dataoecd/13/8/44357464.pdf (stating that the U.S. provided $6.4 trillion of assistance to financial institutions through capital infusions, asset purchases, asset guarantees, and debt guarantees as of October 2009, while the United Kingdom and European nations provided $4.3 trillion of such assistance). 11  See Wilmarth, “Dodd-Frank,” supra note 4, at 858–859, 983.

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Moreover, the federal government publicly guaranteed that none of the 19 largest banks would be allowed to fail. When federal regulators announced their first “stress tests” in February 2009, they declared that the Treasury Department would provide any additional capital that was needed to ensure the survival of all 19 banks. Thus, federal regulators treated the 19 largest banks as TBTF and ensured their survival.12 TBTF Subsidies Distort Our Financial Markets and Create Perverse Incentives for Excessive Risk-Taking and Unhealthy Consolidation In March 2009, Fed Chairman Ben Bernanke acknowledged that “the toobig-to-fail issue has emerged as an enormous problem” because “it reduces market discipline and encourages excessive risk-taking” by TBTF firms.13 Several months later, Governor Mervyn King of the Bank of England condemned the perverse incentives created by TBTF subsidies in even stronger terms. Governor King maintained that “[t]he massive support extended to the banking sector around the world, while necessary to avert economic disaster, has created possibly the biggest moral hazard in history.”14 He further argued that TBTF subsidies provided a likely explanation for decisions by LCFIs to engage in high-risk strategies during the credit boom: Why were banks willing to take risks that proved so damaging to themselves and the rest of the economy? One of the key reasons – mentioned by market participants in conversations before the crisis hit – is that incentives to manage risk and to increase leverage were distorted by the implicit support or guarantee provided by government to creditors of banks that were seen as ‘too important to fail’. …Banks and their creditors 12

Ibid.; see also Wilmarth, “Reforming Financial Regulation,” supra note 4, at 712–713, 743–744. 13  Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve, Financial Reform to Address Systemic Risk, Speech at the Council on Foreign Relations (Mar. 10, 2009), available at http://www.federalreserve.gov/newsevents/speech/bernanke20090310a.htm. 14 Mervyn King, Governor of the Bank of England, Speech to Scottish Business Organizations in Edinburgh 4 (Oct. 20, 2009), available at http://www.bankofengland.co.uk/publications/speeches/2009/speech406.pdf [hereinafter King 2009 Speech]. See also Richard S. Carnell, Jonathan R. Macey & Geoffrey P. Miller, The Law of Banking and Financial Institutions 326 (4th ed. 2009) (explaining that “moral hazard” results from the fact that “[i]nsurance changes the incentives of the person insured…[I]f you no longer fear a harm [due to insurance], you no longer have an incentive to take precautions against it”).

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knew that if they were sufficiently important to the economy or the rest of the financial system, and things went wrong, the government would always stand behind them. And they were right.15 Academic studies and anecdotal evidence show that TBTF subsidies create significant economic distortions and promote moral hazard. In recent years, and particularly during the present crisis, LCFIs have operated with much lower capital ratios and have benefited from a significantly lower cost of funds, compared with smaller banks. In addition, credit ratings agencies and bond market investors have given preferential treatment to TBTF institutions because of the explicit and implicit government backing they receive.16 Analysts have concluded that the TARP capital infusions, FDIC debt guarantees and Fed emergency lending programs described above provided very large transfers of wealth from taxpayers to the shareholders and creditors of the largest U.S. financial institutions during the financial crisis.17 A recent study confirms that large banks received huge benefits from the implicit TBTF subsidy during the past two decades. Based on an analysis of publicly-traded bonds issued by U.S. banks between 1990 and 2010, the authors determined that bond investors expected the federal government to support

15  See King 2009 Speech, supra note 14, at 3. 16 Wilmarth, “Dodd-Frank,” supra note 4, at 981–984 (citing studies and other evidence). 17 Elijah Brewer III & Anne Marie Klingenhagen, “Be Careful What You Wish for: The Stock Market Reactions to Bailing Out Large Financial Institutions,” 18 Journal of Financial Regulation and Compliance 56, 57–59, 64–66 (2010) (finding significant increases in stock market valuations for the 25 largest U.S. banks as a result of Treasury Secretary Paulson’s announcement, on Oct. 14, 2008, of $250 billion of TARP capital infusions into the banking system, including $125 billion for the nine largest banks); Pietro Veronesi & Luigi Zingales, “Paulson’s Gift,” 97 Journal of Financial Economics 339, 340–341, 364 (2010) (concluding that the TARP capital infusions and FDIC debt guarantees announced in October 2008 produced $130 billion of gains for holders of equity and debt securities of the nine largest U.S. banks, at an estimated cost to taxpayers of $21 to $44 billion); Eric de Bodt et al., The Paulson Plan’s Competitive Effects (May 2011), at 2–4, 15–21 (finding that TARP capital infusions between October 2008 and December 2009 produced significant gains for shareholders of the largest banks and also imposed losses on shareholders of smaller banks by injuring the competitiveness of those banks), available at http://ssrn .com/abstract=1944038; Ivry, Keoun & Kuntz, supra note 8 (reporting that that the “belowmarket rates” charged by the Fed on its emergency credit programs – which were “as low as 0.01 percent in December 2008” – produced $13 billion of profits for the banks that participated in those programs, including $4.8 billion of earnings for the six largest U.S. banks).

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the largest financial institutions throughout that period. Even though the largest banks followed risky strategies, their bonds had significantly lower yield spreads over Treasury bonds, compared to bonds issued by smaller banks.18 Additionally, bond investors responded significantly to Fitch’s “issuer” ratings (which included Fitch’s expectation of government support for the biggest banks), but bond investors did not respond significantly to Fitch’s “individual” ratings (which were based on the standalone strengths of the same banks). The authors concluded that “investors do not price the true, intrinsic ability of a [big] financial institution to repay its debts, but instead price implicit government support for the institution.”19 The authors found that this implicit TBTF subsidy gave the largest banks an average funding cost advantage [over smaller banks] of approximately 28 basis points per year over the 1990–2010 period, peaking at more than 120 basis points in 2009. The total value of the subsidy amounted to about $20 billion per year on average over the twenty-year period, topping $100 billion in 2009.20 The authors also determined that “[t]he passage of the Dodd-Frank [Act] in the summer of 2010 did not eliminate investors’ expectations of government support”; instead, the enactment of Dodd-Frank “actually lowered [bond] spreads for the very largest financial institutions.”21 Several other recent studies have found similar evidence of large implicit TBTF subsidies for the biggest banks.22 Given the major advantages conferred by TBTF status, it is not surprising that LCFIs have pursued aggressive growth strategies during the past two decades to reach a size at which they would be considered TBTF by regulators and the financial markets. Each of today’s four largest U.S. banks (Chase, BofA, Citigroup and Wells Fargo) is the product of serial acquisitions and explosive growth since 1990. BofA’s and Citigroup’s rapid expansions led them to brink of failure, from which they were saved by huge federal bailouts. Wachovia 18  Viral V. Acharya, Daniz Anginer & A. Joseph Warburton, The End of Market Discipline? Investor Expectations of Implicit State Guarantees (Mar. 2013), available at: http://ssrn .com/abstract=1961656 at 2, 9–11, 14–15. 19  Ibid at 16. 20  Ibid at 4 (quote), 11–12. 21 Ibid at 20, 18. 22  See Mark J. Roe, Structural Corporate Degradation Due to Too-Big-to-Fail Finance (Aug. 1, 2013), at 11–16 (discussing recent studies), available at http://ssrn.com/abstract=2262901.

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(the fourth-largest U.S. bank at the beginning of the financial crisis) pursued a similar path of frenetic growth until it collapsed in 2008 and was rescued by Wells Fargo in a federally-assisted merger. A comparable pattern of rapid expansion, collapse and bailout occurred among RBS, UBS and other European LCFIs.23 By arranging and assisting acquisitions of troubled LCFIs by very large banks, U.S. regulators have produced domestic financial markets in which the biggest banks enjoy an unhealthy dominance. In 2009, the four largest U.S. banks (BofA, Chase, Citigroup and Wells Fargo) controlled 56% of domestic banking assets, up from 35% in 2000, while the top ten U.S. banks controlled 75% of domestic banking assets, up from 54% in 2000. The four largest banks also controlled a majority of the product markets for home mortgages, home equity loans, and credit card loans. The same four banks and Goldman accounted for 97% of the aggregate notional values of OTC derivatives contracts written by U.S. banks.24 The combined assets of the six largest banks – the foregoing five institutions plus Morgan Stanley – were equal to 63% of U.S. GDP in 2009, compared with only 17% of GDP in 1995.25 Nomi Prins has observed that, as a result of the financial crisis, “we have larger players who are more powerful, who are more dependent on government capital and who are harder to regulate than they were to begin with.”26 Similarly, Simon Johnson and James Kwak maintain that “the problem at the heart of the financial system [is] the enormous growth of top-tier financial institutions and the corresponding increase in their economic and political power.”27

23  Wilmarth, “Dodd-Frank,” supra note 4, at 984–985; Wilmarth, “Reforming Financial Regulation,” supra note 4, at 746 n.153. 24  Wilmarth, “Dodd-Frank,” supra note 4, at 985. 25 Johnson & Kwak, supra note 5, at 202–203, 217; Peter Boone & Simon Johnson, “Shooting Banks,” New Republic, Mar. 11, 2010, at 20. See also Thomas M. Hoenig, President, Federal Reserve Bank of Kansas City, “It’s Not Over ‘Til It’s Over: Leadership and Financial Regulation” (William Taylor Memorial Lecture, Oct. 10, 2010) (noting that “the largest five [U.S. BHCs] control $8.4 trillion of assets, nearly 60 percent of GDP, and the largest 20 control $12.8 trillion of assets or almost 90 percent of GDP”) [hereinafter Hoenig October 10, 2010 Speech], available at http://www.kansascityfed.org/speechbio/hoenigpdf/ william-taylor-hoenig-10-10-10.pdf; Ivry, Keoun & Kuntz, supra note 8 (reporting that “[t]otal assets held by the six biggest U.S. banks increased 39 percent to $9.5 trillion on Sept. 30, 2011, from $6.8 trillion on the same day in 2006”). 26  Wilmarth, “Dodd-Frank,” supra note 4, at 985–986 (quoting Ms. Prins). 27  See Johnson & Kwak, supra note 5, at 191.

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Dodd-Frank Will Not Solve the TBTF Problem

As shown above, TBTF subsidies create dangerous distortions in our financial markets and our general economy. Those subsidies must be eliminated (or at least significantly reduced) in order to restore a more level playing field for smaller financial institutions and to encourage the voluntary breakup of inefficient, risky financial conglomerates.28 Accordingly, U.S. and European governments must adopt reforms to ensure that effective supervisory and market discipline is applied against large financial institutions, A few months before Dodd-Frank was enacted, I wrote an article proposing five key reforms to accomplish these objectives. The reforms I proposed would have (1) strengthened existing statutory restrictions on the growth of SIFIs, (2) created a special resolution process to manage the orderly liquidation or restructuring of SIFIs, (3) established a consolidated supervisory regime and enhanced capital requirements for SIFIs, (4) created a special insurance fund to cover the costs of resolving failed SIFIs, and (5) rigorously insulated FDICinsured banks that are owned by LCFIs from the activities and risks of their nonbank affiliates.29 The following sections of this chapter discuss my proposed reforms and compare those proposals to relevant provisions of Dodd-Frank. As shown below, Dodd-Frank includes a portion of my first proposal as well as major components of my second and third proposals. However, Dodd-Frank omits most of my last two proposals. In my opinion, Dodd-Frank’s omissions are highly significant and raise serious doubts about the statute’s ability to prevent TBTF bailouts in the future. A careful reading of Dodd-Frank indicates that Congress has left the door open for taxpayer-funded protection of creditors of SIFIs during future financial crises.

28

Wilmarth, “Dodd-Frank,” supra note 4, at 987. Large financial conglomerates have never proven their ability to achieve superior performance without the extensive TBTF subsidies they currently receive. Most economic studies have failed to verify favorable economies of scale or scope in banks larger than $100 billion. Anat Admati & Martin Hellwig, The Bankers’ New Clothes: What’s Wrong with Banking and What to Do About It 89, 136–139, 143–144, 290–291 nn.28–34 (2013); Wilmarth, “Reforming Financial Regulation,” supra note 4, at 748–749; Boone & Johnson, supra note 25. 29  Wilmarth, “Reforming Financial Regulation,” supra note 4, at 747–779.

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1 Dodd-Frank Establishes a Special Resolution Regime for Systemically Important Financial Institutions but Does Not Prevent the FDIC and Other Agencies from Protecting Creditors of Those Institutions a Dodd-Frank’s Orderly Liquidation Authority Allows the FDIC to Provide Full Protection for Favored Creditors of SIFIs Dodd-Frank establishes an Orderly Liquidation Authority (“OLA”), which seeks to provide a “viable alternative to the undesirable choice…between bankruptcy of a large, complex financial company that would disrupt markets and damage the economy, and bailout of such financial company that would expose taxpayers to losses and undermine market discipline.”30 In some respects, the OLA for SIFIs – which is similar to the FDIC’s existing resolution regime for failed depository institutions31 – resembles my earlier proposal for a special resolution regime for SIFIs.32 However, contrary to Dodd-Frank’s stated purpose,33 the OLA does not preclude future bailouts for favored creditors of TBTF institutions. Dodd-Frank establishes the Financial Stability Oversight Council (“FSOC”) as an umbrella organization with systemic risk oversight authority. FSOC’s voting members include the leaders of nine federal financial regulatory agencies and an independent member having insurance experience. By a two-thirds vote, FSOC may determine that a domestic or foreign nonbank financial company should be subject to Dodd-Frank’s systemic risk regime, which includes prudential supervision by the FRB and potential liquidation by the FDIC under the OLA. In deciding whether to impose Dodd-Frank’s systemic risk regime on a nonbank financial company, the crucial question to be decided by FSOC is whether “material financial distress at the…nonbank financial company, or the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the…nonbank financial company, could pose a threat to the financial stability of the United States.”34 30  Senate Report No. 111–176, at 4 (2010). 31 See Carnell, Macey & Miller, supra note 14, ch. 13 (describing the FDIC’s resolution regime for failed banks); Fed. Deposit Ins. Corp., “Notice of Proposed Rulemaking Implementing Certain Orderly Liquidation Authority Provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act,” 75 Federal Register 64173, 64175 (Oct. 19, 2010) (stating that “[p]arties who are familiar with the liquidation of insured depository institutions…will recognize many parallel provisions in Title II” of Dodd-Frank) [hereinafter FDIC Proposed OLA Rule]. 32  See Wilmarth, “Reforming Financial Regulation,” supra note 4, at 754–757. 33 See Dodd-Frank (preamble) (stating that the statute is designed “to end ‘too big to fail’ [and] to protect the American taxpayer by ending bailouts”). 34  Wilmarth, “Dodd-Frank,” supra note 4, at 993–994 (discussing and quoting § 113 of Dodd-Frank).

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Dodd-Frank does not use the term “systemically important financial institution” to describe a nonbank financial company that is subject to the statute’s systemic risk regime, but I will refer to such companies as nonbank SIFIs. Dodd-Frank treats BHCs with assets of more than $50 billion as SIFIs, and those BHCs are also subject to enhanced supervision by the FRB and potential liquidation by the FDIC under the OLA.35 Dodd-Frank recognizes that – absent mandatory breakups – the best way to impose effective discipline on SIFIs and to reduce the federal subsidies they receive is to designate them publicly as SIFIs and to impose stringent regulatory requirements that force them to internalize the potential costs of their TBTF status.36 In order to invoke the OLA for a “covered financial company,” the Treasury Secretary must issue a systemic risk determination (“SRD”), based on the recommendation of the FRB, acting together with either the FDIC or the SEC (if the failing company’s largest subsidiary is a securities broker or dealer) or the Federal Insurance Office (if the failing company’s largest subsidiary is an insurance company). The Treasury Secretary’s SRD must find that (i) the ­covered financial company’s failure and resolution under otherwise applicable insolvency rules (e.g., the federal bankruptcy laws) would have “serious adverse effects on financial stability,” (ii) application of the OLA would “avoid or mitigate such adverse effects,” and (iii) “no viable private sector alternative is ­available to prevent” the company’s failure.37 I have previously argued that the systemic resolution process for SIFIs should embody three core principles in order to create a close similarity between that process and Chapter 11 of the federal Bankruptcy Code. Those core principles are: (A) requiring equity owners in a failed SIFI to lose their entire investment if the SIFI’s assets are insufficient to pay all valid creditor claims, (B) removing senior managers and other employees who were responsible for the SIFI’s failure, and (C) requiring unsecured creditors to accept meaningful “haircuts” in the form of significant reductions of their debt claims or an exchange of substantial portions of their debt claims for equity in a ­successor institution.38 Dodd-Frank incorporates the first two of my core principles. It requires the FDIC to ensure that equity owners of a failed SIFI do not receive any payment until all creditor claims are paid, and that managers responsible for the failure are removed. At first sight, Dodd-Frank also seems to embody the third 35  36  37 38 

Ibid at 994 (discussing §§ 115 and 165 of Dodd-Frank). Ibid at 994–995. Wilmarth, “Dodd-Frank,” supra note 4, at 996 (quoting § 203(b) of Dodd-Frank). Ibid at 996–997; Wilmarth, “Reforming Financial Regulation,” supra note 4, at 756–757.

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principle by directing the FDIC to impose losses on unsecured creditors if a failed SIFI’s assets are insufficient to pay all secured and unsecured debts. However, a careful reading of the statute reveals that Dodd-Frank allows the FDIC to provide full protection to favored classes of unsecured creditors of failed SIFIs.39 In its capacity as receiver for a failed SIFI, the FDIC may provide funds for the payment or transfer of creditors’ claims in at least two ways. First, the FDIC may provide funding directly to the SIFI’s receivership estate by making loans, purchasing or guaranteeing assets, or assuming or guaranteeing liabilities. Second, the FDIC may provide funding to establish a “bridge financial company” (“BFC”), and the FDIC may then approve a transfer of designated assets and liabilities from the failed SIFI to the BFC. In either case, the FDIC may (i) take steps to “mitigate[] the potential for serious adverse effects to the financial system,” and (ii) provide preferential treatment to certain creditors if the FDIC determines that such treatment is necessary to “maximize” the value of a failed SIFI’s assets or to preserve “essential” operations of the SIFI or a successor BFC. Subject to the foregoing conditions, the FDIC may give preferential treatment to certain creditors as long as every creditor receives at least the amount that creditor would have recovered in a liquidation proceeding under Chapter 7 of the federal Bankruptcy Code.40 In October 2010, the FDIC issued a proposed rule to implement its authority under the OLA. The FDIC subsequently approved an interim final OLA rule41 and a final OLA rule.42 The FDIC has declared that it can provide preferential treatment to certain creditors in OLA proceedings in order “to continue key operations, services, and transactions that will maximize the value of the [failed SIFI’s] assets and avoid a disorderly collapse in the marketplace.”43 The OLA rule excludes the following classes of creditors from any possibility of preferential treatment: (i) holders of unsecured senior debt with a term of more than 360  days, and (ii) holders of subordinated debt. Accordingly, the 39  Wilmarth, “Dodd-Frank,” supra note 4, at 997. 40  Ibid at 997–998 (discussing and quoting various provisions of Article II of Dodd-Frank). See also FDIC Proposed OLA Rule, supra note 31, at 64175, 64177 (explaining Dodd-Frank’s minimum guarantee for creditors of a failed SIFI). 41 Fed. Deposit Ins. Corp., Interim final rule, 76 Fed. Reg. 4207 (Jan. 25, 2011) [hereinafter FDIC Interim OLA Rule]. 42  Fed. Deposit Ins. Corp., Final rule, 76 Fed. Reg. 41626 (July 15, 2011) (adopting regulations to be codified at 12 C.F.R. Part 380) [hereinafter FDIC Final OLA Rule]. 43  FDIC Proposed OLA Rule, supra note 31, at 64175; FDIC Interim OLA Rule, supra note 41, at 4211.

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OLA rule would allow the FDIC to provide full protection to short-term, unsecured creditors of a failed SIFI whenever the FDIC determines that such protection is “essential for [the SIFI’s] continued operation and orderly liquidation.”44 Thus, the OLA rule allows the FDIC to give full protection to short-term liabilities of SIFIs, including commercial paper and securities repurchase agreements. Those types of wholesale liabilities proved to be highly volatile and prone to creditor “runs” during the financial crisis.45 Unfortunately, by stating that the FDIC reserves the right to provide preferential treatment to short-term creditors of failed SIFIs, but will never provide such treatment to holders of long-term debt or subordinated debt, the OLA rule will likely have at least two undesirable (better: Undesirable or unintended ?) results. First, the OLA rule creates the appearance of an implicit subsidy for short-term creditors of SIFIs, and second, it encourages SIFIs to rely even more heavily on vulnerable, short-term funding strategies that led to repeated disasters during the financial crisis.46 As indicated by the OLA rule, Dodd-Frank gives the FDIC considerable leeway to provide de facto bailouts for favored creditors of failed SIFIs. DoddFrank also provides a funding source for such bailouts. Section  201(n) of Dodd-Frank establishes an Orderly Liquidation Fund (“OLF”) to finance liquidations of SIFIs. As discussed below, Dodd-Frank does not establish a pre-funding mechanism for the OLF. However, the FDIC may obtain funds for the OLF by borrowing from the Treasury in amounts up to (i) 10% of a failed SIFI’s assets within thirty days after the FDIC’s appointment as receiver, plus (ii) 90% of the “fair value” of the SIFI’s assets that are “available for repayment” thereafter.”47 The FDIC’s authority to borrow from the Treasury provides an immediate source of funding to protect unsecured creditors that are deemed to have systemic significance. In addition, the “fair value” standard potentially gives the FDIC considerable discretion in appraising the assets of a failed SIFI, since 44

FDIC Proposed OLA Rule, supra note 31, at 64177–78; FDIC Interim OLA Rule, supra note 41, at 4211; see also FDIC Final OLA Rule, supra note 42, at 41634 (reaffirming position set forth in the interim OLA rule). 45  See Zoltan Pozsar et al., Shadow Banking (Federal Reserve Bank of N.Y. Staff Report No. 458, July 2010), at 2–6, 46–59, available at http://ssrn.com/abstract=1645337. 46  Wilmarth, “Dodd-Frank,” supra note 4, at 998–999. 47 Dodd-Frank, § 210(n)(5), (6). In order to borrow funds from the Treasury to finance an orderly liquidation, the FDIC must enter into a repayment agreement with the Treasury after consulting with the Senate Committee on Banking, Housing, and Urban Affairs and the House Committee on Financial Services. Id. § 210(n)(9).

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the “fair value” standard does not require the FDIC to rely on current market values in measuring the value of a failed SIFI’s assets.48 Dodd-Frank generally requires the FDIC to impose a “claw-back” on creditors who receive preferential treatment if the proceeds of the liquidation of a failed SIFI are insufficient to repay the full amount that the FDIC has borrowed from the Treasury to finance the liquidation. However, Dodd-Frank authorizes the FDIC to exercise its powers under the OLA – including its authority to provide preferential treatment to favored creditors of a failed SIFI – for the purpose of preserving “the financial stability of the United States” and preventing “serious adverse effects to the financial system.”49 Accordingly, the FDIC could conceivably assert the power to waive its right of “claw-back” against a failed SIFI’s creditors who received preferential treatment if the FDIC determines that such a waiver is necessary to maintain the stability of the financial markets.50 Since 2012, the FDIC has advocated a “single point of entry” strategy (“SPE”) as its preferred approach for resolving failed SIFIs under the OLA. Under SPE, the FDIC would place the top-tier holding company for a failed SIFI in receivership and would transfer the holding company’s assets to a BFC. The equity interests of the shareholders of the SIFI’s parent holding company would be wiped out, and the company’s debt securities would be converted into equity of the BFC. Most importantly, the failed SIFI’s operating subsidiaries (e.g., banks, securities brokerdealers, insurance companies, and merchant banking subsidiaries) would continue in operation, and the rights of their creditors would not be affected. As a practical matter, the SPE approach would resemble a “reorganization” of the SIFI in contrast to the “liquidation” mandated by Title II of Dodd-Frank. The FDIC’s SPE approach would greatly increase the likelihood that creditors of a failed SIFI’s operating subsidiaries (including derivatives counterparties, lenders under repurchase agreements and other short-term wholesale creditors) will be protected if an OLA receivership is established for the failed SIFI. The SPE approach would therefore provide highly preferential treatment for short-term wholesale creditors of SIFI subsidiaries. In combination with the FDIC’s existing OLA rule, the SPE approach would continue TBTF-style treatment for short-term wholesale creditors and thereby encourage “big banks to use even more of the derivatives and other complex financial contracts that caused so much trouble during the financial crisis.”51 .

48  49  50  51

See Wilmarth, “Dodd-Frank,” supra note 4, at 999. Dodd-Frank § 206(1). See also § 210(a)(9)(E)(iii). See Wilmarth, “Dodd-Frank,” supra note 4, at 1000. David A. Skeel, Jr., “Single Point of Entry and the Bankruptcy Alternative” (Feb. 26, 2014), available at http://ssrn.com/abstract=2408544.

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b Dodd-Frank Does Not Prevent Federal Regulators from Using Other Sources of Funding to Protect Creditors of SIFIs Dodd-Frank could potentially be interpreted as allowing the FDIC to borrow an additional $100 billion from the Treasury for use in accomplishing the orderly liquidation of a failed SIFI. Dodd-Frank states that the FDIC’s borrowing authority for the OLF does not “affect” the FDIC’s authority to borrow from the Treasury Department under 12 U.S.C. § 1824(a).52 Under § 1824(a), the FDIC may exercise its “judgment” to borrow up to $100 billion from the Treasury “for insurance purposes,” and the term “insurance purposes” appears to include functions beyond the FDIC’s responsibility to administer the Deposit Insurance Fund (“DIF”) for banks and thrifts.53 Dodd-Frank bars the  FDIC from using the  DIF to assist the OLF or from using the OLF to assist the DIF.54 How­ ever, the FDIC could conceivably assert that it has authority to borrow up to $100 billion from the Treasury under § 1824(a) for the “insurance purpose” of financing an orderly liquidation of a SIFI outside the normal funding parameters of the OLF. Assuming that such supplemental borrowing authority is available to the FDIC, the FDIC could use that authority to protect a SIFI’s uninsured and unsecured creditors as long as such protection “maximizes” the value of the SIFI’s assets or “mitigates the potential for serious adverse effects to the financial system.”55 The “systemic risk exception” (“SRE”) to the Federal Deposit Insurance Act (“FDI Act”) provides a further potential source of funding to protect creditors of failed SIFIs.56 Under the SRE, the Treasury Secretary can authorize the FDIC

52  Dodd-Frank § 201(n)(8)(A). 53 Under § 1824(a), the FDIC may borrow up to $100 billion “for insurance purposes” and such borrowed funds “shall be used by the [FDIC] solely in carrying out its functions with respect to such insurance.” 12 U.S.C. § 1824(a). Section 1824(a) further provides that the FDIC “may employ any funds obtained under this section for purposes of the [DIF] and the borrowing shall become a liability of the [DIF] to the extent funds are employed therefor.” Id. (emphasis added). The foregoing language strongly indicates that funds borrowed by the FDIC under § 1824(a) do not have to be used exclusively for the DIF and can be used for other “insurance purposes” in accordance with the “judgment” of the Board of Directors of the FDIC. It could be argued that borrowing for the purpose of funding the OLF would fall within such “insurance purposes.” 54  Dodd-Frank, § 210(n)(8)(A). 55 Ibid § 210(a)(9)(E)(i), (iii). 56  Wilmarth, “Dodd-Frank,” supra note 4, at 1001 (referring to the SRE under 12 U.S.C. § 1823(c)(4)(G), as originally enacted in 1991 and as invoked by federal regulators during the financial crisis).

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to provide full protection to uninsured creditors of a bank in order to avoid or mitigate “serious effects on economic conditions or financial stability.”57 DoddFrank amended and narrowed the SRE by requiring that a bank must be placed in receivership in order for the bank’s creditors to receive extraordinary protection under the SRE.58 Thus, if a failing SIFI owned a bank that was placed in receivership, the SRE would permit the FDIC (with the Treasury Secretary’s approval) to provide full protection to creditors of that bank in order to avoid or mitigate systemic risk. By protecting a SIFI-owned bank’s creditors (which could include the SIFI itself), the FDIC could use the SRE to extend indirect support to the SIFI or its creditors. Two provisions of Dodd-Frank limit the authority of the FRB and the FDIC to provide financial support to failing SIFIs or their subsidiary banks outside the OLA or the SRE. First, §1101 of Dodd-Frank provides that the FRB may not extend emergency secured loans under §13(3) of the Federal Reserve Act59 except to solvent firms that are “participant[s] in any program or facility with broad-based eligibility” that has been approved by the Treasury Secretary and reported to Congress.60 Second, § 1105 of Dodd-Frank forbids the FDIC from guaranteeing debt obligations of depository institutions or their holding companies or other affiliates except pursuant to a “widely available program” for “solvent” institutions that has been approved by the Treasury Secretary and endorsed by a joint resolution of Congress.61 57  In order to invoke the SRE, the Treasury Secretary must receive a favorable recommendation from the FDIC and the FRB and consult with the President. 12 U.S.C. § 1823(c)(4)(G)(i). 58 See Dodd-Frank, § 1106(b) (amending 12 U.S.C. § 1823(c)(4)(G)). 59  12 U.S.C. § 343. See Wilmarth, “Dodd-Frank,” supra note 4, at 1002 (referring to § 13(3) as amended in 1991 and as applied by the FRB to provide emergency credit to particular firms and segments of the financial markets during the financial crisis). 60 Dodd-Frank, § 1101(a) (requiring the Fed to use its § 13(3) authority solely for the purpose of establishing a lending “program or facility with broad-based eligibility” that is open only to solvent firms and is designed “for the purpose of providing liquidity to the financial system, and not to aid a failing financial company”). See Senate Report No. 111–176, at 6, 182–183 (2010) (discussing Dodd-Frank’s restrictions on the FRB’s lending authority under § 13(3)). 61 Dodd-Frank, § 1105. In addition, § 1106(a) of Dodd-Frank bars the FDIC from establishing any “widely available debt guarantee program” based on the SRE under the FDI Act. In October 2008, federal regulators invoked the SRE in order to authorize the FDIC to establish the Debt Guarantee Program (“DGP”). The DGP enabled depository institutions and their affiliates to issue more than $300 billion of FDIC-guaranteed debt securities between October 2008 and the end of 2009. See Wilmarth, “Dodd-Frank,” supra note 4, at 1002 n.212. Section 1106(a) of Dodd-Frank prohibits the use of the SRE to establish any program similar to the DGP. See Senate Report No. 111–176, at 6–7, 183–184 (2010) (discussing Dodd-Frank’s

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In light of the foregoing constraints, it is difficult to envision how the FRB or the FDIC could provide loans or debt guarantees to individual failing SIFIs or their subsidiary banks under § 1101 or § 1105 of Dodd-Frank.62 However, the FRB could conceivably use its remaining authority under § 13(3) to create a “broad-based” program similar to the Primary Dealer Credit Facility (“PDCF”) in order to provide emergency liquidity assistance to a selected group of SIFIs that the FRB deems to be “solvent.”63 As shown by the events of 2008, it is extremely difficult for outsiders (including members of Congress) to secondguess a regulator’s determination of solvency in the midst of a systemic crisis. Moreover, regulators are strongly inclined during a crisis to make generous assessments of solvency in order to justify their decision to provide emergency assistance to troubled LCFIs.64 Thus, during a financial crisis the FRB could potentially assert its authority under amended § 13(3) to provide emergency loans to a targeted group of troubled SIFIs that it identified as “solvent.” Moreover, Dodd-Frank does not limit the ability of individual SIFIs to receive liquidity support from the FRB’s discount window or from Federal Home Loan Banks (“FHLBs”). The FRB’s discount window (often referred to as the FRB’s “lender of last resort” facility) provides short-term loans to depository institutions secured by qualifying collateral. Similarly, FHLBs – sometimes described as “lender[s] of next-to-last resort” – provide collateralized advances to member institutions, including banks and insurance companies.65 During the financial crisis, banks did not borrow significant amounts from the discount window due to the perceived “stigma” of doing so as well as the availability of alternative sources of credit through FHLBs and several emergency liquidity facilities that the FRB established under its § 13(3) authority. The FHLBs provided $235 billion of advances to member institutions during the second half of 2007, following the outbreak of the financial crisis. During that period, FHLBs extended almost $150 billion of advances to ten major

limitations on the FDIC’s authority to guarantee debt obligations of depository institutions and their holding companies). 62  See Wilmarth, “Dodd-Frank, supra note 4, at 1002. 63 The FRB established the PDCF in March 2008 (at the time of its rescue of Bear) and expanded that facility in September 2008 (at the time of Lehman’s failure). The PDCF allowed the 19 primary dealers in government securities to make secured borrowings from the FRB on a basis similar to the FRB’s discount window for banks. The 19 primary dealers eligible for participation in the PDCF were securities broker-dealers; however, all but four of those dealers were affiliated with banks. Wilmarth, “Dodd-Frank,” supra note 4, at 1002–1003 n.214. 64  Ibid at 1002–1003. 65  Ibid at 1003–1004.

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LCFIs. Six of those LCFIs incurred large losses during the crisis and failed, were acquired in emergency transactions, or received “exceptional assistance” from the federal government. Accordingly, FHLB advances provided a significant source of support for troubled LCFIs, particularly during the early phase of the financial crisis. During future crises, it seems likely that individual LCFIs will use the FRB’s discount window more frequently, along with FHLB advances, because Dodd-Frank prevents the FRB from providing emergency credit to individual institutions under § 13(3).66 Discount window loans and FHLB advances cannot be made to banks in receivership, but they do provide a potential source of funding for troubled SIFIs or SIFI-owned banks as long as that funding is extended prior to the appointment of a receiver for either the bank or the SIFI. To the extent that the FRB or FHLBs provide such funding, at least some short-term creditors of troubled SIFIs or SIFI-owned banks are likely to benefit by obtaining full payment of their claims before any receivership is created.67 In sum, notwithstanding Dodd-Frank’s explicit promise to end bailouts of SIFIs, federal agencies retain several powers that permit them to protect creditors of weakened SIFIs. A more fundamental problem is that Dodd-Frank’s “no bailout” pledge does not bind future Congresses. When a future Congress confronts the next systemic financial crisis, that Congress may well decide to abandon Dodd-Frank’s “no bailout” position either explicitly (by amending or repealing the statute) or implicitly (by looking the other way while regulators expansively construe their authority to protect creditors of SIFIs). For example, Congress and President George H.W. Bush made “never again” statements when they rescued the thrift industry with taxpayer funds in 1989, but those statements did not prevent Congress and President George W. Bush from using public funds to bail out major financial institutions in 2008.68 Thus, as Adam Levitin has observed: Law is an insufficient commitment device for avoiding bailouts altogether. It is impossible to produce binding commitment to a preset resolution process, irrespective of the results. The financial Ulysses cannot be bound to the mast…Once the ship is foundering, we do not want Ulysses to be bound to the mast, lest [we] go down with the ship and drown. Instead, we want to be sure his hands are free – too bail.69 66  See Wilmarth, “Dodd-Frank,” supra note 4, at 1004. 67 Ibid at 1004–1005; see also 12 U.S.C. § 347b(b) (allowing the FRB to make discount window loans to “undercapitalized” banks subject to specified limitations). 68  Wilmarth, “Dodd-Frank,” supra note 4, at 1005. 69  See Adam J. Levitin, “In Defense of Bailouts.” 99 Georgetown Law Review 435, 439 (2011).

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Levitin predicts that future Congresses will relax or remove Dodd-Frank’s constraints on TBTF bailouts, or will permit federal regulators to evade those limitations, if such actions are deemed necessary to prevent failures of SIFIs that could destabilize our financial system.70 Cheryl Block has similarly concluded that “despite all the… ‘no more taxpayer-funded bailout’ clamor included in recent financial reform legislation, bailouts in the future are likely if circumstances become sufficiently severe.”71 Based on comparable reasoning, Standard & Poor’s (“S&P”) determined in 2011 that “under certain circumstances and with selected systemically important financial institutions, future extraordinary government support is still possible.”72 A major reason for doubting whether the OLA could successfully resolve the failure of a global SIFI is the lack of any assurance that foreign countries in which the SIFI operates would agree to follow the OLA procedures (including the FDIC’s proposed SPE). Very few nations have adopted SIFI resolution laws similar to Title II of Dodd-Frank, and past experience suggests that foreign nations are likely during a financial crisis to adopt “ring-fencing” policies that include segregation and seizure of SIFI-owned assets located within their jurisdictions.73 Accordingly, during a future crisis U.S. regulators might well decide that they must arrange open-firm bailouts for global SIFIs (similar to those arranged during 2008) instead of using OLA receiverships that might trigger protracted disputes with foreign regulators as well as panicked runs by creditors of failed SIFIs.74

70  Ibid, at 489. 71 Cheryl D. Block, “Measuring the True Cost of Government Bailout,” 88 Washington University Law Review 149, 224 (2010); see also id. at 227 (“pretending that there will never be another bailout simply leaves us less prepared when the next severe crisis hits”). 72  Standard & Poor’s, “The U.S. Government Says Support for Banks Will Be Different ‘Next Time’ – But Will It?” (July 12, 2011), at 2. 73 See, e.g., Paul L. Lee & Edite Ligere, “Cross-Border Resolution of Banking Groups: International Initiatives and U.S. Perspectives – Part II,” Pratt’s Journal of Bankruptcy Law (Oct. 2013), at 583, 585–589, 599–606. 74 See, e.g., Simon Johnson, “Sadly, Too Big to Fail Is Not Over,” Aug. 1, 2013 (New York Times Economix Blog), available at http://economix.blogs.nytimes.com/2013/08/01/sadly-too -big-to-fail-is-not-over/; Marc Jarsulic & Simon Johnson, “How a Big-Bank Failure Could Unfold,” May 23, 2013 (New York Times Economix Blog), available at http://economix .blogs.nytimes.com/2013/05/23/how-a-big-bank-failure-could-unfold/.

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2 Dodd-Frank Subjects SIFIs to Enhanced Supervisory Standards, But Those Provisions are Not Likely to Prevent Future Bailouts of SIFIs Dodd-Frank provides the FRB with consolidated supervision and enforcement authority over nonbank SIFIs comparable to the FRB’s umbrella supervisory and enforcement powers with respect to BHCs and financial holding companies (“FHCs”). Dodd-Frank also requires the FRB to adopt enhanced prudential standards for nonbank SIFIs and large BHCs “[i]n order to prevent or mitigate risks to the financial stability of the United States.”75 The enhanced standards must be “more stringent” than the ordinary supervisory rules that apply to nonbank financial companies and BHCs that are not SIFIs.76 In particular, Dodd-Frank requires the FRB to adopt enhanced risk-based capital requirements, leverage limits, liquidity requirements, overall risk management rules, risk concentration limits, requirements for resolution plans (“living wills”) and credit exposure reports. The FRB may also, in its discretion, require SIFIs to satisfy contingent capital requirements, enhanced public disclosures, short-term debt limits, and additional prudential standards.77 Dodd-Frank’s provisions requiring consolidated FRB supervision and enhanced prudential standards for SIFIs represent valuable improvements. For at least five reasons, however, those provisions are unlikely to prevent future failures of SIFIs with the attendant risk of governmental bailouts for systemically significant creditors. First, like previous regulatory reforms, DoddFrank relies heavily on the concept of stronger capital requirements. Unfortunately, capital-based regulation has repeatedly failed in the past.78 As regulators learned during the banking and thrift crises of the 1980s and early 1990s, capital levels are “lagging indicators” of bank problems79 because (i) “many assets held by banks…are not traded on any organized market and, therefore, are very difficult for regulators and outside investors to value,” and (ii) bank managers “have strong incentives to postpone any recognition of asset depreciation and capital losses” until their banks have already suffered serious damage.80 75  Wilmarth, “Dodd-Frank,” supra note 4, at 1006–1007 (discussing §§ 115 and 165 of Dodd-Frank). 76  Dodd-Frank § 161(a)(1)(A), (d). 77  Dodd-Frank § 165(b)(1)(B). 78  Wilmarth, “Dodd-Frank,” supra note 4, at 1009–1010. 79  See 1 Fed. Deposit Insurance Corp., History of the Eighties: Lessons for the Future 39–40, 55–56 (1997) [hereinafter FDIC History Lessons]. 80 Wilmarth, “Transformation,” supra note 1, at 459; see also Daniel K. Tarullo, Banking on Basel: The Future of International Financial Regulation 171–172 (2008).

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Second, LCFIs have repeatedly demonstrated their ability to engage in “regulatory capital arbitrage” in order to weaken the effectiveness of capital requirements.81 For example, the Basel II international capital accord was designed to prevent arbitrage techniques (including securitization) that banks used to undermine the effectiveness of the Basel I accord.82 However, analysts have concluded that the Basel II accord (including its heavy reliance on internal risk-based models developed by LCFIs) contained significant flaws and allowed LCFIs to operate with dangerously inadequate capital levels during the period leading up to the financial crisis.83 Third, the past shortcomings of capital-based rules are part of a broader phenomenon of supervisory failure. Regulators did not stop large banks from pursuing hazardous (and in many cases fatal) strategies during the 1980s, including rapid growth with heavy concentrations in high-risk assets and excessive reliance on volatile, short-term liabilities. During the 1980s, regulators tacitly condoned (or, at least, proved to be unwilling or unable to stop) risky behavior as long as banks continued to report profits.84 Similarly, there is widespread agreement that federal banking and securities regulators failed to restrain excessive risk-taking by LCFIs during the two decades leading up to the financial crisis.85 Fourth, repeated regulatory failures during past financial crises reflect a “political economy of regulation”86 in which regulators face significant 81  Johnson & Kwak, supra note 5, at 137–141; Wilmarth, “Transformation,” supra note 1, at 457–461. 82  Tarullo, supra note 80, at 79–83. 83 Id. at 139–214 (identifying numerous shortcomings in the Basel II accord); Admati & Hellwig, supra note 28, at 96, 183 (explaining that Basel II allowed LCFIs to operate with inadequate capital); Wilmarth, “Dodd-Frank,” supra note 4, at 1010 (same). 84  FDIC History Lessons, supra note 79, at 39–46, 245–247, 373–378. 85 See, e.g., Kathleen C. Engel & Patricia A. McCoy, The Subprime Virus 157–223 (2011); Johnson & Kwak, supra note 5, at 6–10, 120–150; Arthur E. Wilmarth, Jr., “Turning a Blind Eye: Why Washington Keeps Giving In to Washington,” 81 University of Cincinnati Law Review 1283, 1328–1345 (2013), available at http://ssrn.com/abstract=2327872. See also John C. Coffee, Jr., “Bail-Ins Versus Bail-Outs: Using Contingent Capital to Mitigate Systemic Risk” (Columbia Law School Center for Law & Economic Studies, Working Paper No. 380, 2010), at 17–18 (stating that “[a]greement is virtually universal that lax regulation by all the financial regulators played a significant role in the 2008 financial crisis”), available at http://ssrn.com/abstract=1675015. 86 Jeffrey N. Gordon & Christopher Muller, “Confronting Financial Crisis: Dodd-Frank’s Dangers and the Case for a Systemic Emergency Insurance Fund,” 28 Yale Journal on Regulation 151, 155, 177–180 (2011).

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political and practical challenges that undermine their efforts to discipline LCFIs. A full discussion of those challenges is beyond the scope of this chapter. For present purposes, it is sufficient to note that analysts have pointed to strong evidence of “capture” of financial regulatory agencies by LCFIs during the two decades leading up to the financial crisis, due to factors such as (i) large political contributions and lobbying expenditures made by LCFIs, (ii) an intellectual and policy environment favoring deregulation, and (iii) a continuous interchange of senior personnel between the largest financial institutions and the top echelons of the financial regulatory agencies.87 Commentators have also noted that LCFIs skillfully engaged in global regulatory arbitrage by threatening to move operations from the U.S. to London or other foreign financial centers if U.S. regulators did not make regulatory concessions.88 Fifth, Dodd-Frank does not provide specific instructions about the higher capital requirements and other enhanced prudential standards that the FRB must adopt. Instead, Dodd-Frank sets forth general categories of supervisory requirements that the FRB either must or may address. Thus, the actual achievement of stronger regulatory standards depends upon implementation by the FRB through rulemaking. Unfortunately, during the three-year period following Dodd-Frank’s enactment, the financial industry has used its lobbying prowess to obstruct the FRB’s efforts to adopt enhanced prudential requirements for SIFIs.89 During the same period, the FRB and other federal regulators failed to complete more than three-fifths of the required rulemakings to implement the statute, and Wall Street’s enormous lobbying power was widely viewed as a major reason for the agencies’ shortcomings.90 For example, domestic and foreign LCFIs vigorously opposed efforts by the FRB and

87  For discussions of the regulatory “capture” problem, see Johnson & Kwak, supra note 5, at 82–109, 118–121, 133–150; Wilmarth, supra note 85, at 1363–1428; see also Deniz Igan et al., “A Fistful of Dollars: Lobbying and the Financial Crisis” (Int’l Monetary Fund Working Paper 09/287, Dec. 2009), available at http://ssrn.com/abstract=1531520. 88 Coffee, supra note 85, at 18–21; Gordon & Muller, supra note 86, at 178–179; Wilmarth, supra note 85, at 1393–1397. 89  Wilmarth, “Dodd-Frank,” supra note 4, at 1012; see also Wilmarth, supra note 85, at 1299– 1301 (explaining that “[t]he financial industry’s opposition has bogged down the FRB’s efforts to establish enhanced prudential requirements for both nonbank SIFIs and bank SIFIs,” and the FRB’s proposed requirements for SIFIs “remained unfinished business” in mid-2013). 90 Wilmarth, supra note 85, at 1288–1289, 1296–1312; Kevin McCoy, “Who Killed Financial Reform: After three years, key parts of the plan to avert another Wall Street crisis remain undone,” USA Today, June 4, 2013, at 1A.

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other federal regulators to adopt stronger capital requirements that would go beyond Basel III’s standards.91 For all of the foregoing reasons, as John Coffee has noted, “the intensity of regulatory supervision is likely to follow a sine curve: tight regulation after a crash, followed by gradual relaxation thereafter” as the economy improves and the crisis fades in the memories of regulators and the public.92 When the next economic boom occurs, regulators will face escalating political pressures to reduce the regulatory burdens on SIFIs in order to help those institutions continue to finance the boom. If an unsustainable boom triggers a severe financial and economic crisis, a different set of political factors will push regulators and legislators to provide forbearance and bailouts to SIFIs and their creditors. Accordingly, while Dodd-Frank’s provisions for stronger supervision and enhanced prudential standards represent improvements over prior law, they are unlikely to prevent future crises involving SIFIs as well as governmental efforts to protect systemically important creditors.93 3 Dodd-Frank Does Not Require SIFIs to Pay Insurance Premiums to Pre-Fund the Orderly Liquidation Fund As noted above, Dodd-Frank establishes an Orderly Liquidation Fund (“OLF”) to provide financing for the FDIC’s liquidation of failed SIFIs. However, DoddFrank does not require LCFIs to pay any assessments to pre-fund the OLF. Instead, Dodd-Frank authorizes the FDIC to borrow from the Treasury to provide the necessary funding for the OLF after a SIFI is placed in receivership.94 The FDIC must normally repay any borrowings from the Treasury within five years, but the Treasury may extend the repayment period in order “to avoid a serious adverse effect on the financial system of the United States.”95 DoddFrank authorizes the FDIC to repay borrowings from the Treasury by making ex post assessments on (i) creditors who received preferential payments (to the extent of such preferences), (ii) nonbank SIFIs supervised by the FRB 91 Wilmarth, supra note 85, at 1299–1302; Donna Borak, “Why U.S. Banks View Tough Leverage Proposal as Counter-Productive, American Banker, Oct. 30, 2013, 2013 WLNR 27166532; Jesse Hamilton, “U.S. Banks Say Proposal to Limit Leverage Arbitrary, Harmful,” Bloomberg.com, Oct. 22, 2013 Daniel Shafer et al., “US bankers support European peers in fighting Fed capital plan,” FT.com, April 25, 2013. 92  Coffee, supra note 85, at 20–21. 93  Block, supra note 71, at 224–227; Levitin, supra note 69, at 439, 475–480, 487–490; Wilmarth, “Dodd-Frank,” supra note 4, at 1014–1015. 94  Wilmarth, “Dodd-Frank,” supra note 4, at 1015. 95  Dodd-Frank, §§ 210(n)(9)(B), 210(o)(1)(B), (C) (quote).

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under Dodd-Frank, (iii) BHCs with assets of $50 billion or more, and (iii) other financial companies with assets of $50 billion or more.96 Thus, Dodd-Frank relies on an ex post funding system for financing liquidations of SIFIs.97 However, it is contrary to customary insurance principles to rely on an OLF that is funded only after a SIFI fails and must be liquidated.98 When commentators have considered analogous insurance issues created by the DIF, they have recognized that moral hazard is reduced when banks pay risk-based premiums that compel “each bank [to] bear the cost of its own risktaking.”99 No one advocates a post-funded DIF today; indeed, analysts have generally argued that the DIF needs a higher level of pre-funding in order to respond adequately to systemic banking crises.100 Because SIFIs are not required to pay premiums to pre-fund the OLF, they receive an implicit subsidy in the form of lower funding costs by virtue of the protection their creditors expect to receive from the Treasury-backed OLF. SIFIs will pay nothing for that subsidy until the first SIFI fails.101 Not surprisingly, LCFIs viewed the absence of OLF pre-funding in the Dodd-Frank Act as a significant “victory,” because it relieved them of the burden of paying an “upfront fee” to cover the potential costs of their implicit subsidy.102 A pre-funded OLF is essential to shrink TBTF subsidies for LCFIs. The FDIC should be authorized to assess risk-adjusted premiums over a period of several years to establish a pre-funded OLF with sufficient financial resources to provide reasonable protection of taxpayers against the potential cost of resolving failures of SIFIs during a future systemic financial crisis. As noted above, federal regulators provided $290 billion of capital assistance to the 19 largest 96 Ibid § 210(o)(1). 97  Wilmarth, “Dodd-Frank,” supra note 4, at 1015–1017 (explaining that Republicans defeated efforts by Democrats and FDIC Chairman Sheila Bair to include a mandate in Dodd-Frank for assessments on SIFIs to create a pre-funded OLF). 98  See Carnell, Macey & Miller, supra note 14, at 535 (noting that ordinarily “an insurer collects, pools, and invests policyholders’ premiums and draws on that pool to pay policyholders’ claims”). 99 Ibid at 328. 100  See, e.g., Viral V. Acharya, Joao A.C. Santos & Tanju Yorulmazer, “Systemic Risk and Deposit Insurance Premiums,” Economic Policy Review (Fed. Res. Bank of NY, Aug. 2010), at 89. 101  So Wilmarth, “Dodd-Frank,” supra note 4, at 1017. 102 Mike Ferrulo, “Regulatory Reform: Democrats Set to Begin Final Push to Enact DoddFrank Financial Overhaul,” 94 Banking Report (BNA) 1277 (June 29, 2010) (reporting that the absence of a pre-funded OLF was “seen as a victory for large financial institutions,” and quoting analyst Jaret Seiberg’s comment that “[t]he key for [the financial services] industry was to avoid the upfront fee”).

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BHCs – each with assets of more than $100 billion – and to AIG during the current crisis. Accordingly, $300 billion (appropriately adjusted for inflation) would be the minimum acceptable size for a pre-funded OLF. OLF premiums should be paid by all BHCs with assets of more than $100 billion (also adjusted for inflation) and by all designated nonbank SIFIs. The FDIC should impose additional assessments on SIFIs in order to replenish the OLF within three years after the OLF incurs any loss due to the failure of a SIFI.103 There are five reasons why Congress must amend Dodd-Frank to establish a pre-funded OLF. First, it is unlikely that most SIFIs would have adequate financial resources to pay large OLF assessments after one or more of their peers fail during a future financial crisis. SIFIs are frequently exposed to highly correlated risk exposures during a serious financial disruption, because they followed similar high-risk business strategies (“herding”) during the credit boom that led to the crisis. Many SIFIs are therefore likely to face a substantial risk of failure during a major disturbance in the financial markets. Consequently, during a future financial crisis the FDIC probably will not be able in the short term to collect enough premiums from surviving SIFIs to cover the costs of resolving one or more failed SIFIs. As a result, the FDIC will have to borrow large sums from the Treasury to cover short-term resolution costs. Even if the FDIC ultimately repays the borrowed funds by imposing ex post assessments on surviving SIFIs, the public and the financial markets will rightly conclude that the federal government (and, ultimately, the taxpayers) provided bridge loans to pay the creditors of failed SIFIs.104 Second, under Dodd-Frank’s post-funded OLF, the most reckless SIFIs will effectively shift the potential costs of their risk-taking to more prudent SIFIs, because the latter will be more likely to survive and bear the ex post costs of resolving their failed peers. Thus, a post-funded OLF is undesirable because “firms that fail never pay and the costs are borne by surviving firms.”105 103 Wilmarth, “Dodd-Frank,” supra note 4, at 1019–1020. Jeffrey Gordon and Christopher Muller have proposed a similar “Systemic Risk Emergency Fund” with a pre-funded base of $250 billion to be financed by risk-adjusted assessments paid by large financial firms. They would also provide their proposed fund with a supplemental borrowing authority of up to $750 billion from the Treasury. Gordon & Muller, supra note 86, at 204–206. See also Xin Huang et al., “A Framework for Assessing the Systemic Risk of Major Financial Institutions,” 33 Journal of Banking & Finance 2036 (2009) (proposing a stress testing methodology for calculating an insurance premium sufficient to protect a hypothetical fund against losses of more than 15% of the total liabilities of twelve major U.S. banks during the period 2001–2008, and concluding that the hypothetical aggregate insurance premium would have had an “upper bound” of $250 billion in July 2008). 104  Wilmarth, “Dodd-Frank,” supra note 4, at 1020–1021. 105  Ibid at 1021 (quoting FDIC Chairman Sheila Bair).

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Third, a pre-funded OLF would encourage each SIFI to monitor other SIFIs and to alert regulators to excessive risk-taking by those institutions. Every SIFI would know that the failure of another SIFI would deplete the OLF and would also trigger future assessments that it and other surviving SIFIs must pay. Thus, each SIFI would have good reasons to complain to regulators if it became aware of unsound practices or conditions at another SIFI.106 Fourth, the payment of risk-based assessments to pre-fund the OLF would reduce TBTF subsidies for SIFIs by forcing them to internalize more of the “negative externality” (i.e., the potential public bailout cost) of their activities. A pre-funded OLF would provide a reserve fund, paid for by SIFIs, which would shield governments and taxpayers from having to incur the expense of underwriting future resolutions of failed SIFIs.107 Fifth, as Jeffrey Gordon and Christopher Muller have noted, a pre-funded OLF would also reduce the TBTF subsidy by making Dodd-Frank’s “liquidation threat more credible.”108 They correctly point out that a pre-funded OLF would encourage regulators to invoke the OLA receivership process for a failing SIFI by providing regulators with the necessary up-front financial resources to cover shortfalls in the SIFI’s assets.109 In contrast, Dodd-Frank’s post-funded OLF creates a strong incentive for regulators to grant forbearance in order to postpone (and hopefully avoid) an OLA receivership, because such a receivership would require regulators to take the politically unpopular step of borrowing from the Treasury in order to finance a failed SIFI’s resolution.110 To further reduce the potential TBTF subsidy for SIFIs, the OLF should be strictly separated from the DIF, which insures bank deposits. As discussed above, the SRE in the FDI Act is a potential source of bailout funds for SIFIowned banks, and those funds could indirectly support creditors of SIFIs.111 Congress should repeal the SRE and should designate the OLF as the exclusive source of future funding for all resolutions of failed SIFIs. By repealing the SRE, Congress would ensure that (i) the FDIC must apply the FDI Act’s least-cost test in resolving all future bank failures, (ii) the DIF must be used solely to pay 106  Ibid; see also Gordon & Muller, supra note 86, at 210 (contending that a pre-funded OLF that has authority to impose additional assessments to offset the costs of resolving failed SIFIs would create a desirable “mutualization of risk [among SIFIs] that should encourage more cautious firms to press regulators to rein in firms and practices that pose systemic risks”). 107  Wilmarth, “Dodd-Frank,” supra note 4, at 1021–1022. 108  Gordon & Muller, supra note 86, at 208. 109 Ibid. 110  Ibid at 193; Wilmarth, “Dodd-Frank, supra note 4, at 1022. 111  Wilmarth, “Dodd-Frank,” supra note 4, at 1022–1023.

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the claims of bank depositors, and (iii) non-deposit creditors of SIFIs could no longer view the DIF as a potential source of financial support. By making all of the foregoing changes, Congress would significantly reduce the implicit TBTF subsidy currently enjoyed by SIFIs.112 4 The Dodd-Frank Act Does Not Prevent Financial Holding Companies from Using Federal Safety Net Subsidies to Support Risky Nonbanking Activities Dodd-Frank contains three sections that are intended to prevent the federal “safety net” for banks113 from being used to support risky nonbanking activities connected to the capital markets. As discussed below, none of those sections is likely to be effective. The first provision (the Kanjorski Amendment) is unwieldy and constrained by stringent procedural requirements. The other two provisions (the Volcker Rule and the Lincoln Amendment) are riddled with loopholes and have long phase-in periods. Moreover, implementations of the Volcker Rule and the Lincoln Amendment have been blocked by aggressive industry lobbying. a The Kanjorski Amendment Section 121 of Dodd-Frank, known as the “Kanjorski Amendment,” was originally sponsored by Representative Paul Kanjorski. Section 121 provides the FRB with potential authority to require large BHCs (with more than $50 billion of assets) or nonbank SIFIs to divest high-risk operations. However, the FRB may exercise its divestiture authority under § 121 only if (i) the BHC or nonbank SIFI “poses a grave threat to the financial stability of the United States” and (ii) the FRB’s proposed action is approved by at least two-thirds of FSOC’s voting members.114 Additionally, the FRB may not exercise its divestiture authority unless it has previously attempted to “mitigate” the threat posed by the BHC or nonbank SIFI by taking several less drastic remedial measures.115 If, and only if, 112  Ibid at 1023. 113 The federal “safety net” for banks includes (i) federal deposit insurance, (ii) protection of uninsured depositors and other uninsured creditors in TBTF banks under the SRE, and (iii) discount window advances and other liquidity assistance provided by the FRB as lender of last resort. See Wilmarth, “Dodd-Frank,” supra note 4, at 1023 n.308. 114  Dodd-Frank, § 121(a). 115 Under § 121(a) of Dodd-Frank, before the FRB may require a breakup of a large BHC or nonbank SIFI, the FRB must first take all of the following actions with regard to that company: (i) imposing limitations on mergers or affiliations, (ii) placing restrictions on financial products, (iii) requiring termination of activities, and (iv) imposing conditions on the manner of conducting activities.

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the FRB determines that all of those remedial measures are “inadequate to mitigate [the] threat,” the FRB may then exercise its residual authority to “require the company to sell or otherwise transfer assets or off-balance-sheet items to unaffiliated parties.”116 The FRB’s divestiture authority under § 121 is thus a last resort, and it is restricted by numerous procedural requirements (including, most notably, approval by a two-thirds vote of FSOC). The Bank Holding Company Act (“BHC Act”) contains a similar provision, under which the FRB can force a BHC to divest a nonbank subsidiary that “constitutes a serious risk to the financial safety, soundness or stability” of any of the BHC’s banking subsidiaries.117 The FRB may exercise its divestiture authority under the BHC Act without the concurrence of any other federal agency, and the FRB is not required to take any intermediate remedial steps before requiring a divestiture. However, according to a senior Federal Reserve official, the FRB’s divestiture authority under the BHC Act “has never been successfully used for a major banking organization.”118 In view of the much more stringent procedural and substantive constraints on the FRB’s authority under the Kanjorski Amendment, the prospects for an FRB-ordered breakup of a SIFI seem remote at best. b The Volcker Rule Section 619 of Dodd-Frank, the “Volcker Rule,” was originally proposed by former FRB Chairman Paul Volcker.119 As approved by the Senate Banking Committee, the Volcker Rule would have generally barred banks from (i) sponsoring or investing in hedge funds or private equity funds and (ii) engaging in proprietary trading – i.e., buying and selling securities, derivatives and other tradable assets for their own account. Thus, the original version of the Volcker Rule sought to prohibit equity investments and trading activities by banks except for “market making” activities conducted on behalf of clients.120 The Senate committee report on the Dodd-Frank Act explained that the Volcker Rule would prevent banks “protected by the federal safety net, which have a lower cost of funds, from directing those funds to high-risk uses.”121 Thus, 116  117  118  119  120 121 

Dodd-Frank, § 121(a)(5). See Senate Report No. 111–176, at 51–52 (explaining § 121). 12 U.S.C. § 1844(e)(1). Hoenig October 10, 2010 Speech, supra note 25, at 4. Wilmarth, “Dodd-Frank,” supra note 4, at 1025. Senate Report No. 111–176, at 8–9, 90–92 (2010). Ibid at 8–9; see also id. at 90 (stating that the Volcker Rule sought to prevent “the inappropriate transfer of economic subsidies” by banks).

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the Senate report made clear that a primary goal of the Volcker Rule was to prevent banks from spreading their federal safety net subsidies to nonbank affiliates engaged in capital markets activities. Wall Street vehemently opposed the Volcker Rule.122 After heavy lobbying by the financial industry, the House-Senate conference committee on the Dodd-Frank Act agreed on a last-minute compromise that significantly weakened the Volcker Rule.123 The final compromise inserted exemptions in the Volcker Rule that allow banks (i) to invest up to 3% of their Tier 1 capital in hedge funds or private equity funds (as long as a bank’s investments do not exceed 3% of the total ownership interests in any single fund), (ii) purchase and sell government securities, (iii) engage in “risk-mitigating hedging activities,” (iv) make investments through insurance company affiliates, and (v) make small business investment company investments. The compromise also delayed the Volcker Rule’s effective date so that banks will have (A) up to seven years after Dodd-Frank’s enactment date to bring most of their equity investing and proprietary trading activities into compliance with the Volcker Rule, and (B) up to twelve years to bring “illiquid” investments that were in existence on May 1, 2010, into compliance with the Rule.124 Probably the most troublesome aspect of the Volcker Rule is that the Rule attempts to distinguish between prohibited “proprietary trading” and permissible “market making.” The Rule defines “proprietary trading” as “engaging as a principal for the trading account of the banking entity,” but the Rule allows “[t]he purchase, sale, acquisition, or disposition of securities and other instruments…on behalf of customers.”125 Distinguishing between proprietary trading and market making is “notoriously difficult.”126 Moreover, the exact parameters of “proprietary trading,” “market making” and other crucial terms

122  Wilmarth, “Dodd-Frank,” supra note 4, at 1026, 1028. 123  Ibid at 1028; see also John Cassidy, “The Volcker Rule: Obama’s economic adviser and his battles over the financial-reform bill,” New Yorker, July 26, 2010, at 25 (reporting that the compromise “disappointed Mr. Volcker”). 124  Wilmarth, “Dodd-Frank,” supra note 4, at 1028 (discussing § 13(d) of the BHC Act, added by Dodd-Frank, § 619). 125 Dodd-Frank, § 619 (enacting new § 13(d)(1)(D) & (h)(4) of the BHC Act). 126 Wilmarth, “Dodd-Frank,” supra note 4, at 1029; see also Government Accountability Office, Proprietary Trading: Regulators Will Need More Comprehensive Information to Fully Monitor Compliance with New Restrictions When Implemented, GAO-11-529 (July 2011), at 37 (stating that “a key challenge in implementing the proprietary trading restrictions [under the Volcker Rule] will be disentangling [permitted] activities associated with market-making, hedging and underwriting from prohibited proprietary trading activities”).

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in the Volcker Rule – including the exemption for “[r]isk-mitigating hedging activities”127 – are left open by the statute. The scope and impact of the Volcker Rule will be determined by regulations to be adopted jointly by the federal banking agencies, the CFTC and the SEC.128 The agencies issued lengthy proposed regulations in October 2011, but the proposed rules were “roundly criticized for being overly complex and riddled with uncertainty.”129 Due to the financial industry’s intense lobbying efforts and disagreements among regulators, the implementing regulations for the Volcker Rule remained unfinished in October 2013. As one news report explained, “three years after DoddFrank outlined the Volcker rule as a central part of the government response [to the financial crisis], the rule languishes unfinished and unenforced, mired in policy tangles and infighting among the five separate agencies whose job is to produce the fine print.”130 As a result, it is highly doubtful whether the Volcker Rule will have any significant impact in restraining risk-taking by SIFIs or in preventing them from exploiting their safety net subsidies to fund speculative activities.131 (Could it conceivably revived in the not too distant future?) The agencies finally adopted the Volcker Rule in December 2014. That story is too complicated to tell here, and the Volcker Rule as adopted still has all of the problems described above. c The Lincoln Amendment Section 716 of Dodd-Frank, the “Lincoln Amendment,” was originally sponsored by Senator Blanche Lincoln. As adopted by the Agriculture Committee (which Senator Lincoln chaired), the Lincoln Amendment would have barred dealers 127  Dodd-Frank, § 619 (adding new § 13(d)(1)(C) of the BHC Act). See Eric Dash & Nelson D. Schwartz, “In a Final Push, Banking Lobbyists Make a Run at Reform Measures,” New York Times (June 21, 2010), at B1 (reporting that “traders [on Wall Street] say it will be tricky for regulators to define what constitutes a proprietary trade as opposed to a reasonable hedge against looming risks. Therefore, banks might still be able to make big bets by simply classifying them differently”). 128  Dodd-Frank § 619 (adding new § 13(b) of the BHC Act). 129 Mike Ferrulo, “Regulatory Reform: Senate Banking Members Push Regulators For More Progress Implementing Dodd-Frank,” 97 BNA’s Banking Report 997 (Dec. 13, 2011); see also Yin Wilczek, “Regulatory Reform: Banking Regulators Issue Volcker Proposal,” 97 BNA’s Banking Report 633 (Oct. 18, 2011) (reporting that both supporters and critics of the Volcker Rule attacked the proposed implementing regulations as “too complex, while leaving many questions unanswered”). 130 Scott Patterson & Deborah Solomon, “A Simple Rule Proves Difficult to Write,” Wall Street Journal, Sept. 10, 2013, at A1; see also Wilmarth, supra note 85, at 1302–1304, 1367–1368 (describing the financial industry’s extensive lobbying efforts to block implementation of the Volcker Rule). 131  Wilmarth, “Dodd-Frank,” supra note 4, at 1029–1030; Patterson & Solomon, supra note 130.

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in swaps and other OTC derivatives from receiving any assistance from the DIF or from the Fed’s discount window or other emergency lending facilities.132 Senator Lincoln designed her amendment to force major banks to “spin off their derivatives operations” in order “to prevent a situation in which a bank’s derivatives deals failed and forced taxpayers to bail out the institution.”133 The Lincoln Amendment was “also an effort to crack down on the possibility that banks would use cheaper funding provided by deposits insured by the FDIC, to subsidize their trading activities.”134 Thus, the purposes of the Lincoln Amendment – insulating banks from the risks of speculative activities and preventing the spread of safety net subsidies – were similar to the objectives of the Volcker Rule, but the Lincoln Amendment focused on dealing and trading in derivatives instead of all types of proprietary trading.135 The Lincoln Amendment provoked “tremendous pushback…from Repub­ licans, fellow Democrats, the White House, banking regulators, and Wall Street interests.”136 As was true with the Volcker Rule, the House-Senate conference committee on the Dodd-Frank Act agreed to a final compromise that significantly weakened the Lincoln Amendment.137 As enacted, the Lincoln Amendment allows an FDIC-insured bank to act as a swaps dealer with regard to (i) “[h]edging and other similar risk mitigating activities directly related to the [bank’s] activities,” (ii) swaps involving interest rates, currency rates and other “reference assets that are permissible for investment by a national bank,” including gold and silver (but not other types of metals) and energy or agricultural commodities, and (iii) credit default swaps that are cleared pursuant to

132  Wilmarth, “Dodd-Frank,” supra note 4, at 1030. 133 Richard Hill, “Derivatives: Conferees Reach Compromise: Banks Could Continue to Trade Some Derivatives,” 42 Securities Regulation & Law Report (BNA) 1234 (June 28, 2010). 134  Robert Schmidt & Phil Mattingly, “Banks Would Be Forced to Push Out Derivatives Trading Under Plan,” Bloomberg.com, April 15, 2010. 135  Wilmarth, “Dodd-Frank, supra note 4, at 1031. 136 Hill, supra note 133; see also Stacy Kaper & Cheyenne Hopkins, “Key Issues Unresolved as Reform Finishes Up,” American Banker, June 25, 2010, at 1 (reporting that “banks have vigorously opposed [the Lincoln Amendment], arguing it would cost them millions of dollars to spin off their derivatives units. Regulators, too, have argued against the provision, saying it would drive derivatives trades overseas or underground, where they would not be regulated”). 137  Devlin Barrett & Damien Paletta, “The Financial-Regulation Overhaul: A Fight to the Wire as Pro-Business Democrats Dig In on Derivatives,” Wall Street Journal, June 26, 2010, at A10; Edward Wyatt & David M. Herszenhorn,” Accord Reached for an Overhaul of Finance Rules,” New York Times, June 26, 2010, at A1.

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Title VII of Dodd-Frank and also carry investment-grade ratings.138 In addition, the Lincoln Amendment allows banks up to five years after Dodd-Frank’s effective date to divest or spin off nonconforming derivatives operations into separate affiliates.139 Analysts estimate that the compromised Lincoln Amendment will require major banks to spin off only ten to twenty percent of their pre-Dodd-Frank derivatives activities into separate affiliates.140 In addition, banks will be able to argue for retention of derivatives that are used for “hedging” purposes, an open-ended standard that will require elaboration by regulators.141 As in the case of the Volcker Rule, commentators concluded that the final version of the Lincoln Amendment was “significantly weakened,”142 and “watered down,”143 with the result that “the largest banks’ [derivatives] operations are largely left intact.”144 Despite the significant exemptions included in the Lincoln Amendment, the financial industry has vigorously lobbied to repeal it or prevent its implementation. In October 2013, the House overwhelmingly passed a bill supported by Wall Street that would repeal the Lincoln Amendment and thereby relieve banks of their duty to “push out” derivatives into nonbank affiliates. The Obama Administration opposed the bill but did not threaten to veto it.145 138 Dodd-Frank, § 716(d); see also Hill, supra note 133; Wyatt & Herszenhorn, supra note 137. 139  See Dodd-Frank, § 716(h) (providing that the Lincoln Amendment will take effect two years after Dodd-Frank’s effective date); id. § 716(f) (permitting up to three additional years for banks to divest or cease nonconforming derivatives operations). 140 Christine Harper & Bradley Keoun, “Financial Reform: The New Rules Won’t Stop the Next Crisis,” Bloomberg BusinessWeek; July 6–11, 2010, at 42; Randall Smith & Aaron Lucchetti, “The Financial Regulatory Overhaul: Biggest Banks Manage to Dodge Some Bullets,” Wall Street Journal, June 26, 2010, at A5. 141  Wyatt & Herszenhorn, supra note 137. 142  Hill, supra note 133 (quoting the Consumer Federation of America). 143  Smith & Lucchetti, supra note 140. 144 Bradley Keoun & Dawn Kopecki, “JP Morgan, Citigroup, Morgan Stanley Rise as Bill Gives Investment Leeway,” Bloomberg.com, June 25, 2010 (quoting analyst Nancy Bush). 145 Victoria Finkle, “House Votes to Roll Back Dodd-Frank Swaps Provision,” American Banker, Oct. 31, 2013, 2013 WLNR 27310331 (reporting that the House bill to repeal the Lincoln Amendment passed by “a bipartisan vote of 292–122, including 70 Democrats”); Eric Lipton, “House Votes to Repeal Dodd-Frank Provision,” New York Times, Oct. 31, 2013, at (reporting that Wall Street banks drafted and lobbied heavily for the bill); see also Silla Brush, “Fed Grants Foreign Banks Leeway in Dodd-Frank Swap Pushout Rule,” Bloomberg. com, June 5, 2013 (reporting that the FRB and OCC granted domestic and foreign banks an additional two-year exemption, until July 2015, to come into compliance with the Lincoln Amendment).

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Banks Controlled by Financial Conglomerates Should Operate as “Narrow Banks” So That They Cannot Transfer Their Federal Safety Net Subsidies to Their Nonbank Affiliates As explained above, a fundamental purpose of the Volcker Rule and the Lincoln Amendment is to prevent LCFIs from using federal safety net subsidies to support their speculative activities in the capital markets. As enacted, however, both provisions have numerous gaps and exemptions that undermine their stated purpose. In addition, Wall Street’s formidable lobbying machine has blocked both provisions from taking effect. As described below, a more effective way to prevent the spread of federal safety net subsidies from banks to their affiliates involved in capital markets activities would be to create a two-tiered structure of bank regulation and deposit insurance. The first tier of “traditional” banking organizations would provide a relatively broad range of banking-related services, but those organizations would not be allowed to engage, or affiliate with firms engaged, in securities underwriting or dealing, insurance underwriting, or derivatives dealing or trading. In contrast, the second tier of “narrow banks” could affiliate with “nontraditional” financial conglomerates engaged in capital markets operations (except for private equity investments). Narrow banks, however, would be prohibited from making any extensions of credit or other transfers of funds to their nonbank affiliates, except for lawful dividends paid to their parent holding companies. The narrow bank approach provides the most politically feasible approach for ensuring that banks cannot transfer their safety net subsidies to affiliated companies engaged in speculative transactions in the capital markets, and it is therefore consistent with the objectives of both the Volcker Rule and the Lincoln Amendment.146 1 The First Tier of Traditional Banking Organizations Under my proposal, the first tier of regulated banking firms would be “traditional” banking organizations that limit their activities (including the activities of all holding company affiliates) to lines of business that satisfy the”closely related to banking” test under Section 4(c)(8) of the BHC Act.147 For example, 146 For discussions of similar “narrow bank” proposals, see, e.g., Robert E. Litan, What Should Banks Do? 164–189 (1987); Kay, supra note 5, at 39–92; Ronnie J. Phillips & Alessandro Roselli, How to Avoid the Next Taxpayer Bailout of the Financial System: The Narrow Banking Proposal (Networks Fin. Instit. Pol’y Brief 2009-PB-05, 2009), available at http:// ssrn.com/abstract_id=1459065. 147  See 12 U.S.C. § 1843(c)(8) (2006); Carnell, Macey & Miller, supra note 14, at 442–444 (describing “closely related to banking” activities that are permissible for nonbank subsidiaries of BHCs under § 4(c)(8)).

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this first tier of traditional banks could take deposits, make loans, offer fiduciary services, and act as agents in selling securities, mutual funds and insurance products underwritten by non-affiliated firms. Additionally, they could underwrite and deal solely in “bank-eligible” securities that national banks are permitted to underwrite and deal in directly.148 First-tier banking organizations could also purchase, as end-users, derivatives transactions that (i) hedge against their own firm-specific risks, and (ii) qualify for hedging treatment under Financial Accounting Standard (“FAS”) Statement No. 133.149 Most first-tier banking firms would probably be small and midsized ­communityoriented banks. In the past, those banks typically have not engaged as principal in insurance underwriting, securities underwriting or dealing, derivatives dealing or trading, or other capital markets activities. Community banks should be encouraged to continue their primary business of attracting core deposits, providing “high touch,” relationship-based loans to consumers and to small and medium-sized enterprises (“SMEs”), and offering wealth management and other fiduciary services to local customers.150 Traditional, first-tier banks and their holding companies should continue to operate under their current supervisory arrangements, and all deposits of first-tier banks (up to the current statutory maximum of $250,000) should be covered by deposit insurance. In order to provide reasonable flexibility to first-tier banking organizations, Congress should amend § 4(c)(8) of the BHC Act by permitting the FRB to expand the list of “closely related” activities that are currently allowed for holding company affiliates of traditional banks.151 However, Congress should prohibit first-tier BHCs from engaging as principal in underwriting or dealing in securities, underwriting any type of insurance (except for credit insurance), dealing or trading in derivatives, or making private equity investments. 148  See Wilmarth, “Transformation,” supra note 1, at 225, 225–226 n.30 (discussing “bank-­ eligible” securities that national banks are authorized to underwrite or purchase or sell for their own account); Carnell, Macey & Miller, supra note 14, at 132–134 (same). 149 Wilmarth, “Dodd-Frank,” supra note 4, at 1036. 150  In sharp contrast to traditional community banks, megabanks provide impersonal, highly automated lending and deposit programs to SMEs and consumers, and megabanks also focus on complex, higher-risk transactions in the capital markets. Id. at 1035–1038; Wilmarth, “Transformation,” supra note 1, at 261–270, 372–407. 151 GLBA prohibits the FRB from approving any “closely related” activities for bank holding companies under § 4(c)(8) of the BHC Act beyond those that were permitted on November 11, 1999. Carnell, Macey & Miller, supra note 14, at 444. Congress should amend § 4(c)(8) to authorize the FRB to approve a limited range of new activities that are “closely related” to the traditional banking functions of accepting deposits, extending credit, discounting negotiable instruments and providing fiduciary services. Wilmarth, “DoddFrank,” supra note 4, at 1036–1037 n.375.

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2 The Second Tier of Nontraditional Banking Organizations Unlike first-tier banking firms, the second tier of “nontraditional” banking organizations would be allowed to engage, through nonbank subsidiaries, in (i) underwriting and dealing (i.e., proprietary trading) in “bank-ineligible” securities,152 (ii) underwriting all types of insurance, and (iii) dealing and trading in derivatives. Second-tier banking organizations would include: (A) FHCs registered under §§ 4(k) and 4(l) of the BHC Act,153 (B) holding companies owning grandfathered “nonbank banks,” and (C) grandfathered “unitary thrift” holding companies.154 In addition, firms controlling industrial banks should be required either to register as FHCs or to divest their ownership of such banks if they cannot comply with the BHC Act’s prohibition of commercial activities.155 Second-tier holding companies would thus encompass all of the largest banking organizations, most of which are heavily engaged in capital markets activities, as well as other financial conglomerates that control FDICinsured depository institutions. 152 See Wilmarth, “Transformation,” supra note 1, at 219–220, 225–226 n.30, 318–320 (discussing distinction between (i) “bank-eligible” securities, which banks may underwrite and deal in directly, and (ii) “bank-ineligible” securities, which affiliates of banks may underwrite and deal in under GLBA, but banks may not). 153 12 U.S.C. § 1843(k), (l) (2006). See Carnell, Macey & Miller, supra note 14, at 467–470 (describing “financial” activities, including securities underwriting and dealing and insurance underwriting, that are authorized for FHCs under the BHC Act, as amended by GLBA). 154 See Arthur E. Wilmarth, Jr., “Wal-Mart and the Separation of Banking and Commerce,” 39 Connecticut Law Review 1539, 1569–1571, 1584–1586 (2007) (explaining that (i) during the 1980s and 1990s, many securities firms, life insurers and industrial firms used the “nonbank bank” loophole or the “unitary thrift” loophole to acquire FDIC-insured institutions, and (ii) those loopholes were closed to new acquisitions by a 1987 statute and by GLBA, respectively), available at http://ssrn.com/abstract=984103 [hereinafter Wilmarth, “Wal-Mart”]. 155 Industrial banks are exempted from treatment as “banks” under the BHC Act. See 12 U.S.C. § 1841(c)(2)(H). As a result, the BHC Act allows commercial (i.e., nonfinancial) firms to retain their existing ownership of industrial banks. Section 603 of Dodd-Frank imposed a three-year moratorium on the authority of federal regulators to approve any new acquisitions of industrial banks by commercial firms, but that moratorium expired in July 2013. See Wilmarth, “Wal-Mart,” supra note 155, at 1543–1544, 1554–1620 (arguing that Congress should prohibit commercial firms from owning industrial banks because such ownership (i) undermines the long-established U.S. policy of separating banking and commerce, (ii) threatens to spread federal safety net subsidies to the commercial sector of the U.S. economy, (iii) threatens the solvency of the DIF, (iv) creates competitive inequities between commercial firms that own industrial banks and other commercial firms, and (v) increases the likelihood of federal bailouts of commercial companies).

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a Congress Should Require a “Narrow Bank” Structure for SecondTier Banks Under my proposal, FDIC-insured banks that are subsidiaries of second-tier holding companies would be required to operate as “narrow banks.” The purpose of the narrow bank structure would be to prevent a “nontraditional” second-tier holding company from transferring the bank’s federal safety net subsidies to its nonbank affiliates. Narrow banks could offer FDIC-insured deposit accounts, including checking and savings accounts and certificates of deposit. Narrow banks would hold all of their assets in the form of cash and marketable, short-term debt obligations, including qualifying government securities, highly-rated commercial paper and other liquid, short-term debt instruments that are eligible for investment by money market mutual funds (“MMMFs”) under the SEC’s rules. Narrow banks could not hold any other types of loans or investments, nor could they accept any uninsured deposits. Narrow banks would present a very small risk to the DIF, because (i) each narrow bank’s non-cash assets would consist solely of short-term securities that could be “marked to market” on a daily basis, and the FDIC could therefore readily determine whether a narrow bank was threatened with insolvency, and (ii) the FDIC could promptly convert a narrow bank’s assets into cash if the FDIC decided to liquidate the bank and pay off the claims of its insured depositors.156 Thus, my proposed limitations on narrow bank investments would protect the DIF from any significant loss if a narrow bank failed. b Four Additional Rules Would Prevent Narrow Banks from Transferring Safety Net Subsidies to Their Affiliates Congress should adopt four supplemental rules to prevent second-tier holding companies from exploiting their narrow banks’ safety net subsidies. First, narrow banks should be absolutely prohibited – without any possibility of a regulatory waiver – from making any extensions of credit or other transfers of funds to their affiliates, except for the payment of lawful dividends out of profits to their parent holding companies.157 Currently, transactions between FDICinsured banks and their affiliates are restricted by §§ 23A and 23B of the Federal Reserve Act.158 However, the FRB repeatedly waived those restrictions during 156  See Wilmarth, “Dodd-Frank,” supra note 4, at 1038; Kenneth E. Scott, “Deposit Insurance and Bank Regulation: The Policy Choices,” 44 Business Lawyer 907, 921–922, 928–929 (1989). 157  Scott, supra note 156, at 929; Wilmarth, “Dodd-Frank,” supra note 4, at 1041. 158 12 U.S.C. §§ 371c, 371c-1 (2006).

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recent financial crises. The FRB’s waivers allowed bank subsidiaries of FHCs to provide extensive support to affiliated securities broker-dealers and MMMFs. By granting those waivers, the FRB enabled FHC-owned banks to transfer the safety net subsidy provided by low-cost, FDIC-insured deposits to their nonbank affiliates.159 Dodd-Frank limits the authority of the FRB to grant future waivers or exemptions under §§ 23A and 23B, because it requires the FRB to obtain the concurrence of either the OCC (with respect to waivers granted by orders for national banks) or the FDIC (with respect to waivers granted by orders for state banks or exemptions granted by rulemaking).160 Even so, it is unlikely that the OCC or the FDIC would refuse to concur with the FRB’s proposal for a waiver under conditions of financial stress. Accordingly, Dodd-Frank does not ensure that the restrictions on affiliate transactions in §§ 23A and 23B will be adhered to in a crisis setting. For example, in 2011 the FRB permitted BofA to evade the restrictions of § 23A by transferring an undisclosed amount of derivatives contracts from its Merrill broker-dealer subsidiary to its subsidiary bank. That transaction increased the potential risk that the DIF and taxpayers might ultimately have to cover losses incurred by BofA on the transferred derivatives. However, the transfer reportedly allowed BofA – which was struggling with a host of problems – to avoid contractual requirements to post $3.3 billion in additional collateral with counterparties, due to the fact that BofA’s subsidiary bank held a significantly higher credit rating than Merrill.161 One commentator noted that “the Fed’s priorities seem to lie with protecting [BofA] from losses at Merrill, even if that means greater risks for the FDIC’s insurance fund.”162 My proposal for second-tier narrow banks would replace §§ 23A and 23B with an absolute rule. That rule would completely prohibit any extensions of credit or other transfers of funds by second-tier banks to their nonbank affiliates (except for lawful dividends paid to parent holding companies). Thus, my proposal would bar federal regulators from approving any transfers of safety net subsidies by narrow banks to their affiliates. An absolute bar on affiliate 159  Wilmarth, “Dodd-Frank,” supra note 4, at 1041–1042. 160  Dodd-Frank, § 608(a)(4) (amending 12 U.S.C. § 371c(f)).id. § 608(b)(6) (amending 12 U.S.C. § 371c-1(e)(2)). 161 Kate Davidson, “Democrats Raise Red Flag on BofA Derivatives Transfer,” American Banker, Oct. 28, 2011; Simon Johnson, “Bank of America Is Too Much of a Behemoth to Fail,” Bloomberg.com, Oct. 23, 2011; Jonathan Weil, “Bank of America Bosses Find Friend in the Fed,” Bloomberg.com, Oct. 19, 2011. 162  Weil, supra note 161.

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transactions is necessary to prevent FDIC-insured banks from being used as backdoor bailout devices for their nonbank affiliates. Second, as discussed above, Congress should repeal the SRE currently included in the FDI Act. By repealing the SRE, Congress would require the FDIC to follow the least costly resolution procedure for every failed bank, and the FDIC could no longer rely on the TBTF policy as a justification for protecting uninsured creditors of a failed bank or its nonbank affiliates. Repealing the SRE would ensure that the DIF could not be used to support a bailout of uninsured creditors of a failed or failing SIFI. Removing the SRE from the FDI Act would also make clear to the financial markets that the DIF only protects bank depositors. Uninsured creditors of SIFIs and their nonbank subsidiaries would therefore have stronger incentives to monitor the financial operations and condition of such entities.163 Additionally, a repeal of the SRE would mean that smaller banks would no longer bear any part of the cost of protecting uninsured creditors of TBTF banks. Under current law, all FDIC-insured banks must pay a special assessment (allocated in proportion to their total assets) to reimburse the FDIC for the cost of protecting uninsured claimants of a TBTF bank under the SRE.164 A 2000 FDIC report noted the unfairness of expecting smaller banks to help pay for “systemic risk” bailouts when “it is virtually inconceivable that they would receive similar treatment if distressed.”165 The FDIC report suggested that the way to correct this inequity is “to remove the [SRE],”166 as my proposal would do. Third, second-tier narrow banks should be barred from purchasing derivatives except as end-users in transactions that qualify for hedging treatment under FAS 133. My proposal would require all derivatives dealing and trading activities of second-tier banking organizations to be conducted through separate nonbank affiliates, in the same manner that GLBA currently requires all underwriting and dealing in bank-ineligible securities to be conducted through nonbank affiliates of FHCs.167 Prohibiting second-tier banks from dealing and trading in derivatives would accomplish an essential goal of the Volcker Rule 163  Wilmarth, “Dodd-Frank,” supra note 4, at 1042–1043. 164  12 U.S.C. § 1823(c)(4)(G)(ii). 165 See Federal Deposit Ins. Corp., Options Paper, Aug. 2000, at 33, available at http://www .fdic.gov/deposit/insurance/initiative/Options_080700m.pdf. 166  Ibid. 167  See Carnell, Macey & Miller, supra note 14, at 27, 130–134, 467–470, 490–491 (explaining that, under GLBA, all underwriting and dealing of bank-ineligible securities by FHCs must be conducted through nonbank holding company subsidiaries or through nonbank financial subsidiaries of banks); Wilmarth, “Transformation,” supra note 1, at 219–220, 225–226 n.30, 318–320 (same).

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and the Lincoln Amendment, because it would prevent FHCs from continuing to exploit federal safety net subsidies by conducting speculative trading activities within their FDIC-insured bank subsidiaries. BofA’s transfer of derivatives from Merrill to its bank subsidiary in 2011 confirms that bank dealers in OTC derivatives enjoy significant competitive advantages over nonbank dealers, due to banks’ explicit and implicit safety net subsidies. Banks typically borrow funds at significantly lower interest rates than their holding company affiliates because (i) banks can obtain direct, lowcost funding through FDIC-insured deposits, and (ii) banks present lower risks to their creditors because of their direct access to other federal safety net resources, including (A) the FRB’s discount window lending facility, (B) the FRB’s guarantee of interbank payments made on Fedwire, and (C) the greater potential availability of TBTF bailouts for uninsured creditors of banks (as compared to creditors of BHCs).168 The OCC has noted that FHCs generate higher profits when they conduct derivatives activities directly within their banks, in part because the “favorable [funding] rate enjoyed by the banks” is lower than “the borrowing rate of their holding companies.”169 Such an outcome may be favorable to FHCs, but it is certainly not beneficial to the DIF and taxpayers. The DIF and taxpayers are exposed to a significantly higher risk of losses when derivatives dealing and trading activities are conducted directly within banks instead of within nonbank holding company affiliates. Congress should terminate this artificial, federally-subsidized advantage for bank derivatives dealers.170 Fourth, Congress should prohibit all private equity investments by second-tier banks and their holding company affiliates. To accomplish this reform – which would be consistent with the Volcker Rule as originally proposed – Congress should repeal Sections 4(k)(4)(H) and (I) of the BHC Act,171 which allow FHCs to make merchant banking investments and insurance company portfolio investments.172 Private equity investments involve a high degree of 168 Carnell, Macey & Miller, supra note 14, at 492; Wilmarth, “Dodd-Frank,” supra note 4, at 1044. 169  See Office of the Comptroller of the Currency, OCC Interpretive Letter No. 892, at 3 (2000) (from Comptroller of the Currency John D. Hawke, Jr., to Rep. James A. Leach, Chairman of House Committee on Banking & Financial Services), available at http://www.occ.treas .gov/interp/sep00/int892.pdf. 170  Wilmarth, “Dodd-Frank,” supra note 4, at 1044–1045. 171 12 U.S.C. § 1843(k)(4)(H), (I) (2006). 172  See Carnell, Macey & Miller, supra note 14, at 483–485 (explaining that “through the merchant banking and insurance company investment provisions, [GLBA] allows significant nonfinancial affiliations” with banks).

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risk and have inflicted significant losses on FHCs in the past.173 In addition, private equity investments threaten to “weaken the separation of banking and commerce” by allowing FHCs “to maintain long-term control over entities that conduct commercial (i.e., nonfinancial) businesses.”174 Such affiliations between banks and commercial firms are undesirable because they are likely to create serious competitive and economic distortions, including the spread of federal safety net benefits to the commercial sector of our economy.175 In combination, the four supplemental rules described above would help to ensure that narrow banks cannot transfer their federal safety net subsidies to their nonbank affiliates. Restricting the scope of safety net subsidies is of utmost importance in order to restore a more level playing field between small and large banks, and between banking and nonbanking firms. Safety net subsidies have increasingly distorted our regulatory and economic policies over the past three decades. During that period, nonbanking firms have pursued every available avenue to acquire FDIC-insured depository institutions so that they can secure the funding advantages provided by low-cost, FDIC-insured deposits. At the same time, nonbank affiliates of banks have made every effort to exploit the funding advantages and other safety net benefits conferred by their affiliation with FDIC-insured institutions.176 The most practicable way to prevent the spread of federal safety net subsidies – as well as their distorting effects on regulation and economic activity – is to establish strong barriers that prohibit narrow banks from transferring their subsidies to their nonbanking affiliates, including those engaged in speculative capital markets activities. The narrow bank structure and the supplemental rules described above would force financial conglomerates to prove that they can produce superior risk-related returns to investors without relying on explicit and implicit government subsidies. Economic studies have failed to confirm the existence of favorable economies of scale or scope in giant financial conglomerates, and those conglomerates have not been able to generate

173  174  175  176 

Wilmarth, “Transformation,” supra note 1, at 330–332, 375–378. Wilmarth, “Wal-Mart,” supra note 154, at 1581–1582. For further discussion of this argument, see ibid at 1588–1613. Id. at 1569–1570, 1584–1593; see also Kay, supra note 5, at 43 (stating: “The opportunity to gain access to the retail deposit base has been and remains irresistible to ambitious deal makers. That deposit base carries an explicit or implicit government guarantee and can be used to leverage a range of other, more exciting, financial activities. The archetype of these deal-makers was Sandy Weill, the architect of Citigroup”).

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consistently positive returns, even under the current regulatory system that allows them to capture extensive federal subsidies.177 In late 2009, a prominent bank analyst suggested that if Congress prevented nonbank subsidiaries of FHCs from relying on low-cost deposit funding provided by their affiliated banks, large FHCs would not be economically viable and would be forced to break up voluntarily.178 Many of the largest commercial and industrial conglomerates in the U.S. and Europe have been broken up through hostile takeovers and voluntary divestitures during the past three decades because they proved to be “less efficient and less profitable than companies pursuing more focused business strategies.”179 It is long past time for financial conglomerates to be stripped of their safety net subsidies and their presumptive access to TBTF bailouts so that they will be subject to the same type of scrutiny and discipline that the capital markets have already applied to commercial and industrial conglomerates. The narrow bank concept provides a workable plan to impose such scrutiny and discipline on FHCs. c Responses to Critiques of the Narrow Bank Proposal Critics have raised two major objections to the narrow bank concept. First, some analysts argue that the narrow bank proposal would lack credibility because regulators would retain the inherent authority (whether explicit or implicit) to organize bailouts of major financial firms during periods of severe economic distress. Accordingly, the narrow bank concept would simply shift the TBTF problem from insured banks to their nonbank affiliates.180 However, the force of this objection has been weakened by the systemic risk oversight and resolution regime established by Dodd-Frank. Under DoddFrank, FHCs that might have been considered for TBTF bailouts in the past will 177  Wilmarth, “Reforming Financial Regulation,” supra note 1, at 748–749; see also Johnson & Kwak, supra note 5, at 212–213. 178  Karen Shaw Petrou, the managing partner of Federal Financial Analytics, explained that “[i]nteraffiliate restrictions would limit the use of bank deposits on nonbanking activities,” and “[y]ou don’t own a bank because you like branches, you own a bank because you want cheap core funding.” Ms. Petrou therefore concluded that an imposition of stringent limits on affiliate transactions, “really strikes at the heart of a diversified banking organization” and “I think you would see most of the very large banking organizations pull themselves apart” if Congress passed such legislation. Stacy Kaper, “Big Banks Face Most Pain under House Bill,” American Banker, Dec. 2, 2009, at 1 (quoting Ms. Petrou). 179  Wilmarth, “Dodd-Frank,” supra note 4, at 1047. 180  See Scott, supra note 156, at 929–930 (noting the claim of some critics that there would be “irresistible political pressure” for bailouts of uninsured “substitute-banks” that are created to provide the credit previously extended by FDIC-insured banks).

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be designated and regulated as SIFIs and will also be subject to resolution under Dodd-Frank’s OLA. In addition, as shown above, the potential for TBTF bailouts of SIFIs would be reduced further if (i) Congress required all SIFIs to pay risk-based premiums to pre-fund the OLF, so that the OLF would have the necessary resources to handle future resolutions of failed SIFIs, and (ii) Congress repealed the SRE so that the DIF would no longer be available as a potential bailout fund for TBTF institutions. Thus, if my proposed reforms were fully implemented, (i) the narrow bank structure would prevent SIFI-owned banks from transferring their safety net subsidies to their nonbank affiliates, and (ii) Dodd-Frank’s systemic risk oversight and resolution regime would require SIFIs to internalize the potential risks that their operations present to financial and economic stability. In combination, both sets of regulatory reforms would greatly reduce the TBTF subsidies that might otherwise be available to large financial conglomerates. Moreover, the narrow bank structure would increase the effectiveness of Dodd-Frank’s requirement for “living wills” (resolution plans) by making it much easier for regulators to separate banks owned by failed SIFIs from their nonbank affiliates. As explained above, narrow banks would not be allowed to become entangled with their nonbank affiliates through extensions of credit and other transfers of funds.181 The second principal objection to the narrow bank proposal is that it would place U.S. FHCs at a significant disadvantage in competing with foreign universal banks that are not required to comply with similar constraints.182 Again, there are persuasive rebuttals to this objection. In September 2011 the U.K. Independent Commission on Banking (“ICB”), chaired by John Vickers, issued a report advocating a reform program similar to my proposal. The ICB program called for large financial conglomerates to adopt a “ring-fenced” structure that would separate and “insulate” their retail banking operations – including financial services provided to consumers and SMEs – from their wholesale activities in the capital markets.183 Thus, the ICB’s program would require financial conglomerates to “build firewalls between their consumer units and investment banks” and would likely cause “a jump in the cost of funding for their investment-banking divisions as the implicit [U.K.] government 181  Wilmarth, “Dodd-Frank,” supra note 4, at 1050–1051. 182  See Kay, supra note 5, at 71–74; Scott, supra note 156, at 931. 183  Howard Mustoe & Gavin Finch, “Banks in U.K. Have to Insulate Consumer Units in $11 Billion Vickers Plan,” Bloomberg.com, Sept. 12, 2011; see also Kay, supra note 5, at 51–69 (advocating adoption by the U.K. of a narrow banking plan that would accomplish “the separation of utility from casino banking”).

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guarantee is removed.”184 In February 2013, the U.K. government introduced legislation to implement the ICB’s “ring-fencing” recommendations.185 U.K. Chancellor of the Exchequer George Osborne had previously pledged that the implementing legislation would “separate [retail] banking from investment banking to protect the British economy, protect British taxpayers, and make sure that nothing is too big to fail.”186 If the U.S. and the U.K. both decide to mandate a narrow banking structure (supplemented by strong systemic risk oversight and resolution regimes), their combined leadership in global financial markets would (i) preclude claims by global SIFIs that they would face an unlevel playing field if they competed in both the New York and London financial markets, and (ii) place considerable pressure on other major global financial centers to adopt similar financial reforms.187 The financial sector accounts for a large share of the domestic economies of the U.S. and U.K. Both economies were severely damaged by two financial crises occurring after 2000 (the dotcom-telecom bust and the subprime lending crisis). Both crises were caused (at least in part) by a group of SIFIs that continues to dominate the financial systems in both nations. Accordingly, regardless of what other nations may do, the U.S. and the U.K. have compelling national reasons to make sweeping changes to their financial

184  Liam Vaughan, Howard Mustoe & Gavin Finch, “U.K. Bank Investors Chided as Vickers Returns Firms to 1950s,” Bloomberg.com, Sept. 13, 2011. 185  Lee & Ligere, supra note 73, at 600–601. 186  Marietta Cauchi, “U.K. Backs Broad Bank Overhaul: Lenders Must ‘Ring Fence’ Retail Activities From Riskier Activities, Combating ‘Too Big to Fail’,” Wall Street Journal, Dec. 20, 2011, at C2 (quoting Mr. Osborne’s speech in Parliament on Dec. 19, 2011). [Editors’ note: In December 2013, the U.K. Parliament enacted legislation to implement the ICB’s ringfencing proposals. Wlliam James, “Reform of Britain’s banking laws clears final hurdle,” Reuters.com, Dec. 16, 2013.] 187  Wilmarth, “Dodd-Frank,” supra note 4, at 1051; Kay, supra note 5, at 74. In July 2013, the European Union Parliament “voted overwhelmingly” in favor of broad outlines for a plan to restructure the banking industry. Like the ICB’s program, the proposed plan would “separate sources of funding and balance sheets for retail and investment activities” of banks in the European Union in order to “ensure that capital is not shifted from deposits and credit activities to risky trading activities.” Joe Kirwin, “International Banking: EU Parliament Demands Sharp Divide Between Commercial, Retail Banking,” 101 BNA’s Banking Report 51 (July 9, 2013). However, due in part to heavy lobbying against the plan by large European banks, it was very doubtful whether such a plan of separation would be formally adopted before the European Union Parliament adjourned in 2014. See Jim Brunsden & Eshe Nelson, “Bank-Structure Plan Dealt Blow as EU Lawmaker Says No Time,” Bloomberg.com, Oct. 28, 2013.

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systems in order to protect their domestic economies from the threat of a similar crisis in the future.188 Claims by the financial industry that the U.S. and the U.K. should refrain from implementing fundamental financial reforms until all other major developed nations have agreed to do so rest upon two deeply flawed assumptions: (i) the U.S. and the U.K. should allow foreign nations with the weakest systems of financial regulation to set the maximum level of supervisory constraints on global SIFIs, and (ii) until a comprehensive international agreement on supervisory reform is achieved, the U.S. and the U.K. should continue to provide TBTF bailouts and other safety net subsidies that impose huge costs, create moral hazard and distort economic incentives, simply because other nations provide similar benefits to their SIFIs.189 Both assumptions are unacceptable and must be rejected. Conclusion Dodd-Frank makes meaningful improvements in the regulation of large financial conglomerates. Dodd-Frank establishes a new umbrella oversight body – the FSOC – that will designate nonbank SIFIs and make recommendations for the supervision of those institutions and large BHCs. Dodd-Frank also empowers the FRB to adopt stronger capital requirements and other enhanced prudential standards for both types of SIFIs. In addition, Dodd-Frank establishes the OLA as a new resolution regime for failed SIFIs. However, the OLA’s feasibility remains unproven with regard to global SIFIs that operate across multiple national borders, since most foreign countries have not adopted resolution procedures that are compatible with the OLA. As explained above, the OLA does not completely shut the door to future government support for creditors of SIFIs. The FRB can still provide emergency liquidity assistance to troubled SIFIs through the discount window and through “broad-based” liquidity facilities like the Primary Dealer Credit Facility. 188  See, e.g., King 2009 Speech, supra note 14; Kay, supra note 5, at 71–74; Wilmarth, “DoddFrank,” supra note 5, at 1051–1052; see also Ali Quassim, “International Banking: U.K. Banking Reform Includes ‘Ringfencing’ Retail Banks, Higher Equity Requirements,” 98 BNA’s Banking Report 32 (Jan. 3, 2012) (quoting Chancellor of the Exchequer George Osborne’s statement that the ICB’s reform program seeks to resolve “the ‘British Dilemma’: how Britain can be home to one of the world’s leading financial centers without exposing British taxpayers to the massive costs of those banks failing”). 189  See e.g., Kay, supra note 5, at 42–46, 57–59, 66–75; Wilmarth, “Dodd-Frank,” supra note 4, at 1052.

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FHLBs can still make collateralized advances to SIFIs. The FDIC can potentially use its Treasury borrowing authority and the SRE to protect uninsured creditors of failed SIFIs and their subsidiary banks. While Dodd-Frank has made TBTF bailouts more difficult, the continued existence of these avenues for financial assistance indicates that Dodd-Frank is not likely to stop regulators from protecting creditors of troubled SIFIs during future episodes of systemic financial distress. Moreover, Dodd-Frank relies heavily on the same supervisory tools – capitalbased regulation and prudential supervision – and the same regulatory agencies that failed to prevent the banking and thrift crises of the 1980s and the recent financial crisis. As Simon Johnson and James Kwak have observed: [S]olutions that depend on smarter, better regulatory supervision and corrective action ignore the political constraints on regulation and the political power of the large banks. The idea that we can simply regulate large banks more effectively assumes that regulators will have the incentive to do so, despite everything we know about regulatory capture and political constraints on regulation.190 Congress could have addressed the TBTF problem directly by mandating a breakup of large financial conglomerates. Johnson and Kwak have proposed maximum size limits that would require a significant reduction in size for each of the six largest U.S. banking organizations.191 Like Joseph Stiglitz, Johnson and Kwak maintain that “[t]he best defense against a massive financial crisis is a popular consensus that too big to fail is too big to exist.”192 However, during the Senate’s floor debates on Dodd-Frank, the Senate rejected a similar proposal for maximum size limits. It seems unlikely – in view of Wall Street’s formidable political clout – that Congress will pass such legislation in the foreseeable future.193 My recommended approach would impose structural requirements and activity limitations that would (i) prevent SIFIs from using the federal safety net to subsidize their speculative activities in the capital markets, and (ii) make it much easier for regulators to separate banks from their nonbank 190  Johnson & Kwak, supra note 5, at 207. 191  Ibid at 214–217. 192  Ibid at 221. See also Joseph E. Stiglitz, Freefall: America, Free Markets, and the Sinking of the World Economy 165–166 (2010) (“There is an obvious solution to the too-big-to-fail banks; break them up. If they are too big to fail, they are too big to exist”). 193  Wilmarth, “Dodd-Frank,” supra note 4, at 1055–1056.

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affiliates when SIFIs are threatened with failure. A pre-funded OLF would require all SIFIs to pay risk-based assessments to finance the future costs of resolving failed SIFIs. A repeal of the SRE would prevent the DIF from being used as a backdoor bailout fund for non-deposit creditors of megabanks. A two-tiered system of bank regulation would (i) restrict traditional banking organizations to deposit-taking, lending, fiduciary services and other activities that are “closely related” to banking, and (ii) mandate a “narrow bank” structure for banks owned by financial conglomerates. In turn, the narrow bank structure would (A) insulate narrow banks and the DIF from the risks of capital markets activities conducted by nonbank affiliates, and (B) prevent narrow banks from transferring their FDIC-insured, low-cost funding and other safety net subsidies to nonbank affiliates. My recommended reforms would remove many of the safety net subsidies that are currently exploited by SIFIs and would subject them to the same type of market discipline that investors have applied in breaking up commercial and industrial conglomerates during the past thirty years. Financial conglomerates have never demonstrated that they can provide beneficial services to their customers and attractive returns to their investors without relying on safety net subsidies during good times and massive taxpayer-funded bailouts during crises. It is long past time for SIFIs to prove – based on a true market test – that their claimed synergies and their supposedly superior business model are real and not illusory. If SIFIs cannot produce favorable results without their current TBTF subsidies, market forces should compel them to break up voluntarily.

chapter 8

Say on Pay, Soft Law and the Regulatory Focus on Enforcement and Transparency Poonam Puri* and Simon Kupi** I Introduction “Sunlight is said to be the best of disinfectants,” wrote Louis Brandeis – an aphoristic metaphor one might expect to find in one of the American jurist’s landmark free-speech cases. Yet the statement belonged not to Brandeis the judge, but Brandeis the financial reformer, writing in a 1913 Harper’s Weekly column that fervently attacked a lack of corporate “publicity,” offering that investor disclosure “must be real,” “obligatory,” and “in good type.”1 Over a ­century after Brandeis’s call-to-arms, better-armed regulators and a more ­generously-informed public have the benefit of an incomparably more rigorous system of corporate disclosure. Yet a further refinement on Brandeis’s call tugs harder: is “sunlight” even enough? The three-decades-long controversy over executive pay provides a case in point. Many jurisdictions could boast of rules and guidelines governing disclosure of director and manager pay by the mid-1990s. Enlightened, investors could at last hold companies accountable for stratospheric pay packages decoupled from corporate performance. Or so went the age-old theory. Reality was different: pay packages continued to soar, reaching new levels and assuming new forms. In the global financial crisis that began to unravel in 2007, risk-aggravating compensation practices played a disturbingly central role. Given the importance of compensation to corporate governance – and, in the case of financial institutions, to the world economy itself – did

* Poonam Puri is Associate Dean and Professor at Osgoode Hall Law School, York University, Toronto. ** Simon Kupi is a regulatory lawyer with the National Energy Board in Calgary. 1 Louis D. Brandeis, “What Publicity Can Do” Harper’s Weekly (20 December 1913). The column would later be published, in 1914, as a chapter in Brandeis’ book Other Peoples’ Money and How the Bankers Use It, available online: .

© koninklijke brill nv, leiden, 2015 | doi 10.1163/9789004280328_009

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agencies misplace their faith in the efficacy of transparency in protecting the public interest? In this chapter, we situate transparency within a regulatory framework that leverages “soft law” and soft dimensions of law to promote compliance outcomes. Soft law – which we define as non-binding rules and principles – is a concept that has attracted much academic interest, most notably in international law. We first hope to connect the international literature to more domestic law-focused “new governance” scholarship. We then use the “say on pay” movement as a case study to consider what role soft law and transparency can play both in tandem with and instead of traditional “hard law” sources of regulation. We conclude that while disclosure by itself did little to hold boards to account over pay, say on pay provides an example of how “hard” procedural reforms supporting a soft law system can serve as a kind of optimal regulatory first-move in an untried area – a “win-win” for the regulator, the regulated and the public. But we insist that regulators must be willing to go beyond disclosure and soft law when the evidence so dictates. In Part II, we define soft law. In Part III, we distinguish soft international and soft domestic law and discuss soft law’s advantages and disadvantages for regulation. In Part IV, we consider say on pay as a “hybridized” soft regulatory initiative across jurisdictions. In Part V, we consider one approach to finding the optimal balance of hard and soft law and explore how say on pay’s development reflects that search process. II

What is Soft Law?

The sheer quantity of “soft law” literature – over an array of subject-matter ranging from the environment2 to international banking3 to domestic legislative resolutions4 – betrays a clean consensus on its parameters. In this part, we begin by parsing out a simple, working definition. We also draw attention to three salient features of soft law examined in the existing scholarship: the 2  See e.g. Pierre-Marie Dupuy, “Soft Law and the International Law of the Environment” (1991) 12 Mich. J. Int’l L. 420. 3 See e.g. Douglas W. Arner & Michael W. Taylor, “The Global Financial Crisis and the Financial Stability Board: Hardening and the Soft Law of International Financial Regulation?” (2009) 32 U.N.S.W.L.J. 488; Lawrence L.C. Lee, “The Basle Accords as Soft Law: Strengthening International Banking Supervision” (1999) 39 Va. J. Int’l L. 1. 4  See Jacob E. Gersen & Eric A. Posner, “Soft Law: Lessons from Congressional Practice” (2009) 61 Stan. L. Rev. 573.

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diverse, unbounded body of potential soft law sources; the “hardening” of soft law; and the notion of various dimensions of “softness” that can be used to analyse any rule, principle or system of regulation. At a basic level, almost all scholars believe that hard law refers to rules and principles that are legally binding, whereas soft law refers to rules and principles that are not.5 While some have criticized this definition as too basic or have formulated more context-driven definitions,6 we believe most accounts can be reduced to a binding/non-binding distinction. That is not to say there is no fruit in describing the “softness” of law outside of this simple dichotomy, as we hope to do below. At its core, however, soft law does not bind, but influences. Our benignly-phrased distinction, however, belies the more charged nature of soft law as a matter of legal theory. In particular, to accept the existence of soft law is to immediately take a position against positivist lines of thought that hold non-legally binding authority not to be “law” at all.7 Coming from this 5 See e.g. Dupuy, supra note 2 at 428 (observing that “the very nature of ‘soft’ law lies in the fact that it is not itself legally binding”); Gersen & Posner, supra note 4 at 579 (defining soft law as “a rule issued by a lawmaking authority that does not comply with constitutional and other formalities or understandings that are necessary for the rule to be legally binding”); Roberta S. Karmel & Claire R. Kelly, “The Hardening of Soft Law in Securities Regulation” (2009) 34 Brook. J. Int’l L. 883 at 884 (defining soft law as “nonbinding standards and principles of conduct”); Dina Shelton, “Law, Non-Law and the Problem of ‘Soft Law’” in Dina Shelton, ed., Commitment and Compliance: The Role of Non-Binding Norms in the International Legal System (Oxford: Oxford University Press, 2000) at 1 (describing soft law as consisting of “legally non-binding norms”); Lorne Sossin & Charles W. Smith, “Hard Choices and Soft Law: Ethical Codes, Policy Guidelines and the Role of the Courts in Regulating Government” (2003) 40 Alta. L. Rev. 867 at 869 (noting how soft law (construed more narrowly to refer to administrative codes and guidelines) “cannot in theory bind decision-makers, yet in practice…often has as much or more influence that legislative standards”). 6 In particular, Gregory Shaffer and Mark Pollack prefer to view hard and soft law “not as binary categories but rather as choices arrayed along a continuum.” See Gregory C. Shaffer & Mark C.A Pollack, “Hard vs. Soft Law: Alternatives, Complements, and Antagonists in International Governance” (2010) 94 Minn. L. Rev. 706 at 716. Christine Chinkin also resists a definition, observing that “[t]here is a wide diversity in the instruments of so-called soft law which makes the generic term a misleading simplification” and that “[i]t is no longer possible to assume that a proposition is either a legally binding norm or not” at the international level. See Christine M. Chinkin, “The Challenge of Soft Law: Development and Change in International Law” (1989) 38 Int’l & Comp. L. Q. 850 at 850, 866. 7  For instance, according to the father of legal positivism, John Austin, a law is simply “a command which obliges a person or persons” (the so-called “command theory of law”). See John Austin, The Province of Jurisprudence Determined and the Uses of the Study of Jurisprudence (Indianapolis, IN: Hackett Publishing Company, 1998) at 24.

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tradition, Jan Klabbers forcefully argues that the label should be committed to the dustbin in favour of a return to a “binary” notion of law: one either has a legal obligation, or does not.8 We find Klabbers’ limited notion of “law” insufficient for describing the broader picture of modern regulation that we focus on in this chapter – in which adjudication is but one, part. In particular, Klabbers’ account falls victim to a “command” theory of law that fails to explain why many laws enjoy respect in spite of a lack of sanctions. In this respect, the twentieth century’s leading positivist, H.L.A. Hart, saw law as encompassing not only what actors are “obliged” to do, but also their “obligations” – the rules and principles they have “internalized” on moral, logical or other grounds unrelated to coercion.9 This internalization process is at the heart of the concept of soft law, even though Hart himself would surely consider soft law a “pre-legal form of social structure” rather than a legal system in itself – the same critique he levied at international law (much of which is, as it happens, either soft law or markedly soft in character).10 However, just as Hart nevertheless accepted the “international law” label as a shorthand for a set of rules and principles with important “analogies of content” to conventional law,11 we believe soft law to be a descriptive term that runs little risk of stoking confusion in concept-of-law debates. Beyond this, a powerful pragmatic case exists for acknowledging soft law as part of the broader legal landscape. In particular, an unprecedented number of “soft” rules and principles now permeate modern regulation in sources from NGO policies to industry guidelines to the public statements of administrative agencies. Be it from the rise of the “new governance” movement12 or the cost or complexity of administering conventional legal rules, soft law can no longer simply be ignored or dismissed as irrelevant. Indeed, in the domestic regulatory space that is the focal point of this chapter, guidelines are today often described as attracting greater interest from regulated actors or their counsel than the less fleshed-out legislation or regulation on which they are based.13 Moreover, soft law often plays a significant role in the law-making process: it can be a stepping-stone for future hard law or can, on the other hand, pre-empt such regulation. 8 9 

Jan Klabbers, “The Redundancy of Soft Law” (1996) 65 Nordic J. Int’l L. 167. See Leslie Green, ed., H.L.A. Hart, The Concept of Law (Oxford: Oxford University Press, 2012) at 82. 10  Ibid., ch. 10, “International Law.” 11  Ibid. at 237. 12 For an overview of the advent of the “new governance” movement in regulation, see generally Orly Lobel, “The Renew Deal: The Fall of Regulation and the Rise of Governance in Contemporary Legal Thought” 89 Minn. L. Rev. 342. 13  Sossin & Smith, supra note 5 at 869.

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Whether international or domestic, we accept that soft law instruments can be found in sources that are both non-binding (such as memoranda of understanding or UN resolutions) and binding (such as statutes or treaties), and that originate with both state actors (such as regulators or judges) as well as nonstate actors (such as industry associations or NGOs). This accords with what we view as the “anarchic” make-up of the soft law field – the lack, in other words, of a soft law “system” prescribed by rules designating what soft law is and how to amend or adjudicate it.14 While our view that non-state actors can promulgate something labelled as law may be controversial for some, we believe it essential to an appreciation of the increasingly “blurred” boundaries of modern regulation whereby, as described by Jason Solomon, [r]egulated entities are involved themselves in setting the standards, third parties may be involved in monitoring and enforcement, and state actors may serve as facilitators who oversee mechanisms for information pooling, rather than the experts in administrative agencies envisioned when the administrative state began …. The “private role in public governance” may go so far as second-order agreements to implement the regulatory standard that in turn operate to change the content of the standard down the road.15 Here, we note that by designating any instrument soft law, we make no statement as to its normative merits. In other words, we take the traditional positivist view that law need not be “good” to be law. We recognize that regulators must be attuned to the significant risks from third parties’ role in soft law, particularly when soft law crowds out hard law or, rather, “hardens” into it. “Hardening” is the phenomenon whereby soft law becomes hard law or, to refer back to our adopted definition, where formerly non-binding rules and principles become binding. Thus far, the dominant strand of hardening literature concerns international law. On the hardening account, soft law experiences a gestation period during which states and their populations simultaneously assess, and grow accustomed to, the operation of the relevant rules and principles as a matter of practice.16 In domestic law, however, we argue that the 14

These are what Hart deems as the “secondary rules”: the “rule of recognition,” “rules of change” and “rules of adjudication.” See The Concept of Law, supra note 9, and in particular ch. 5, “Law as the Union of Primary and Secondary Rules.” 15  Jason M. Solomon, “New Governance, Preemptive Self-Regulation, and the Blurring of Boundaries in Regulatory Theory and Practice” (2010) Wis. L. Rev. 592 at 595. 16  See e.g. Chinkin, supra note 6 at 856; Lee, supra note 3 at 40; Shaffer & Pollack, supra note 6 at 721; and Karmel & Kelly, supra note 5 at 894.

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opposite phenomenon is of equal – if not greater – importance: namely, the possibility that soft law may pre-empt hard law.17 Domestic soft law thus calls for more, not less, active regulation at the same time as it facilitates a more open and less adversarial style of oversight. A final way of framing soft law is in its adjectival sense: namely, we believe a law can legitimately be described as “softer” or “harder” in nature. For Kenneth Abbott and Duncan Snidal, “legalization” – or, for our purposes, a law’s place on the hard-soft spectrum – varies across three dimensions: (i) precision of rules; (ii) obligation; and (iii) delegation to a third-party decision-maker.18 In the first place, a law may be more or less precise, with more vague rules and principles moving in a “softer,” more laissez-faire direction. Next, a law may specify or indicate its binding or non-binding nature, either by way of specific language in the instrument itself (as is often the case with memoranda of understanding) or the indication of relevant provisions (such “the parties shall” versus “the parties expect”). Lastly, a law may or may not be supported by monitoring or enforcement infrastructure. As we explore in greater depth in the parts below, Shaffer and Pollack’s spectrum is an invaluable concept in assessing and devising regulatory frameworks for particular industries, especially where those frameworks must adapt to varied and changing circumstances. Thus, certain features of a “new governance” mode of regulation – such as the movement toward principles-based regulation, for instance – can be usefully described as experiments in selective “softening.” At the same time, we believe that each of the Abbott and Snidal factors goes to the same matter: the degree to which a law is binding. In particular, an imprecise rule, or a rule without a mechanism for third-party enforcement, cannot be said to “bind” anything in real terms, whatever its label. Having set out a high-level description of what we view soft law to be, we proceed to consider the relative advantages and disadvantages of soft law as a form of regulation. III

The Compliance Utility of Soft Law

The question lingers: why soft law? Why would states – bodies that exist to promulgate and enforce laws – ever opt for non-binding authority over binding authority? In the case of international soft law, there may be no option at all. 17  See Part III(2)(b), below. 18 Kenneth W. Abbott & Duncan Snidal, Hard and Soft Law in International Governance, (2001) 54 Int’l Org. 421 at 421. See also Shaffer & Pollack, supra note 6 at 714 and Karmel & Kelly, supra note 5 at 895 (both citing the Abbott and Snidal construct).

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In a diverse, multi-polar and international system the prospect that all states will converge on any given rule or principle is dim. The compliance utility of domestic soft law, in contrast, is more of a puzzle: regulators are not only wellequipped to enforce the law, but often have extensive rule-making powers of their own. In this Part, we begin by exploring the distinctions between international and domestic soft law. We find that domestic soft law is grounded not in practical necessity, but in a shift toward new-governance models of regulation that emphasize notions of engagement and flexibility. But we also view soft law as carrying distinct risks: on one hand, reduced regulator accountability; and on the other, the risk that industry-made rules and principles “crowd out” new hard law while failing to adequately protect the public interest. Because these dangers exist unevenly across the field of modern regulation, the extent to which agencies rely on soft law is, in our view, a vital aspect of regulatory design. (1) International versus Domestic Soft Law The proliferation of “soft” international instruments often reflects the prohibitive cost of developing hard law at the interstate level. As Jacob Gersen and Eric Posner have theorized, “[a]ll else equal, the relative importance of soft law to hard law…will rise as the formalities for creating hard law become stricter.”19 In particular, in the absence of a world government capable of passing and enforcing laws to bind all states, international law is not a “legal system” per se but rather, as Hart claimed, a kind of “pre-legal social order” where groups with compatible interests converge around the rules that favour them and reject (or “honour in the breach”) the rest. Palpably, modern nation-states cannot be constrained like individuals. In this environment, there is little guarantee that a state engaging in a violation of even a widely-endorsed rule or principle – say, the United Nations Convention Against Torture – will not be able to rely on military might, diplomacy, or the inertia of other states to resist pressures for change. Hard international law is more frequently observed where relatively small numbers of states agree to treaties or other agreements in respect of shared commitments that they then ratify into domestic law. Otherwise, its development is often split along stark political or economic divides:20 most notably, the current post-colonial “North–South” schism between developed and developing states and the prior Cold War gulf between “Western Bloc” and “Eastern Bloc” states. Hard law is, in short, expensive and hard-won in international law – the product of vigorous bargaining between sovereign entities 19  Gersner & Posner, supra note 4 at 620. 20  See e.g. Dupuy, supra note 2 at 421.

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that often see local regulation of a subject-matter as a “valued national prerogative.”21 International soft law, offering a low-commitment route to consensus, thus “resulted from the inadequacy of hard law, which cannot overcome deadlocks in international relations that result from political or economic differences.”22 It is “often a compromise between those States which did favour any regulatory instrument and those which would have preferred the conclusion of a treaty.”23 It reflects states’ recognition that “with regard to difficult and complex areas of concern… easy solutions do not exist and that too rigidly-defined obligations would not only lead to inefficiency by deterring a significant number of concerned governments from [ratification].”24 The emergence of non-binding instruments on the international scene is, at its core, a result of hard law being too costly to develop, with sponsor-states left to acquiesce to a “weaker” soft law instrument or “no law at all.”25 As Christine Chinkin notes, international soft law takes many forms: Soft law instruments range from treaties, but which include only soft obligations (“legal soft law”), to non-binding or voluntary resolutions and codes of conduct formulated and accepted by international and regional organisations (“non-legal soft law”), to statements prepared by individuals in a non-governmental capacity, but which purport to lay down international principles.26 Sponsor states may see these instruments as a means to a longer-term hard law end. Indeed, there is a case that reform, particularly in new areas of concern, is more likely to succeed over time in an incremental, piecemeal fashion as state actors “acclimatize” to new obligations or begin to accept their normative underpinnings27 – the much-discussed “hardening” of soft law. As Chinkin writes, soft law instruments are thus “frequently not only regulatory but are also intended to construct and programme the development towards a new economic structure.”28 21  Arner & Taylor, supra note 3 at 509. 22  Lee, supra note 3 at 3–4. 23 Christine M. Chinkin, “The Challenge of Soft Law: Development and Change in International Law” (1989) 38 Int’l & Comp. L.Q. 850 at 861. 24  Dupuy, supra note 2 at 430. 25  Chinkin, supra note 23 at 861. 26  Ibid. at 851. 27  Lee, supra note 3 at 40. 28  Chinkin, supra note 23 at 853.

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In contrast, soft law’s relative ease of enactment is less explanatory of its role on the domestic stage. First, there are clear sources of legally-binding rules and principles in most domestic legal systems: “law” is enacted by an elected legislature, enshrined in judicial decisions, voted into force by way of a referendum, et  cetera. Second, owing to the state’s monopoly over coercion, there is no enforceability gap at the domestic level: natural or legal persons cannot escape the law for too long before being subject to a monetary judgment, imprisonment or other deleterious consequences. Finally, while the costs of law-creation and amendment vary greatly across state and subject-area regimes, they are not always high. Most notably, administrative agencies – the bodies charged with the lion’s share of the regulatory task – can often effect change pursuant to statutory rule-making powers on a procedurally-lax “notice and comment” basis. All of this might lead us to expect, as per Gersen and Posner’s prediction, that domestic soft law should be (in relative terms) less important than international soft law. That may be true. Yet it may also understate the extent of soft law’s domestic impact. In particular, notwithstanding the accessibility of hard law solutions in domestic law, a vast body of domestic soft law exists. With the exception of industry or activist-drafted soft law, ease of enactment cannot explain this prevalence. In the next two parts, we argue that domestic soft law exists not as a second-best alternative to hard law, but as a reaction or complement to it. (2) Participatory Aspects of Domestic Soft Law (a) Improved Capacity-Building In the first place, a regulator can employ soft law to better communicate obligations to industry actors, shifting into a “participatory” mode that may be more effective than a strict, formal approach to compliance. As Deborah Rupp and Cynthia Williams note, many traditional accounts of regulation often overemphasize a “rational actor” model of organizational behaviour, explaining outcomes largely in terms of the pursuit of reward and the avoidance of punishment. These accounts focus on credible (usually formal) sanctions and, by extension, hard law. In contrast, soft law’s tools have the potential to engage a broader range of human motivations, needs, emotions, and moral reasoning, and thus might more effectively encourage behaviour that optimize society’s regulatory goals than do approaches that rely only on appeal to instrumental considerations or self-interest of the regulated entity.29 29

Deborah E. Rupp & Cynthia A. Williams, “The Efficacy of Regulation as a Function of Psychological Fit: Reexamining the Hard Law/Soft Law Continuum” (2010) 12 Theo. Inq. L. 581 at 585.

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A soft approach takes binding authority off the table until proven necessary.30 Human, plain-language interactions often take precedence over letter exchanges intermediated by legal language (and often, by lawyers themselves). Alternatively, non-binding guidance documents – interpretation bulletins, public statements, published questions and answers, and so on – can assist smaller companies or individuals with a limited capacity to hire legal help to guide their compliance. Because a soft approach takes place at a distance from the regulator’s formal powers, it is better-suited to promoting regulated entities’ identification with, and internalization of, regulation. A “carrots” and “sticks” approach, in contrast, may engender resistance. Rupp and Williams refer to “self-determination theory” in psychology, which posits that actors are at their optimal condition where they feel both a sense of motivation and responsibility. When regulators operate at arm’s length, for instance, compliance personnel may lack the sense of relatedness necessary to feel a strong, internally-imposed sense of accountability for governance outcomes. Likewise, continuous negative evaluations may lead entities to reject the legitimacy of the regulator’s project. Entities without any sense of discretion over the regulatory process – such as meaningful input into rule-making – are also more liable to see it as reflecting the regulator’s values, not the company’s. Of course, this analysis will not be relevant to all regulatory fora. In some, the ship of “softness” will have sailed, with an adversarial norm baked into regulator-regulated relations through years of litigiousness and gamesmanship. In others, however, a “reset” may well be possible; and in previouslyunregulated or newly-regulated domains, soft law may be an especially attractive starting-point, provided it is paired with meaningful backstop sanction powers to deter non-cooperation. In essence, soft law’s participatory focus allows for a more constructive approach to oversight by giving the company an opportunity to “own up” to conduct on its own terms and approach an issue not as a battle, but as a matter of good governance. With the organization’s role in a soft framework being fundamentally proactive, not reactive, the odds of a compliance mindset seeping into corporate culture and into the behaviour of lower-level employees look better than in the hard-law alternative. (b) Private Role in Development Another participatory aspect of soft law is the ability of regulated entities and stakeholders to devise their own soft law instruments, such as codes, 30  This is a key component of John Braithwaite’s influential model of “Responsive Regulation,” which we discuss further in Part V, below. See Braithwaite, infra note 226 at 484.

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guidelines, label standards and other documents. Certainly, the public is better-served by regulated entities being engaged in the compliance conversation, rather than seeing it as a mere “box-checking” exercise. Moreover, industry is better-positioned than the regulator to understand the impact of any given rule or principle on its business. At the same time, significant dangers accompany the private use of soft law. Most obviously, industry cannot reasonably be expected, in the vast majority of instances, to self-regulate at a sociallyefficient level. Regulation is hardly a trivial cost of doing business, and apart from profitable levels of investment in self-regulation – either out of prudence (e.g., to manage financial risk) or good public relations – companies will have incentives to limit it. Too often, self-regulatory initiatives are designed to do the opposite of “hardening” in international soft law: namely, to forestall the development of binding rules and principles in a given industry by demonstrating the appearance of an internal self-governance competency. We term this the “forestalling” effect, but it is not new: it is part of the broader and welldocumented phenomenon of “regulatory capture.”31 To leverage the advantages of a private law-making role, regulators must continue to assert their presence. Jason Solomon’s survey of the U.S. soft drink industry’s soft law initiatives following the release of a 2001 Surgeon General report on childhood obesity presents an example of industry-made domestic soft law’s forestalling effect.32 In conjunction with a pro-physical education lobbying strategy – presenting inactivity, not diet, as the chief anti-obesity concern – Coke, the American Beverage Association and a consortium of manufacturers and a group called “Alliance for a Healthier Generation” each released guidelines from 2003 to 2006 dealing with school-manufacturer partnerships and the incremental scaling-back of drink sales to younger students. No standard was contractually binding, only one provided for monitoring and most were eclipsed by more stringent local regulation. The perception of self-governance, however, may have drawn momentum away from two bills targeting the issue 31

32

See e.g. George J. Stigler, “The Theory of Economic Regulation” (1971) 2 Bell J. Econ & Man. Sci. 3; Michael E. Levine & Jennifer L. Forrence, “Regulatory Capture, Public Interest, and the Public Agenda: Toward a Synthesis” (1990) 167 J.L. Econ. & Org. 167; Jean-Jacques Laffont & Jean Tirole, “The Politics of Government Decision Making: a Theory of Regulatory Capture,” (1991) 106 Quart. J. of Econ. 1089 and in the specific context of corporate governance, William W. Bratton & Joseph A. McCahery, “Regulatory Competition, Regulatory Capture and Corporate Self-Regulation” (1995) 73 N.C.L. Rev. 1861. Jason M. Solomon, “New Governance, Preemptive Self-Regulation, and the Blurring of Boundaries in Regulatory Theory and Practice” (2010) Wis. L. Rev. 592.

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in 2006 and 2007, co-sponsored by the Parent Teacher Association and the American Medical Association, that later died. Similarly, in an increasingly environmentally-conscious environment, companies have been charged with “greenwashing”: presenting an “environmentally-friendly” public-relations image not backed by meaningful commitments. At the international level, one of the loftiest soft law projects to date – the Equator Principles,33 a set of voluntary standards for social and environmental risk assessment developed in 2003 by a consortium of global financial institutions – has been attacked on these grounds. In particular, the available evidence suggests that the Principles have not driven members away from financing socially- and environmentally-risky projects, and the reporting that members have produced is often patchy and hard to compare across time, firms and industries.34 Non-comparability presents a critical obstacle to the effectiveness of any monitoring-based soft law mechanism. In the face of these risks, Jason Solomon exhorts regulators to turn “agency capture” into “industry capture” by fashioning regulatory structures that enlist private-sector entities to perform monitoring and enforcement roles under their oversight. In the soft drinks example, Solomon offers that the U.S. Department of Health and Human Services and Agriculture might have assumed a more active information-pooling role, working with states to design benchmarking programs to address childhood obesity while keeping third-party interest groups at the table to assist in monitoring.35 Such an approach would secure the advantage of an industry input while properly constraining self-serving action. Canada’s Competition Bureau, for instance, has employed soft law against soft law in its approach to “green” misrepresentations actionable under Canada’s Competition Act. In June 2008, the Bureau partnered with the Canadian Standards Association (a private, notfor-profit standards agency) to develop “Environmental Claims: A Guide for Industry and Advertisers,” a non-binding guideline setting out best practices in relation to environmental claims “that are made by manufacturers, importers, distributors, or any person who promotes a product/service or 33  See The Equator Principles Association, “About the Equator Principles,” online: . 34 Poonam Puri, “Public Disclosure and Global Sustainable Development in the Banking Industry: The Equator Principles” (2012) (unpublished), online: . 35  Solomon, supra note 32 at 624.

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business interest who is likely to benefit from the product’s environmental claims.”36 Actors such as the Canadian Standards Association present the other side of the “private soft law” coin: that is, not all non-state soft law initiatives will be set up to resist regulation. In particular, NGOs and activist groups have played an aggressive role in creating soft law – almost always with hardening, not forestalling, in mind. The prevalence of these organizations internationally again reflects the high costs of a hard-law solution in the present international system. Domestically, however, such entities are often likelier to lobby directly for hard-law solutions: soft law is not the “bankable” solution they seek. The case of say on pay explored in Part IV, however, offers an interesting exception. While shareholders encouraged legislators to enact procedural say-on-pay reforms to pressure boards to engage with them, they have not clamoured for state involvement in the substance of executive compensation. Rather, shareholders appear more interested in “setting the table” for their own soft law frameworks. The sophistication, resources and market-orientation of shareholders makes private soft law central to the optimal regulatory solution to the pay “governance gap.” This is in contrast to the many regulatory domains – such as public-housing or welfare reform, in one commentator’s assessment37 – where reliance on experimental soft law-based frameworks serves to reinforce existing power dynamics.38 While the role of activists (of various stripes) in employing soft law appears less pernicious than that of industry, such private governance cannot replace the regulator. This is especially so when the tide of public opinion shifts toward regulation and sober attention to legitimate business or policy concerns becomes crucial. Both industry and activist-drafted soft law must instead be actively weaved into a participatory regulatory framework that employs an appropriate balance of hard and soft law and puts the public interest at centre stage. 36  Competition Bureau & Canadian Standards Association, “Environmental Claims: A Guide for Industry and Advertisers” (June 2008) at 2, online: . 37 Gráinne de Búrca, “New Governance and Experimentalism: An Introduction” (2010) Wis. L. Rev. 227 at 231. 38  See also Douglas NeJaime, “When New Governance Fails” (2009) 70 Ohio St. L.J. 323 (noting that the identity-centred areas of sexual orientation, gender and religion leave a substantial role for rights-claiming “cause lawyering” and pose challenges for the use of more decentralized new-governance mechanisms to achieve just outcomes).

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(3) Flexibility Aspects of Domestic Soft Law A second broad way of looking at domestic soft law is through the lens of the flexibility of law. Soft law is flexible in two respects. The first relates to soft law’s non-binding status, which makes it comparatively simpler to amend or “live with” vis-à-vis hard law – together with the fact that a hard law solution can always be enacted in its place. The second, discussed in more depth below, pertains to one of the soft dimensions of law discussed in Part II: the specificity of law. In particular, soft law tends to take a less specific and more principlesbased form. In contrast, agents will usually demand that binding, hard obligations be spelled out to avoid the risks (especially formal sanctions) associated with non-compliance. In both senses of “flexibility,” soft law is better-placed than hard law to adapt to new or changing circumstances; to fast-moving areas such as science, technology or finance; or to altogether novel zones of activity.39 In such cases – where agencies cannot, with certainty, know whether the regulatory cure will be worse than the disease – soft law offers a third way: a fusion, as Christine Chinkin calls it, of regulation and restraint.40 Since we have already discussed soft law’s “non-binding” nature in Part II, we turn to soft law’s relationship with principles-based regulation. As we see it, the two are connected more through close association than logical necessity. Certainly, soft law need not employ principles, and principles-based regulation is often binding. For instance, soft MOUs often feature quite detailed rule-based language, while securities issuers have opposed principles-based regulation on the ground that it may lead to regulatory overreach, not a “softening” of authority. At the same time, much ties the two concepts together – not least their common origins in the broader new governance movement,41 with its focus on decentralization and “orchestration…rather than direct promulgation and enforcement of rules.”42 Julia Black has described principles-based regulation as “moving away from reliance on detailed, prescriptive rules and relying more on high-level, broadly stated rules or Principles to set the standards by which regulated firms must conduct business.”43 At its core, principles help to prevent instruments from 39

The same has been noted of international soft law. See e.g. Shaffer & Pollack, supra note 6 at 719; Karmel & Kelly, supra note 5 at 885; Dupuy, supra note 2 at 421. 40  Chinkin, supra note 23 at 852. 41  See e.g. Louise G. Trubek, “New Governance and Soft Law in Health Care Reform” (2006) 3 Ind. Health L. Rev. 139 at 149. 42 Paul Curran Kingsberry, “Stakeholder Inclusion and Stakeholder Protection: New Governance and the Changing Landscape of American Securities Regulation” (2009) Fordham Urb. L.J. 913 at 918. 43  Julia Black, Martyn Hopper & Christa Band, “Making a success of Principles-based regulation” (2007) 1 Law & Fin. Mkt. Rev. 191 at 191.

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being interpreted (by parties) or applied (by enforcers or adjudicators) in an under-inclusive fashion. The pioneering modern experiment with principlesbased regulation was that of Britain’s former financial services regulator, the Financial Standards Authority (FSA), in the early 2000s. Black identifies three core elements in the approach adopted by the FSA: (1) Broad-based standards in preference to detailed rules; (2) Outcomes-based regulation; and (3) Increasing senior management responsibility.44 While principles-based regulation is often misunderstood as “light-touch” regulation, Black notes that it actually comes with significant costs to industry actors, who must take a more active and critical role in designing internal compliance structures that can evolve in a more real-time fashion in response to regulatory concerns.45 At the same time, with end outcomes defined, corporate management can tailor its compliance program to achieve the required goals on its own terms and in the most efficient manner possible. The built-in interactivity and autonomy of the principles-based model thus dovetails with the participation-enabling aspects of soft law that Rupp and Williams highlight. When used in the shadow of a hard law-based sanction authority, both can lead a move away from “box-ticking” or “creative” compliance and toward more substantive forms of engagement with the law. At the same time, regulators looking to more principles- or soft law-based approaches must guard against the risk that their more devolutionary approach slides into bare self-regulation. The FSA received wide blame for taking an unduly hands-off approach to regulation after the onset of the financial crisis and has since been folded, with its operations restructured into two agencies.46 Citing such cases, some suggest that the financial crisis calls for a rejection of principles-based regulation altogether.47 To us, these post-crisis criticisms seem at least mildly tinged with confirmation bias. As Christie Ford notes, the financial crisis highlights the risks of a principles-based approach “done 44  Ibid. 45  Ibid. at 193. 46 Sebastian Walsh, “And so, farewell to the FSA” Financial News (6 January 2014), online: . 47  See generally Julia Black, “The Rise, Fall and Fate of Principles-Based Regulation” (LSE Legal Studies Working Paper No. 17/2010, 21 November 2010), online: SSRN .

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wrong” – it does not refute principles-based regulation altogether.48 Ford rightly observes that a self-regulatory paradigm wrongly conflated with principles-based regulation is to blame, and that this paradigm is also a risk in rulebased systems.49 Thus, a rule-orientation did not prevent weak U.S. oversight of the over-the-counter market for derivatives on which credit default swaps traded or the capital reserves of large investment banks any more than it might have saved Northern Rock from collapse. As with soft law, a principles-based approach is not a panacea for a “paper tiger” regulator or myopic policy preferences for industry devolution. Indeed, one weakness of principles-based regulation is that it arguably requires a greater resource investment by regulators. The generality of principles means that while they convey a general direction better than rules, they are less easy to apply to concrete cases. They are, in other words, uncertain to some degree, often employing the qualitative (“material trades”) over the quantitative (“trades over $200,000”) and applying to a broader range of circumstances than rules. Black describes principles as having “low initial formation costs but potentially higher elaboration costs for both regulator and regulated than detailed rules.”50 To a greater extent than before, regulators may have to retain industry personnel with the experience and skill-set to “keep pace” with regulated entities so as to not only apply straight-line rules, but discern at a business level the “legitimate” from the “illegitimate.”51 An effective principles-based system will also require resort to soft law, which enhances the prospects for what Cristie Ford calls an “interpretative community that collectively develops, on a rolling basis, the detailed content of statutory principles.”52 Soft guidelines, public statements, FAQs, “Dear CEO” letters, worked examples and individual-level guidance are each important ways in which the spirit of a principle can be hashed out to regulated entities.53 Soft law is thereby intimately linked to a principles-based hard law system, just as principles feature significantly in more high-level soft instruments. As we explore further in Part V, a combination of hard and soft law, and of rules and principles, will often yield better outcomes than any such mode in isolation.

48

See generally Cristie Ford, “Principles-Based Securities Regulation in the Wake of the Global Financial Crisis” (2010) 55 McGill L.J. 1. 49  Ibid. at 23–24. 50  Black et al., supra note 43 at 201 [emphasis added]. 51  Ford, supra note 48 at 292. 52  Ibid. at 277. 53  Black et al., supra note 43 at 197.

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(4) Accountability Aspects of Domestic Soft Law While soft law can be instrumental in the design of a more participatory, flexible, and effective apparatus for compliance and enforcement, “regulatory soft law” is not without its own governance risks. Specifically, administrative agencies’ ubiquitous use of non-binding, non-statutorily specified guidance documents has been criticized as a run-around of their formal rule-making procedures, particularly as regards consultation obligations.54 Guidance documents can usually be justified on the basis that they merely summarize validly-enacted rules and laws already in place. They are thereby a complement to, not a substitute for the regulator’s rule-making power and, above all, a form of “free advice” to regulated entities. Guidelines may, in fact, play an important access-to-justice role where regulated individuals or smaller companies lack sophisticated legal or compliance support. In other cases, however, the courts have been careful to strike down guidelines that “cross the Rubicon” into unlawfully fettering an agency’s statutory discretion.55 Even when administrative agencies act intra vires, Lorne Sossin has emphasized that courts risk drawing overly-formalistic distinctions between soft and hard law when guidelines may have “as much or more influence than legislative standards” in practice.56 Together with the opposite regulatory-capture risks noted above, then, domestic soft law can raise accountability concerns. Properly used, however, we believe soft law’s benefits can offset its risks. Certainly, it is clear that regulatory soft law cannot be justified on the observation from the international literature that the alternative is no law. Rather, it is better understood as a means to a more effective form of regulation. IV “Hardening” in the Midst of the Financial Crisis: The Case of Say on Pay Having set out a framework for understanding soft law in a domestic context, we turn to the role of soft law in the post-financial crisis “say on pay” debate. We began this chapter with Brandeis’s oft-quoted statement that “sunlight is the best disinfectant.” In this Part, we examine the history of disclosure-based 54

This debate has been particularly heated in the United States, where a thicket of case law and commentary has arisen around the issue. See generally John Manning, “Nonlegislative Rules” (2004) 72 Geo. Wash. L. Rev. 893; Mary Whisner, “Some Guidance About Federal Agencies and Guidance” (2013) 105 L. Lib. J. 385 at 389. 55  Sossin & Smith, supra note 5 at 869. 56  Ibid.

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executive pay regulation through a soft-law lens. We then consider the present trajectory of reform by laying out the choices for a regulatory model on a softto-hard continuum. In our view, the dominant pattern of soft and semi-soft mechanisms reflects decision-makers’ skepticism toward “top-down” regulation of executive pay – a skepticism that, for better or worse, has been loosened by post-financial crisis narratives about compensation and risk. Notable, however, is the diversity in national approaches to the compensation issue: variance in historical compensation levels, political attitudes and the incidence of scandal across jurisdictions has led to a patchwork of responses. (1) History of Executive Compensation Regulation (a) Disclosure i Early Approaches (1933–1990) Historically, the regulation of executive compensation has been associated with the United States and a disclosure-based approach. U.S. disclosure rules date back to the New Deal era, when salaries at regulated banks, public utilities and bailed-out railroads came under close scrutiny by the Federal Reserve, the Federal Power Commission and the Interstate Commerce Commission, respectively, in early-to-mid 1933. By October 1933, the Federal Trade Commission required disclosure of salaries paid by all corporations with capital and assets over $1 million.57 The Securities Act of 1934 then embedded this responsibility within the newly-established Securities and Exchange Commission (SEC), where it has remained since. Pay reforms often respond to popular pressures. Concerns in the 1970s over companies’ abuse of the “three-martini lunch” and corporate perquisites, for instance, led to reforms requiring better perquisite disclosure, and the emergence in the 1980s of “golden parachutes” handsomely compensating outgoing executives led to a “reasonable compensation” bar to the tax-deductibility of parachutes three-times the executives’ ordinary compensation.58 With the exception of tax law, however, U.S. regulation of executive pay was by way of disclosure, not merit review, caps or other, more intrusive mechanisms. In this respect, the SEC’s approach was consistent with the “classical” model of corporate law, where the board of directors (whether one- or twotier) manages the business and affairs of the corporation on behalf of its shareholders.59 Corporate law intervenes in this principal-agent relationship only to 57

Martin J. Conyon et al., “The Executive Compensation Controversy: A Transatlantic Analysis” (13 February 2011) (unpublished) at 8–9, online: . 58  Ibid. at 12–15. 59  Reiner Kraakman et al., The Anatomy of Corporate Law: A Comparative Approach, 2d. ed. (Oxford: Oxford University Press, 2009) at 56.

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hold the board to its core legal duties (such as the fiduciary duty or duty of care), not to supplant its private governance role. Nor, too, is the government’s interest in disclosure an indirect attempt to second-guess the board on compensation, but is instead geared at levelling the informational playing-field for shareholders, for whom monitoring may be prohibitively costly, if not impossible.60 As such, a soft ethos permeates the hard-law regulation of executive pay: while the law provides minimum “sunlight” and polices egregious board conduct, the substance of pay is left to the market. Was this model effective, however, at keeping boards accountable to shareholders on compensation? Public concern over executive compensation reached a critical mass in the late 1980s and early 1990s, when a pattern of parabolic CEO pay growth began to take hold in both the United States and Britain. For instance, the ratio of the average U.S. CEO’s income to the average U.S. worker’s grew from 18-to-1 to only 20-to-1 from 1965 to 1973, and then to 26.5-to-1 by 1978. By 1989, however, the ratio had doubled to 53-to-1; by 1995, it had more than doubled to 137-to-1; and by 2000, it had tripled to a peak of 411-to-1, the highest ratio on record. Likewise, in the United Kingdom, large-company CEO pay rose a full 600 per cent from 1979 to 1994.61 At the same time, a broader inequality narrative was forming under the reign of “Reaganomics” and “Thatcherism” – with the focus on public spending restraint, lower taxes, deregulation and inflation control leading many to conclude that government was favouring “big business” over Main Street.62 Public “belt-tightening” was matched in the private sector, as the U.S. takeover market showed that “tremendous value could be unleashed by shedding lines of business, focusing operations and reducing excess capacity.”63 A similar divide emerged in Britain, with CEOs receiving record pay increases as the ranks of pink-slipped employees swelled. U.K. unemployment remained above 10 per cent from 1981 through 1987.64

60  See e.g. Iacobucci, infra note 76 at 498. 61 Jeremy R. Delman, “Structuring Say-on-Pay: A Comparative Look at Global Variations in Shareholder Voting on Executive Compensation” (2010) 2 Colum. Bus. L. Rev. 583 at 588. 62 See e.g. Eric Pianin & Thomas B. Edstall, “Schisms from Administration Lingered for Years” Washington Post (9 June 2004), online: ; Nick Thompson and Bryony Jones, “Margaret Thatcher: Hero or villain?” CNN (8 April 2013), online: . 63  Conyon, supra note 57 at 16. 64  Simon Rogers, “How Britain changed under Margaret Thatcher: in 15 charts” The Guardian (8 April 2013), online: .

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ii Reacting to “Excessive” Pay (1990–2000) In February 1992, the SEC enacted a rule to require companies to include shareholder proposals about CEO pay in company proxy statements.65 Then, in October of that year, it overhauled its proxy disclosure system, shifting from a “narrative” form to a table form to facilitate inter-firm comparability.66 ThenSEC Chairman Richard Breeden’s remarks at the time channeled Brandeis: the best protection against abuses in executive compensation is a simple weapon – the cleansing power of sunlight and the power of an informed shareholder base.67 The 1992 reforms thus “hardened” the SEC’s regulatory model not by altering the structure of accountability – which remained board-centric – but the content of disclosure itself, effectively curtailing board discretion over the substance of reports. Borrowing from Abbott and Snidal, the SEC ramped up the precision of its regime, signalling the need for specific pockets of detailed shareholder disclosure.68 At the same time, the SEC’s soft ethos lay unchanged: shareholders only needed informational “ammunition” to hold boards to account. Amidst a “growing outrage” over CEO pay, compensation also became a presidential election issue that year: on the campaign trail, then-candidate Bill Clinton promised to “end the practice of allowing companies to take unlimited tax deductions for excessive executive pay” by setting a $1 million cap for deductibility. By February 1993, the enacted bill had been watered down to provide that only compensation for the CEO and four most highly-paid officers “unrelated to the productivity of the enterprise” would be non-deductible.69 Neither of these policies achieved the aim of controlling “excessive” compensation. Paradoxically, they may have even contributed to the higher pay

65

66  67  68  69 

Previously, companies could refuse to entertain such proposals on the basis that they interfered with the company’s authority over its “ordinary business.” See Marilyn F. Johnson, Karen K. Nelson & Margaret B. Shackwell, “An Empirical Analysis of the SEC’s 1992 Proxy Reforms on Executive Compensation” (Stanford University Graduate School of Business Research Paper Series, February 2001) at 5, online: . Michael S. Sirkin & Lawrence Cagney, Executive Compensation (New York: Law Journal Press, 2006) at 10–32. Johnson et al., supra note 65 at 4. Abbott & Snidal, supra note 18. Conyon et al., supra note 57 at 20.

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levels observed during the late 1990s. Thus, in lieu of giving CEOs salary hikes, companies reacted to the Clinton cap by paying executives with stock – and considerable amounts of it. In this respect, tax-avoidance dovetailed with the “pay for performance” preferences of shareholder activists.70 At the same time, companies did not replace executives’ salaries with “at-risk” compensation: rather, equity pay and non-equity pay rose in lockstep during the 1990s, with the result that gross CEO pay reached a record high in 2000, by which time most executives were paid more from equity than non-equity sources.71 That was a clear defeat for those who assumed that the Clinton cap would help to address their excessive pay concerns. Why did better-informed shareholders not take action on pay, either through proposals, their board votes or the selling of their shares? One answer – anticipating the movement toward “say on pay” rules – is that shareholders lacked an effective lever of power. For instance, shareholder proposals for pay votes, enabled by SEC reform in 1992, rarely broke 10 per cent support.72 Moreover, entirely apart from the hurdles involved in launching a dissident proxy generally, shareholders may have been hesitant to exercise that “nuclear option” for pay reasons alone. Finally, to the extent shareholders could sell (an important question for pension funds and other large investors), the “Wall Street walk” not only requires a substantial exodus to send a message, but effectively penalizes departing shareholders, who realize less on their investments than they would have if governance changes had been made. Lucien Bebchuk and Jesse Fried describe the other side of the coin, “managerial power,” in their influential 2004 book Pay Without Performance: The Unfulfilled Promise of Executive Compensation. Most obviously, directors tasked with compensation decisions may be motivated by a conflicting desire to be re-elected – a matter over which the CEO has much leverage. But subtler motivations also taint the process: “collegiality, a team spirit, a natural desire to avoid conflict within the board team, and sometimes friendship and loyalty.”73 Those tendencies are strengthened when directors are current or former 70

That was, until the backlash against stock options (the use of which exploded during the period) took hold in the early 2000s when opportunistic abuses at Enron and other ­companies came to the fore. See e.g. Greg Hitt & Jacob M. Schlesinger, “Stock Come Under Fire In the Wake of Enron’s Collapse” Wall Street Journal (26 March 2002), online: . 71  Conyon et al., supra note 57 at 6. 72  Martin, supra note 99 at 521. 73 Lucien A. Bebchuk & Jesse A. Fried, Pay Without Performance: The Unfulfilled Promise of Executive Compensation (Cambridge, MA: Harvard University Press, 2004) at 4.

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executives liable to take a “golden rule” approach to pay questions.74 And even when bothered by the board’s pay choices, a director will often lack the time, resources or standing within the company to take on the unpleasant work of challenging their colleagues’ arrangements.75 Still another theory is proffered by Ed Iacobucci, who, approaching the subject from a law-and-economics angle, draws a link between improved disclosure and increases in executive compensation separate from those set out above. In particular, by lowering monitoring costs, disclosure grants shareholders the ability to push companies to align pay with performance. But in implementing such mechanisms, companies will struggle to substitute riskier pay for stable pay.76 One compensation consultant’s account in this regard is telling: I recommended that [the CEO] cut his salary to $100,000 [from $160,000] to make room for a normal 60%-of-salary bonus opportunity. … The CEO did not take kindly to my suggestion. First, he tried to argue me out of the recommendation …. But he wasn’t successful. So he looked me in the eye and posed a question to me that I will never forget: ‘Just who do you think is paying your bills anyway?’ … [W]e broke up and I have never heard from him again.77 In the context of executives’ risk-averse and “endowment effect”-influenced reasoning about losing any part of their fixed salary, Iacobucci theorizes that a decrease in fixed pay may fail to offset even a larger increase in variable pay.78 With such dynamics in play, substitution may wipe out, or even counteract, equity pay’s goal of incentivizing performance. In light of this weighty risk and anticipated managerial opposition, companies acquiesce to constant levels of fixed pay and “stack on” variable pay – precisely the facts borne out by the U.S. experience in the 1990s.79 Apart from this, disclosure also reveals an “average” level of CEO compensation that, far from restraining pay increases, “rachets up” compensation in what some have deemed the “Lake Wobegone” effect: no 74  Claire Hill & Brent McDonnell, “Executive Compensation and the Optimal Penumbra of Delaware Corporation Law” (2009) 4 Va. L. & Bus. Rev. 333 at 335. 75  Bebchuk & Fried, supra note 73 at 4. 76 Edward M. Iacobucci, “The Effects of Disclosure on Executive Compensation” (1998) 48 U.T.L.J. 489 at 510. 77  Ibid. at 496. 78  Ibid. at 510. 79  Conyon et al., supra note 57 at 6.

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company will admit that its executives deserve below average pay.80 As such, average CEO pay rises year-after-year as companies, using compensation consultants’ benchmarking tables as precedents, make average or above-average payouts – with new, higher averages setting the stage for a further round of increases. While “sunlight” may at least be a start for pay-for-performance activists, then, more appears to be needed to address concerns of unchecked pay increases. On the other hand, the above facts are also consistent with the theory that market forces were at play. Thus, during the 1990s – the period over which U.S. CEO pay made its greatest strides – the U.S. economy posted the largest GDP gains out of any country in the world.81 Stephen Bainbridge cites data to the effect that “the six-fold increase in CEO pay between 1980 and 2003 can be fully attributed to the six-fold increase in market capitalization of large U.S. companies.”82 Experienced executives are scarce, in high demand and have a greater impact on corporate fortunes than the average worker.83 Moreover, while objectively large, CEOs’ salaries still amount to only a percentage point or two, at most, of a company’s revenues. Some have observed that many occupations, such as acting, sports and investment banking, yield salaries that meet or exceed those of top executives without the accompanying public uproar.84 Be that as it may, these equally well-paid professions also lack the institutional control executives possess over their own pay. Across the Atlantic in Britain, executive pay scandals at privatized utilities also came to a head in the early 1990s, coinciding with a period of consumer rate hikes and setting the stage for state intervention on pay.85 Infamously, shareholders of British Gas hauled “Cedric,” a 280-pound pig, into the company’s 1994 annual meeting to protest the pay of then-CEO Cedric Brown.86 The U.K. response, however, was distinct from the SEC’s and, in fact, employed soft rather than hard law to improve upon existing disclosure requirements 80

See e.g. Peter Whoriskey, “‘Lake Wobegon’ effect: When all CEOs are above average – pay wise” Seattle Times (15 October 2011), online: . See also Iacobucci, supra note 76 at 513. 81 International Monetary Fund, World Economic Outlook Database, online: (query-generated data showing that the U.S. economy added $4.3 trillion to its GDP stock from 1990 to 2000, with the European Union and China adding $3.9 trillion $2.1 trillion, respectively, on a purchasing-power-parity basis). 82  Stephen M. Bainbridge, “Is ‘Say on Pay’ Justified?” (2010) 32 Regulation 42 at at 44. 83  Lisa M. Fairfax, “Sue on Pay: Say on Pay’s Impact on Directors’ Fiduciary Duties” (2013) 55 Ariz. L. Rev. 1 at 15. 84  Bainbridge, supra note 82 at 42. 85  Conyon et al., supra note 57 at 33. 86 Stephen Davis, “Does ‘Say on Pay’ Work? Lessons on Making CEO Compensation Accountable” (Yale School of Management, Millstein Center for Corporate Governance

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contained in the Companies Act, 1985 and the London Stock Exchange’s Listing Rules.87 In particular, the John Major government adopted the industry-sponsored “Greenbury Code” in 1995,88 which recommended that boards put to shareholders an annual report on executive pay and, in special circumstances, allow an advisory vote. Although non-binding, the Code largely met its goal of encouraging wider public-company disclosure. At the same time, a 1999 government audit found that only seven of 270 companies monitored chose to seek shareholder approval for the report,89 building a case for the “say on pay” reforms that followed. iii Pay Scandals Cross the Atlantic (2000–2006) Disclosure reform in Europe, as in Britain, arrived in response to scandal. While Europe did not observe the stratospheric pay increases seen in the United States and Britain, incidents such as a German controversy over bonuses approved during the Vodafone-Mannesmann merger, a French scandal over Vivendi CEO Jean-Marie Messier’s severance package, and a Swedish controversy around ABB CEO Percy Barnevik’s pension – each in the Enron-scandal era of the early 2000s – fanned the flames of public opinion.90 In 2003, the EU Commission released “Modernizing Company Law and Enhancing Corporate Governance in the European Union – A Plan to Move Forward” and endorsed, among other things, annual compensation report disclosure.91 This soft and relatively modest approach, like that in Britain, largely succeeded: most large public European companies were in compliance by 2005 or 2006.92 In 2006, the SEC again revisited its executive compensation disclosure rules. Noting the “complexity of and variation in compensation programs,”

and Performance, Policy Briefing No. 1, 2007) at 9, online: . 87 For a summary of the disclosure rules in effect by the mid-1990s in Britain, see Directors’ Remuneration: Report of a Study Group chaired by Sir Richard Greenbury (17 July 1995) at 53, online: . 88  Ibid. 89  Delman, supra note 61 at 589. 90  Conyon et al., supra note 57 at 35–37. 91 Commission of the European Communities, Communication from the Commission to the Council and the European Parliament, “Modernising Company Law and Enhancing Corporate Governance in the European Union – A Plan to Move Forward” (21 May 2003), online: . 92  Conyon et al., supra note 57 at 36.

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it acknowledged that the “formatted” nature of the 1992 reforms’ compensation tables, while expanding disclosure, were now resulting in large amounts of inadequate, “boilerplate” information in reports.93 The SEC’s second generation of reforms thus introduced an explanatory “Compensation Discussion and Analysis” (CD&A) section and elaborated upon existing tabular elements.94 The SEC also imposed a “plain language” requirement on such disclosures.95 The SEC’s CD&A reforms could be interpreted as an incremental move toward “principles” concepts to defeat box-checking compliance, consistent with Julia Black’s theory.96 The financial crisis, however, paved the landscape for more substantial change. Barney Frank – who would later lend his name to the statute enacting say-on-pay in the United States – captured the disclosure system’s most basic flaw in a comment to the SEC: This proposed rule would give shareholders valuable information relating to executive compensation, but does not give them much hope for doing anything about it. Short of shaming boards into holding executives accountable, the proposed rule does not ensure that shareholders can effectively change compensation practices.97 The SEC, however, resisted more wholesale reform, with Chairman Cox remarking that “when people are forced to undress in public, they’ll pay more attention to their figures.”98 (b) Say on Pay: Giving Shareholders the Vote i The U.K. Model and Other Pre-Financial Crisis Approaches (2002–2007) Echoing Frank, Jennifer Martin argues that disclosure’s effectiveness “hinges on two elements: (1) getting information to investors, and (2) investors’ being 93  Securities and Exchange Commission, Final Rule, “Executive Compensation and Related Person Disclosure” (7 November 2006) at 11, online: . 94  Ibid. at 12. 95 Ibid. at 16. 96  Black, Hopper & Band, supra note 43 at 195. 97  Letter Comment of Rep. Barney Frank, “Executive Compensation and Related Parties Disclosure” (10 April 2006) at 3, online: Securities and Exchange Commission . 98 Stephen Labaton, “Spotlight on Pay Could Be a Wild Card” New York Times (9 April 2006), online: .

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able to use the information and act.”99 Arguably, the reforms of the 1990s and 2000s brought the former goalpost into closer view; the latter one, however, remained distant. As noted above, the SEC’s shareholder-empowering 1992 proposals rule was largely a non-starter, at least until the say on pay movement began to gather steam with a series of proposals starting in 2006.100 In Britain, companies “consistently resisted” the Greenbury Code’s recommendation that they voluntarily empower shareholders by holding occasional pay votes.101 In 2002, Britain took the next step by implementing the first say on pay reform within the Directors’ Remuneration Report Regulations of 2002. The Regulations, which came into effect in 2003, amended the U.K. Companies Act to require that companies include a director compensation report on both retrospective payments and future policy in their annual filings and then submit that report to a non-binding, or “advisory,” shareholder vote. The U.K. reforms thus “hardened” Britain’s regime from mandating only “objective” disclosure – the substance of a board’s compensation policies – to requiring a level of “subjective” disclosure – the proportion of company shareholders that favoured the board’s approach. The U.K.’s novel advisory-vote model implicitly presented a theory of boardshareholder relations distinct from the SEC’s “Brandeisian” approach – one where, in line with the above critiques, factual disclosure alone cannot empower shareholders to hold the board to account on pay. At the same time, the model’s advisory nature made it softer than it could have been. In other words, the board’s discretionary power, and with it corporate law’s built in softlaw framework, was preserved in the U.K. reform. The advisory vote offers, instead, a sharpened form of disclosure. Since a pay vote can be perceived as a discrete “legitimacy proxy” for the board’s compensation policy, failure may involve significant reputational jeopardy for the board. The effectiveness of a soft advisory vote, then, depends on how effective that jeopardy is in spurring the board to action. In essence, the reform transfers the burden of action in respect of an unpopular pay package from shareholders to directors. The U.K. experience suggests that reputation will often be enough of a sanction. At the same time, only nine companies from 2003 to 2009 failed their pay 99  Jennifer S. Martin, “The House of Mouse and Beyond: Assessing the SEC’s Efforts to Regulate Executive Compensation” (2007) 32 Del. J. Corp. L. 481 at 523. 100 Ibid. at 521; Latham & Watkins LLP, “The rise of shareholder ‘say on pay’ votes” (13 April 2010), online: Lexology (noting that 6, 50, 60 and 75 proposals for an advisory vote, receiving approximately 40 per cent support on average, took place in 2006, 2007, 2008 and 2009, respectively). 101  Delman, supra note 61 at 589.

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votes.102 In consulting on changes to the U.K. rules, the government noted that “the increasingly diverse and fragmented nature of shareholders in the U.K. means that the likelihood of seeing 50 per cent or more votes cast against any resolution can be reasonably expected to remain extremely low.”103 Still, the vote’s transformative power was visible in the first year of say on pay when a slight majority (50.7 per cent) of GlaxoSmithKline shareholders refused to support the company’s pay report, which set out a $35 million “golden parachute” payment to the CEO as well as a mechanism for continuing his bonus and perks for two years. The company immediately asked its compensation consultants to conduct an independent review, and the package was overhauled to cut back the “parachute” terms to one year’s salary and bonus.104 The company also stepped-up its engagement with institutional investors and shareholder groups.105 Indeed, the reform may have “produced a virtual overnight increase in the level of dialogue between companies and funds,” with the Association of British Insurers estimating a tripling in contacts initiated by companies prior to finalizing their compensation plans.106 On the other hand, not all companies were receptive to their votes. For instance, the fact that 59 per cent of Royal Dutch Shell shareholders rejected the company’s 2008 pay report did not prod its directors to change course. Likewise, one CEO responded to a 42 per cent “no” vote by remarking, “[t]his strikes me as a case of excessive micro-managing.”107 In one commentator’s view, “[t]he media attention in the GSK case and resulting board embarrassment were critical factors in ensuring that the shareholder vote had any effect.”108 To the extent that failed votes become of diminished news-value over time, a non-binding vote’s effect in spurring shareholder engagement on pay may not be enough to secure accountability. Amidst the European pay scandals of the early 2000s, variants of the U.K. approach gained traction elsewhere in Europe. In 2004, the Netherlands 102  Ibid. at 610. 103 U.K. Department for Business Innovation & Skills, “Executive Pay: Shareholder voting rights consultation” (March 2012) [U.K. Consultation Report] at 7, online: . 104  Delman, supra note 61 at 590. 105  Sandeep Gopalan, “Say on Pay and the SEC Disclosure Rules: Expressive Law and CEO Compensation” (2008) 35 Pepp. L. Rev. 207 at 229. 106 Davis, supra note 86 at 10. 107  U.K. Consultation Report, supra note 103 at 15. The Report notes that by U.K. standards, a 20 per cent “no” turnout is considered a “high dissent vote”: ibid. at 14. 108  Delman, supra note 104.

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adopted a say-on-pay vote with four substantial differences from the U.K. version: (1) the vote is applicable to executives rather than directors;109 (2) the vote applies to pay policy rather than structure; (3) the vote occurs not on an annual interval, but upon changes in pay policy; and (4) the vote is binding on the company.110 Similarly to Britain, evidence suggests that increased management-shareholder engagement has been a significant by-product of the reform.111 Interestingly, however, Dutch shareholders’ effective veto over pay was not used until 2008.112 Sweden, Norway and Denmark each adopted variants of the Netherlands model in 2006 and 2007,113 although the votes in Sweden and Norway occur annually, as in Britain.114 In 2004, the European Commission recommended that EU companies’ pay policies be submitted to a non-binding shareholder vote, but only if shareholders representing one-quarter of a company’s stock requested it.115 Building on the EU “threshold” model, Germany later adopted a law in 2009 requiring an advisory vote on executives’ pay if shareholders holding at least five per cent or €500,000 of a company’s capital demanded one.116 In 2005, Australia opted for Britain’s advisory model and enacted a law requiring an annual vote on director pay structures.117 As per the U.K. experience, some issuers resisted the change. The compensation committee chair at Telestra, Australia’s largest phone company, reacted to two-thirds disapproval of its pay policy by claiming that the “no” side had “no expertise whatsoever” 109 In practice, however, the CEO (whose pay is typically of greatest shareholder concern), if not other members of the executive team, will be caught by a director rule as a member of the board. 110  See e.g. David F. Larcker, Allan L. McCall, Gaizka Ormazabal & Brian Tayan, “Ten Myths of ‘Say on Pay’” (Stanford Closer Look Series, 28 June 2012) at 7, online: SSRN . 111 UK Consultation Report, supra note 103 at 16. 112  Robert C. Posen, “The (Advisory) Ties That Bind Executive Pay” (4 November 2013), online: The Harvard Law School Forum on Corporate Governance and Financial Regulation . 113  Delman, supra note 61 at 594. 114  Larcker et al., supra note 110. 115 Delman, supra note 61 at 594–595. 116  Ibid. at 597. 117  Randall S. Thomas, “Lessons from the Rapid Evolution of Executive Remuneration Practices in Australia: Hard Law, Soft Law, Boards and Consultants” (Vanderbilt University Law School Law & Economics Working Paper No. 11–18, 7 April 2011) at 4, online: SSRN .

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on the matter.118 That view remains a common critique of say on pay,119 despite the fact that such votes are frequently influenced by the relatively thorough assessments of proxy firms120 and despite managers’ opportunity to clearly convey their positions to shareholders through “plain language” CD&A or by way of direct appeals prior to the vote. ii Dodd-Frank and Post-Financial Crisis “Hardening” (2007-Present) The financial crisis put a spotlight on compensation in the financial sector, and in particular patterns of acquiescence to pay-for-performance structures that – in part due to the sheer size of the rewards involved – could expose institutions to enterprise- and even economy-threatening levels of risk. The Financial Stability Forum, in its Principles for Sound Compensation Practices, put the matter as follows: High short-term profits led to generous bonus payments to employees without adequate regard to the longer-term risks they exposed on the firms. These perverse incentives amplified the excessive risk-taking that severely threatened the global financial system and left firms with fewer resources to absorb losses as risks materialized. The lack of attention to risk also contributed to the large, in some cases extreme absolute levels of compensation in the industry.121 Top financial executives escaping their failed firms loss-free and penaltyfree also provided fodder for popular disdain over pay, most visibly in the “Occupy” movement and its campaign against “the one per cent.”122 Lucian Bebchuk, Alma Cohen and Holger Spamann observe that top executives at Bear Sterns and Lehman Brothers extracted $1.4 billion and $1 billion, respectively, from their firms in cash bonuses and equity sales from 2000 to 2008, 118 Delman, supra note 61 at 596. 119  See e.g. Bainbridge, supra note 82 at 47. 120  The role of proxy firms is discussed in greater depth in Part IV(2)(b), below. 121 Financial Stability Forum, FSF Principles for Sound Compensation Practices (2 April 2009), online: . 122 See generally Karla Adam, “Occupy Wall Street protests go global” Washington Post (15 October 2011), online: ; Joanna Walters, “Occupy America: protests against Wall Street and inequality hit 70 cities” The Guardian (8 October 2011), online: .

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more than offsetting their losses from the rapid depreciation of their company stock positions when their firms’ fortunes went south.123 Perhaps on the legs of another pay “revolt,” the U.S. became the latest country to vote “yes” on say-on-pay in 2010, adopting a variant of the U.K.’s nonbinding model in its mammoth Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), which brought advisory pay votes to the United States starting in 2011. Some 300 companies under the U.S. Troubled Asset Relief Program (TARP) had already been subject to non-binding votes starting in 2009.124 In extending the vote more broadly, Dodd-Frank’s vote differs from the U.K. model in two important respects. First, it allows shareholders to vote to determine, once every six years, whether a pay vote should be annually, once every two years or once every three years. Second, it applies to the salaries of executives, not directors.125 Similarly to the U.K. experience of an under-two-per-cent failure rate, most U.S. compensation packages (upwards of 97 per cent) have escaped the jeopardy of a failed say-on-pay vote. Still, shareholders have been putting the device to increasing use, with the proportion of “no” votes doubling since the inaugural proxy season: 36 companies lost their say-on-pay votes in 2011, 57 lost their votes in 2012 and 70 lost them in 2013.126 One of the highest-profile defeats was that of Citigroup, whose CEO, Vikram Pandit, was awarded $11 million in salary and a multi-year retention package estimated at $40 million following a year in which the company’s stock dipped from $51.50 to $21.40. Following the vote, Pandit resigned and the company overhauled its policies following meetings with “nearly 20 shareholders representing more than 30% of Citigroup stock.”127 The effectiveness of the “shame” sanction in prodding pay-policy changes is buttressed by the fact that 39 companies that failed in 2012

123  Lucian A. Bebchuk, Alma Cohen & Holger Spamann, “The Wages of Failure: Executive Compensation at Bears Sterns and Lehman 2000–2008” (2010) 27 Yale J. on Reg. 257 at 259–260. 124  Fairfax, supra note 83 at 4. 125 Securities and Exchange Commission, Office of Investor Education and Advocacy, “Investor Bulletin: Say-on-Pay and Golden Parachute Votes” (March 2011), online: . 126  See Poonam Puri, “Developments in Financial Services Regulation: A Canadian Perspective” (Paper presented at Annual Banking Law Update conference, Johannesburg, South Africa, 28 February 2013) at 16; Shall Partners, “List of Companies That Have Failed Say on Pay in 2013” (3 December 2013), online: . 127  Puri, ibid. at 16.

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turned around in 2013, garnering whopping increases in shareholder approval: the group’s average level of support moved up 48 per cent, from 38 per cent to 86 per cent.128 The number of such cases, indeed, understates the governance impact of the reform, as many companies now often move to change their policies prior to a vote based on shareholder or proxy advisory firm feedback. For instance, in its 2011 proxy filing, Disney disclosed tax gross-up provisions for its top executives in a change-of-control situation. Proxy firm Institutional Shareholder Services (ISS) issued a report to shareholders recommending an “against” vote. In response to the report and subsequent shareholder dissent, Disney eliminated the impugned provisions. 77 per cent of shareholders approved Disney’s revised package.129 Other companies, however, have taken a less deferential posture. Rather than accepting the proxy firm’s recommendations, some have defended their packages in direct letters to shareholders – often only to fail their subsequent vote.130 12 companies failed in both 2012 and 2013,131 and three firms have failed all three votes to date.132 These cases continue to highlight, as per the U.K. experience, the shortfalls of the softer advisory approach in dealing with recidivist cases. Despite financial institutions’ pay packages being centre-stage during the financial crisis, investors were slow to punish such firms with “no” votes. For instance, in 2011, only PICO Holdings – a company with just $32 million in annual revenue – failed its vote.133 Citibank remains the only high-profile, national bank to have failed its vote – a testament, perhaps, to the reputational risks around compensation post-crisis. 2013 saw an uptick in protest, however, with shareholders saying “no” at five companies: reinsurance firm Everest Re, payday lender DFC Global Corp., regional bank holding companies East West Bancorp and SWS Group, and independent investment bank Gleacher & Company. As of December 2013, these companies had revenues of

128 Noam Noked, “Facts Behind 2013 ‘Turnaround’ Success for Say on Pay Votes” (5 September 2013), online: The Harvard Law School Forum on Corporate Governance and Financial Regulation . 129  James F. Cotter, Alan R. Palmiter & Randall S. Thomas, “The First Year of Say-on-Pay Under Dodd-Frank: An Empirical Analysis and Look Forward” (2013) 81 Geo. Wash. L. Rev. 967 at 1004–1005. 130 Ibid. at 1006–1010 (analysing the cases of Adobe Systems and Huntington Bancshares). 131  Noked, supra note 128. 132  Shall Partners, supra note 126. 133  Puri, supra note 126 at 17.

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$5.42 billion, $1.1 billion and $812 million, $275 million and $203 million, respectively.134 Belgium also adopted an advisory say on pay vote in 2010 in its Companies Code. The Belgian structure is broadly similar to the U.K.’s initial model, encompassing an annual vote on a director pay report.135 In 2013, the country saw a peculiar say-on-pay defeat for government-controlled telecom company Belgacom, with the government withholding its votes and 70 per cent of remaining shareholders voting against the compensation report, largely around concerns of excessive pay.136 The defeat was only part of the controversy around the state-owned company, whose CEO, Didier Bellens, was later fired by the Belgian Prime Minister in November 2013 for “repeated, accumulated outbursts” that included describing the Belgian government as “the worst shareholder” at a breakfast session.137 Despite following the SEC’s lead on prior compensation reforms,138 Canadian securities regulators (which operate on a province-to-province basis) have yet to adopt say on pay. In January 2011, the Ontario Securities Commission presented a Staff Notice inviting comment on, among other things, a pay vote, noting that the matter had been “receiving increased attention” from stakeholders.139 While submissions to the Commission generally supported the premise of enhanced shareholder democracy, many described a vote as a “blunt instrument” ill-suited to tinkering with complex compensation arrangements.140 In particular, many large Canadian companies – 123 as of 134 See Shall Partners, “2013 Say on Pay Fails” (3 December 2013), online: . Revenue data for these firms was drawn from Yahoo! Finance: . 135  Companies Code (Belgium), art. 96, s. 3. 136  Randall S. Thomas & Christoph Van der Elst, “The International Scope of Say on Pay” (ECGI Working Paper No. 227/2013, September 2013) at 30, online: SSRN . 137 Frances Robinson, “Belgian Government Fires Belgacom CEO” Wall Street Journal (15 November 2013), online: . 138  See e.g. Fasken Martineau LLP, “New executive compensation disclosure: plan ahead” (26 November 2008), online: (noting the Canadian Securities Administrators’ convergence with the SEC reforms establishing CD&A disclosure). 139 OSC Staff Notice 54–701, “Regulatory Developments Regarding Shareholder Democracy Issues” (10 January 2011), online: . 140  Puri, supra note 126 at 17–18.

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December 2013 – have already voluntarily adopted say-on-pay votes, including all of Canada’s “Big Five” banks,141 after pressure from shareholder activists began mounting in 2010.142 The adopters represent some 80 per cent of Canada’s 60 largest publicly-traded companies, although only three per cent of all of Canada’s publicly-listed firms.143 Some also noted that the reform would produce no benefit for the substantial bloc of Canadian companies dominated by controlling shareholders, each of whom have a “direct line” to the board on compensation matters.144 While pro-shareholder groups such as the Canadian Coalition for Good Governance (CCGG) and Shareholder Association for Research and Education (SHARE) support an advisory vote, several powerful institutional investors, including the Ontario Teachers’ Pension Plan and Blackrock Asset Management, remain opposed.145 Similarly to the U.S. experience, Canadian investors have become progressively more assertive in casting say-on-pay votes. Overall support for pay programs at vote-adopting companies averaged 94.3 per cent in 2011 before falling to 91.5 per cent in 2012 and 89.7 per cent in 2013.146 While only four companies have failed say-on-pay votes to date,147 three of those cases took place in 2013. 2013’s failures included Barrick Gold, the world’s largest gold-mining company. Barrick awarded a $17 million pay package, including a $12 million signing bonus, to incoming executive John Thornton despite a 20-year low in Barrick’s 141 Shareholder Association for Research and Education (SHARE), “Canadian companies that have adopted a Say on Pay” (December 2013), online: . 142  Agnese Smith, “Nay on say: Will Canada ever legislate mandatory say on pay? Or is a voluntary approach enough?” National Magazine (January 2013), online: . 143  Nicholas Van Praet, “Canada out of step on say on pay” Financial Post (15 April 2013), online: . 144 Neill May, “Do You Like Say on Pay?” Canadian Lawyer (3 June 2013), online: . 145  Smith, supra note 142. 146 Janet McFarland, “Shareholders increasingly draw line in sand on executive pay” The Globe and Mail (28 July 2013), online: . 147  Osler, Hoskin & Harcourt LLP, “Research Report: Canadian Governance Highlights from the 2013 Proxy Season” (2013) at 2, online: .

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share price resulting from a collapse in gold prices.148 This case of pay “before” performance was met with an 85 per cent “against” vote, prompting founder and then-board chair Peter Munk to quip that “[b]ad times bring out bad people.”149 A rehaul of the Barrick board in December 2013, together with indications that two long-standing directors would not seek re-election, may have reflected further governance-related pressures from institutional investors.150 In December 2013, Canada’s federal government launched a consultation process on potential reforms to Canada’s federal corporations statute, the Canada Business Corporations Act. The first-listed proposal is a shareholder advisory vote on executive compensation.151 Given the Ontario Securities Commission’s apparent lack of interest in say-on-pay since its 2011 Staff Notice, it remains to be seen whether Canada’s federal government – which has already pursued (albeit unsuccessfully) the creation of a national securities regulator in recent years152 – will be more willing to take up reform. Like Canada, Switzerland enjoyed some success under a voluntary say-onpay model, with institutional investors convincing large Swiss companies such as Nestle, UBS and Credit Suisse to accede to votes.153 In a 2013 referendum, however, a grassroots movement led by Thomas Minder, an entrepreneur and independent member of the Swiss parliament, succeeded in passing (with 68 per cent approval) a law called “Eidgenössische Volksinitiative gegen die Abzockerei” (literally, “Swiss Popular Initiative Against Rip-offs”) that firmly 148 Richard LeBlanc, “Canada has its first Say on Pay Failure: Barrick Gold” (25 April 2013), online: Governance Gateway Blog ; Micah Luxen, “Barrick goes a bonus too far” Canadian Business (10 May 2013), online: . 149  Ibid. 150 Rachelle Younglai, “Barrick Gold loses two more directors” The Globe and Mail (17 December 2013), online: . 151  Industry Canada, “Consultation on the Canada Business Corporations Act” (December 2013) at 5, online: . 152 Somewhat uniquely, Canada lacks a federal securities regulator, with its 13 provinces and territories each separately taking up regulation within their jurisdictions. The federal government’s proposed national Securities Act, which would have created a federal role in the area, was declared unconstitutional in a reference to the Supreme Court of Canada in 2011 that found the Act to be outside of the federal “trade and commerce” power. See Reference re Securities Act, 2011 SCC 66, online: . 153  Delman, supra note 61 at 598.

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departed from that “soft” approach. The law grants shareholders a binding annual vote on director and executive compensation and prohibits firms from paying any compensation to executives joining or leaving the company or in a change-of-control scenario. Violations carry stiff penalties of up to six years’ salary and a three-year prison term.154 Consistent with trends elsewhere, the success of Minder’s initiative followed a highly-publicized controversy over a $78 million “golden parachute” for Novartis’s chairman, David Vasella, just a month prior to the vote.155 Formerly-voluntarist Switzerland, then, currently has the world’s most stringent say-on-pay law. Despite Swiss voters’ support (at 68 per cent) for the Minder measure, they rejected by nearly the same margin (66 per cent) a subsequent proposal to cap executives’ pay at twelve-times that of their companies’ lowest-paid workers in November 2013.156 Such a chasm in support levels exemplifies the distance – even as perceived by the lay public – between say on pay’s “soft” proceduralism and the “harder” substantive regulation of pay. “Hardening” also arrived in Australia and Britain. Thus, after the financial crisis, Australia’s government asked its Productivity Commission to study director and officer pay. While the Commission concluded that executive compensation was not a widespread failure, it made numerous governance recommendations aimed at board accountability.157 On say on pay, Australia opted to add a socalled “two strikes” rule that came into effect in 2011. If 25 per cent of Australian shareholders vote against a company’s pay policy at two consecutive annual meetings, a “board spill” resolution is triggered where shareholders vote, by ordinary resolution, on whether all directors should stand for re-­election within 90 days.158 In Britain, the government observed in a March 2012 consultation report that, looking to say on pay in practice, “historical voting records, feedback from shareholders and anecdotal evidence suggest that not all companies are responding adequately to shareholder concerns.”159 In October 2013, the Enterprise and Regulatory Reform Act 2013 added a binding, forward-looking

154 Raphael Minder, “Swiss Voters Approve a Plan to Severely Limit Executive Compensation” New York Times (3 March 2013), online: . 155  Ibid. 156  Caroline Copley, “Swiss voters reject proposal to limit executives’ pay” Reuters (24 November 2013), online: . 157  Thomas, supra note 117 at 7. 158  Matt Orsagh, “‘Say on Pay in Australia: Two Strikes and You’re Out” (26 September 2012), online: CFA Institute . 159 U.K. Consultation Report, supra note 103 at 6.

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shareholder vote on pay policy to U.K. process, thus splitting its compensation report into a forward-looking section on pay policy (subject to a binding vote) and a backward-looking “implementation report” (subject to an advisory vote).160 As in the Netherlands, a failed vote would force a company to fall back on the last approved package or submit a revised package to a separate vote. Outrage over bankers’ bonuses in the European Union also led to the EU-level imposition of a cap on bankers’ bonuses in April 2013 – a distinct hard-law approach to financial-industry compensation. With limited exceptions, the EU law caps the fixed-to-variable pay ratio of “material risk-taking” bank employees (defined to include, among other things, those earning more than €500,000 in a year) at 1:1 starting in 2014.161 Spanish officials supportive of the cap have hinted at imposing a banking-sector vote on executive compensation to account for the greater relative importance of fixed pay at Spanish banks.162 Likewise, rumours have spread regarding banks’ plans to substantially raise banker salaries in response to the cap.163 Such a result would resemble the unintended consequences of the 1992 Clinton deductibility cap – further underscoring the risks of a hard-law approach in encouraging “creative compliance,” and perhaps providing momentum to the spread of say on pay. Another development potentially impacting say on pay is a proposed SEC rule, mandated by Dodd-Frank, requiring companies to disclose the ratio of their CEO’s pay to that of their median worker. Perhaps unsurprisingly, companies have opposed ratios on the ground that they provide a misleading picture of executive compensation at a hefty cost.164 SEC personnel have, in turn, been frank about the difficulty and cost of guaranteeing 160  Linklaters, LLP, “Executive Pay: Most significant rules on directors’ pay in a decade come into force on 1 October” (24 September 2013), online: . 161 See generally Freshfields Bruckhaus Deringer LLP, “New EU rules on bankers’ pay (including the bonus cap)” (May 2013), online: . 162  Tobias Buck & Miles Johnson, “Spain set to give shareholders more say on pay” Finan­ cial Times (14 March 2013), . 163 Anousha Sakoui, “RBS denies plan to avoid EU bonus cap” Financial Times (22 December 2013), online: . 164 See e.g. Joe Mont, “CEOs Make Final Pitch To Limit Scope of SEC’s Pay Ratio Rule” Compliance Week (4 December 2013), online: . For a full list of submitted comments on the proposed rule, see .

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comparability,165 and a September 2013 proposal opted for flexibility instead, allowing each issuer to develop a methodology “that best suits its particular circumstances.”166 Consistent with the domestic soft law literature, we query whether companies can be trusted to provide particularly forthright ratios on a carte blanche basis. At the same time, given the sheer magnitude of executive pay relative to that of rank-and-file employees, it will likely be difficult for companies to substantially understate the gap in most cases. (2) Soft Law Aspects of the Say-on-Pay “Revolution” As canvassed above, say on pay has attracted considerable attention among a range of developed jurisdictions since Britain first enacted its advisory vote in 2002. As with the brief surge of regulatory interest in disclosure in the earlyto-mid 1990s, much of the move toward say-on-pay can be explained as a response to public outrage. Pepper Culpepper notes a sustained rise in press coverage of executive compensation – often aside value-laden terms such as “fat cats” and references to scandal – since the Enron collapse in 2001, notwithstanding pay having peaked prior to the dot-com bust in 2000.167 As more scandals unraveled, compensation’s link to the global financial crisis (however tenuous when extended to non-financial companies) provided a fuel for the issue’s continued salience. Three soft-law phenomena can be adduced from this climate. First, a “hardening” took place, with shareholder-empowering say on pay laws supplementing disclosure laws seen to be insufficient at securing managerial accountability on pay. Second, institutional investors, proxy advisory firms, compensation consultants and others developed a body of soft-law principles around pay, spurred on by their increased influence under the new laws. Third, a “new governance”-style cultural shift took form as the reforms buttressed a move toward greater board-shareholder communication, a move that may be leading companies to “internalize” norms about compensation. (a) “Hardening” in Executive Compensation Disclosure As noted above, prior laws in say on pay-adopting countries focused on disclosure of executive compensation. In 1992, the U.S. government pivoted slightly 165  Emily Chasan, “SEC Skeptical on Pay Ratio Disclosure” CFO Journal (12 November 2013), online: . 166  Securities and Exchange Commission, Press Release, “SEC Proposes Rules for Pay Ratio Disclosure” (18 September 2013), online: . 167 Pepper C. Culpepper, “The Politics of Executive Pay in the United Kingdom and the United States” (December 2012) (unpublished) at 14–17, online: .

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toward a “shareholder empowerment” framework by enabling shareholder proposals on pay. While these proposals began to take flight after 2006, they overwhelmingly failed and, as such, did not trigger a wave of advisory votes.168 The say-on-pay story, then, represents a “hardening” phenomenon, or a move to more binding authority, in three respects. First, say on pay laws hardened the proposal mechanism by elevating the contemplated pay vote into a legally-mandated exercise. Second, as noted above, they hardened pay decision-making in the context of the longstanding “private governance” model of corporate law, which largely defers to the board on pay matters. Finally, changes in the models of early-adopters Britain and Australia – prompted by continued public outrage, further increases in compensation levels and fringe cases of companies flouting failed votes – also moved in a harder direction. In particular, as canvassed in the preceding part, Australia added teeth to its law with a forced “board spill” vote in 2011, while Britain moved from an advisory to a binding vote in 2013. The table presented at Appendix A demonstrates the hardening of say on pay with a view to four aspects of national regimes: (1) whether votes are made mandatory under law (“harder”) or are adopted voluntarily by firms (“softer”); (2) whether votes are binding on boards (“harder”) or are purely advisory (“softer”); (3) whether the vote concerns the more high-level domain of pay policy (“softer”) of the firm or, instead, is a vote directly on specific, paid out compensation packages (“harder”); and (4) how frequent the votes are (with annual votes being “harder” than votes held more sparsely or contingent on pay changes). As noted above, the recently-established Swiss model – although not yet finalized – appears to be the “hardest” of the current vote structures, largely due to the fact that it appears to be the only model contemplating a binding vote on pay packages (rather than pay policy, as per the current U.K. and Nordic models). Canada’s voluntarist model remains the “softest” approach, although the influence of non-state actors has also led to significant convergence with the U.S. approach at large companies. One interesting issue is the extent to which Australia (“two strikes”) or the Nordic countries (binding votes) present a “harder” model of regulation. While Australia remains an advisory-vote jurisdiction, we proffer that its regime may be more onerous insofar as boards must secure a higher approval rate (75 per cent) to avoid the “first strike” and “second strike” that have now become focal points of media coverage.169 At the same time, the “two strikes” model gives 168  See note 100, supra. 169 See e.g. Sally Rose, “How to avoid a ‘second strike’” Financial Review (19 October 2012), online: ; Julie Walker, “Australia Has Had Three Years With The Two-Strikes

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the board more time – over two years – to react to potential consequences from the time of the first vote. Likewise, the Australian model has minimal impact on companies with controlling shareholders, or whose shareholders do not see such “nuclear option” of board ejection as warranted with respect to pay alone. Perhaps tellingly, the first year where companies faced their “second strike” also saw no shareholders opting for fresh boards.170 Another site of hardening is in the courts, which retain an oversight role over corporate decision-making on pay. Aggrieved U.S. shareholders have attempted – so far without success – to leverage failed votes to sue companies for violations of their hard-law fiduciary duty and duty of care. As early as August 2011, nine companies had been served with say-on-pay suits, one of which (Bank of New York Mellon) had actually passed its vote.171 Two aspects of U.S. law, however, impose a high bar on such plaintiffs. First, in its leading Disney case on the issue in 2006, the Delaware Court of Chancery held that boards’ pay decisions amount to “business judgment” not to be second-guessed by courts absent gross negligence or bad faith.172 The business judgment rule has also found fertile soil in Canada and Australia.173 Prior to say on pay, this proved a high barrier to litigants’ success, with U.S. cases taking a markedly hands-off and process-focused approach to compensation matters.174 That approach has, likewise, bled over to the say on pay cases: for instance, in 2012’s Gordon v. Goodyear, the Federal District Court of Illinois held, in the context of a company’s say on pay defeat by a 55 per cent margin, that a failed vote and poor performance alone were not sufficient to

Law And Executive Pay Pain Won’t Go Away” Business Insider Australia (17 October 2013), online: ; Stephanie Quine, “Twostrikes law calls for better board engagement” Lawyer’s Weekly (7 June 2013), online: . 170  Walker, ibid. 171  Fairfax, supra note 83 at 23–24. 172 See generally In re Walt Disney Co. Derivative Litigation, 907 A.2d 693 (Del. Ch. 2005), online: . 173  In Canada, see BCE v. 1976 Debentureholders, 2008 SCC 69 at para. 40. In Australia, the business judgment rule has been codified: see Corporations Act 2001, s. 180(2), online: . 174 Robert E. Scully, Jr., “Executive Compensation, the Business Judgment Rule, and the Dodd-Frank Act: Back to the Future for Private Litigation?” The Federal Lawyer (January 2011) at 37, online: Stites & Harbison, PLLC .

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make out a claim that business judgment had not been validly exercised.175 The lions’ share of say-on-pay cases have, as such, been dismissed.176 A second difficulty for plaintiffs is that Dodd-Frank expressly states that its vote “may not be construed…to create or imply any change to the fiduciary duties” or “to create or imply any additional fiduciary duties” applicable to boards of reporting issuers.177 The Act’s provisions concerning compensation consultant independence, too, appear likely to reinforce, rather than peel back, courts’ deference to managerial processes.178 While U.S. courts have occasionally been willing to overturn pay decisions,179 it is difficult to envision them wading in on a politically-sensitive debate about a matter that, for the most part, is well outside of their competencies to assess, as even proponents of judicial reform will note.180 At the same time, it is hard to deny that the “tainted” aspects of board decision-making on pay might merit more probing examination of such processes.181 As Claire Hill and Brent McDonnell note, this dynamic has lent itself to the creation of a more substantive “penumbra” around corporate law in the form of obiter dicta, articles, legal conference speeches, legal memoranda and “best practices” of important players in the governance debate182 – in other words, to soft law. (b) Expansion of Soft Law on the Substance of Pay A second impact of the pay-sensitive climate of the new millennium was a proliferation in soft law, particularly by non-state actors and in respect of the substance of pay – in other words, the very place where legislators and judges feared to tread.183 Consistent with our theory above, many institutional investors and other shareholder activists invested in vigorous lobbying for a “hard law” vote in their respective jurisdictions, such a vote yielding higher payoffs than “soft law” 175  2012 WL 2885695 (N.D. Ill.). 176  Meridian Compensation Partners, “Say on Pay Lawsuits: History, Analysis and Future Direction” (April 2013), online: . 177  Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111–203, s. 951(c). 178  Fairfax, supra note 83 at 33. 179 Ibid. at 40. 180  Ibid. at 41. 181  Ibid. at 43. 182  See generally Hill & McDonnell, supra note 74. 183 An exception, however, lies with regulated financial institutions, at least in the midst of the crisis. U.S. TARP program participants, for instance, were subject to pay caps of $500,000, although arguably for the separate rationale of limiting, and providing incentives for the prompt repayment of, taxpayer “bailout” funds: Steve Liesman, “TARP Executive

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tactics in fostering board engagement. Yet once the vote was won, few governments, managers or shareholders clamoured for substantive “hard” regulation over pay, at least outside of the EU drive against bankers’ bonuses.184 This sentiment was also reflected in the “Jekyll-and-Hyde” result in the Swiss popular ballots of 2013, as discussed above. Thus, while many believe something is broken with respect to managerial accountability over pay and that more than Brandeisian “sunlight” is required, fewer have a sense of what compensation would look like if the regime was fixed. As one commentator notes: [T]he deeper question is: How much is a good CEO of an enormous company worth? And that’s just the problem. It’s an extremely hard question to answer. Today’s largest multinational corporations are bigger, more international, more complicated, and more besieged by global competition than they used to be. Maybe executives should be compensated more for a harder and more consequential job. But how much more is impossible to say. CBS CEO Les Moonves is notorious for pulling down pay packages worth more than $60 million. But his company had $14.1 billion in revenue last year. Relative to his median worker’s pay, Moonves is a king. But if he’s the best in the business, making less than half-a-percent of his company’s total revenue doesn’t seem so crazy. It’s easy to say a $60 million takehome is wrong. It’s harder to say what number is right.185 We noted, above, that such uncertainty lies at the core of the choice of a soft-law solution because soft law is more flexible than hard law in two respects: first, its non-binding nature makes it comparatively easier to amend, and second, it relies more heavily on principles-based forms. Consistent with theory, then, soft law approaches to the substance of pay have emerged in tandem with hard law approaches to its procedure. In particular, shareholder groups have established guidelines setting out their expectations vis-à-vis investee firms, both in response to mandatory sayon-pay and in its absence. For example, in 2009, the Canadian Coalition for Good Governance (CCGG), an institutional investor advocacy group, issued an

Compensation Limits Set at $500,000” CNBC Politics (4 February 2009), online: . More recently, of course, the EU has moved to limit bankers’ bonuses: see note 158 and commentary above. 184  See note 158 and commentary above. 185 Derek Thompson, “Why Do CEOs Make So Much Money?” The Atlantic (19 December 2013), online: .

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Executive Compensation Principles document to “provide enhanced guidance to boards and to promote compensation decisions that are aligned with longterm company and shareholder success.”186 The CCGG is explicit that its focus is on promoting “pay for performance.” As updated in 2013, the CCGG’s Principles include the following: Principle 1: A significant component of executive compensation should be “at risk” and based on performance. Principle 2: “Performance” should be based on key business metrics that are aligned with corporate strategy and the period during which risks are being assumed. Principle 3: Executives should build equity in the company to align their interests with those of Shareholders. Principle 4: A company may choose to offer pensions, benefits and severance and change-of-control entitlements. When such perquisites are offered, the company should ensure that the benefit entitlements are not excessive. Principle 5: Compensation structure should be simple and easily understood by management, the board and shareholders. Principle 6: Boards and shareholders should actively engage with each other and consider each other’s perspective on executive compensation matters.187 These principles are high-level, facilitating flexibility. However, they also leave many significant items to be worked out in concrete cases, including the meaning of “excessive” benefit entitlements under Principle 4. Under Principle 6, the CCGG recommends that boards voluntarily adopt an annual, advisory say-on-pay vote – a position that has so far carried the day at a significant number of large Canadian companies. The CCGG also proposes that boards “take the results of the vote into account…when considering future compensation policies, procedures and decisions and in determining whether there is a need to significantly increase engagement with shareholders on compensation and related matters.”188 The Principles also, however, envision shareholders voicing their concerns prior to a board vote, giving companies time to formulate 186  Canadian Coalition for Good Governance, “Executive Compensation Principles” (January 2013) at 1, online: . 187  Ibid. at 2. 188  Ibid. at 10.

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responses and explain to the shareholder base why changes were or were not implemented.189 This amounts to a more fleshed-out and bilateral framework than can be gleaned from say on pay as spelled out in legislation. While clearly non-binding, the practical influence of the Principles is substantial, with CCGG members controlling some $2 trillion in assets.190 Likewise, a major U.K. pension fund, Universities Superannuation Scheme (USS) Investment Management, together with a consortium of like-minded institutional investors, stresses a broadly similar set of principles in its “Remuneration principles for building and reinforcing long-term business success”: 1. 2. 3. 4. 5.

Remuneration committees should expect executive management to make a material long-term investment in shares of the businesses they manage. Pay should be aligned to long-term success and the desired corporate culture throughout the organisation. Pay schemes should be clear, understandable for both investors and executives, and ensure that executive rewards reflect long-term returns to shareholders. Remuneration committees should use the discretion afforded them by shareholders to ensure that awards properly reflect business performance. Companies and investors should have regular discussions on strategy and long-term performance.191

Notable about both the CCGG and USS Investment Management policies is a marked absence in references to “excessive” pay generally, suggesting a divergence between popular, inequality discourse-fused notions of “excess” and shareholder concerns about executives’ opportunistic use of equity-based compensation.192 Issuer-produced documents, such as compensation committee terms of reference, are also a source of soft law in the executive compensation area. 189  Ibid. 190 Canadian Coalition for Good Governance, “About CCGG,” online: . 191  “Remuneration principles for building and reinforcing long-term business success” (February 2013), online: . 192 The early-2000s backlash against stock options presents a notable example of the latter: see note 70.

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However, they frequently employ “boilerplate” language rather than engaging at a more granular level with pay policy. For instance, it is difficult to find a terms-of-reference document that does not allude to the need for a compensation package that is “both motivational and competitive so that it will attract, hold and inspire performance of Executive Management of a quality and nature that will enhance the sustainable profitability and growth of the Company.”193 Such a goalpost is commendable, but too high-level to be of much normative significance. In contrast, proxy advisory firms have invested resources into more expansive and technical policy documents, in line with their business of providing voting advice to shareholders and consulting advice to management around say-on-pay votes. Institutional Shareholder Services (ISS) and Glass, Lewis & Co., the largest proxy firms, both publish regularly-updated pay guidelines on a country or region-specific basis. ISS’s U.S. Proxy Voting Concise Guidelines, for example, set out five high-level principles: (1) “Maintain appropriate pay-forperformance alignment, with an emphasis on long-term shareholder value”; (2) “Avoid arrangements that risk pay-for-failure”; (3) “Maintain an independent and effective compensation committee”; (4) “Provide shareholders with clear, comprehensive disclosure guidelines”; and (5) “Avoid inappropriate pay to nonexecutive directors.”194 These share the generality and pay-for-performance focus of the shareholder groups’ guidance documents. The Guidelines also, however, set out ISS’s criteria for determining an “against” recommendation in respect of a say-on-pay vote: (1) “There is a misalignment between CEO pay and company performance”; (2) “The company maintains significant problematic pay practices”; and (3) “The board exhibits a significant level of poor communication and responsiveness to shareholders.”195 With respect to pay-for-­ performance, ISS outlines a two-stage analysis. First, ISS considers both a company’s total shareholder returns (TSR) and its CEO pay compared to its industry peers over a three-year period and whether the two rankings align. Next, it considers the CEO’s pay compared to its peer-group median. Finally, it considers the growth trend of TSR against that of the CEO’s pay over a five-year 193  Goldcorp, “Terms of Reference for the Compensation Committee” (January 2012), art. I, online: . 194 Institutional Shareholder Services, 2014 U.S. Proxy Voting Guidelines (19 December 2013) at 10, online: . ISS has also released a lengthier, expanded version of its Guidelines: see 2014 Proxy Voting Summary Guidelines (19 December 2013), online: . 195  Ibid.

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period. ISS applies a similar approach in Canada.196 If its analyses raise red flags, ISS considers additional metrics to determine any problematic aspects of the company’s compensation plan, including the ratio of performance- to timebased equity awards; the ratio of performance- to non-performance-based compensation; disclosure quality; the company’s own peer-group benchmarking practices; financial results; any special circumstances; and “realizable pay” compared to grant pay.197 As for the “problematic pay packages” identified in ISS’s second voting factor, ISS flags “non-performance-based compensation elements,” “incentives that may motivate excessive risk-taking” and “options backdating,” each of which it expands on in the Guidelines.198 The specificity and depth of ISS’s standards reflect the “reputational capital” at stake for their author. ISS standards are no doubt the most influential soft law instruments governing pay, both in how they impact the company’s internal practices (often developed alongside compensation consultants who watch the guidelines closely) and in how they influence actual shareholder votes (with many investors admitting that they depend wholly on ISS’s recommendations).199 The leading firms in the pay consultancy market include, among others, Frederick W. Cook & Co., Aon Hewitt, Mercer, Pearl Meyer & Partners and Towers Watson. These actors convey norms privately through manager liaisons, but also at conferences and in marketing or other publications describing current pay trends and key shareholder or proxy firm issues.200 Dodd-Frank’s rules requiring compensation committees to consider their advisers’ independence and report on their conflicts implicitly recognize the “gatekeeper” role played by such organizations in the pay-setting process.201 Beyond this, consultants’ benchmarking tables are one of the determining influences on executive 196  Institutional Shareholder Services, Canadian Corporate Governance Policy: 2014 Updates (21 November 2013) at 15, online: . 197 Ibid. at 11–12. 198  Ibid. at 12. 199  Stout, infra note 214. 200 See e.g. Kelly Crean & Amy Knierem, “14 for’14: Observations and Expectations for the 2014 Proxy Season” (September 2013), online: Mercer ; Steve Kilne & Katherine Edwards, “Strong Market Gains Put Pressure on Companies to Hit Heightened Performance Expectations” (17 December 2013), online: Towers Watson . 201  See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111–203, s. 952.

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pay and have received substantial attention from critics concerned with their impact on the pay “ratcheting” effect.202 As one of the principal (albeit unintended) beneficiaries of the move toward say on pay – akin to the governance “industry” created around Sarbanes-Oxley – consultants’ governance impact can only be expected to grow. States have also been active in creating soft law on pay matters, although at the international and supranational rather than the domestic level. Since domestic state-made soft law on pay has been the domain of courts (which, as noted above, have taken a conservative approach to the issue) and regulators (whose jurisdiction over substantive pay has been limited) it is perhaps natural that the locus of domestic state activity vis-à-vis executive compensation has been in procedurally-oriented legislation, not soft law proper. At the international level, however, the financial crisis prodded governments into considering joint approaches to pay issues, particularly in the financial industry and from a risk perspective. Thus, in 2009, a meeting of G-20 leaders led to a report converging on “action to ensure that governance of compensation is effective; that financial firms align their compensation practices with prudent risk taking; and that compensation policies are subject to effective supervisory oversight and engagement by shareholders.”203 In 2009, the EU took a step beyond its “soft” 2004 recommendations by recommending, among other things, that member states adopt the principle that “golden parachute” severance pay be limited to two years’ pay; that a “balance” be 202 Warren Buffett, for instance, criticizes consultants on the basis that “outlandish ‘goodies’ are showered upon CEOs simply because of a corporate version of the argument we all used when children: ‘But, Mom, all the other kids have one’.” See Berkshire Hathaway, 2006 Annual Report at 16, online: . See also Rob Wile, “Compensation Consultants: Meet the Conflicted Advisors Behind Ginormous CEO Salaries” Business Insider (8 May 2012), online: ; Gretchen Morgenson, “Corporate America’s Pay Pal” New York Times (15 October 2006), online: University of California at Santa Cruz . But see Georgios Voulgaris, Konstantinos Stathopoulos & Martin Walker, “Compensation Consultants and CEO Pay: UK Evidence” (1 March 2010) (unpublished), online: SSRN (finding that while compensation consultants’ use is linked to compensation increases, those increases stem from a move toward equity-based compensation, with consultants also being linked to a negative influence on basic pay). 203  Marisa Ann Pagnattaro & Stephanie Greene, “‘Say on Pay’: The Movement to Reform Executive Compensation in the United States and European Union” (2011) 31 Nw. J. Int’l L. Bus. 593 at 596.

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struck between fixed and variable pay; that variable pay be deferred by default, with share awards subject to a three-year vesting period; and that variable pay be subject to a “clawback” for misstatements.204 It followed this with a recommendation specific to financial services firms encouraging a pay policy that “promotes sound and effective risk management and which does not induce excessive risk taking,” together with policies oriented toward fixed-to-variable pay balance and pay deferral.205 This change in tack reflected the mounting post-crisis outrage over pay in Europe, and arguably anticipated the later move toward a “hard” cap on bankers’ bonuses in 2013. Nevertheless, the standards remained non-binding, and separate reviews of EU compliance in 2010 revealed substantial levels of non-compliance with both recommendations, suggesting the challenges of forging a common approach at a multi-state level. In our view, it is premature for say on pay-adopting countries to move toward a state-driven hard law approach to substantive compensation matters. While we believe regulators should remain at the table to oversee that the new shareholder-engagement dynamics serve the public interest, the evidence suggests that private entities have achieved some success in curbing egregious “pay for failure” cases. Until the say on pay model’s defects are made clearer, there is no reason to believe that top-down rules on pay – particularly given the lack of state expertise on pay matters – will produce better results. (c) Greater Levels of Stakeholder Participation in the Pay-Setting Process Consistent with Rupp and Williams’ focus on the capacity-building aspects of soft law, the most important contribution of say on pay’s “semi-soft” approach to executive compensation has been a marked increase in board engagement on pay matters. Whereas a top-down regulatory approach risks alienating boards by curtailing their discretion, say on pay’s focus is on empowering the board’s principals with a vote that serves as a reputational threat against conduct misaligned with shareholder preferences. The evidence suggests that boards, by and large, have opted to engage with rather than contest the views of shareholders, leading to a cultural sea-change in corporate governance: Before advisory votes came into force, the typical corporate compensation committee had to produce a package aimed at persuading the board. After advisory votes, the board compensation committee had to design packages capable of persuading shareholders. … Pay panels now meet 204  Ibid. at 623. 205 Ibid. at 625.

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more frequently; engage in design-stage consultation with key investors, investor trade organizations and/or proxy service advisors; utilize more information; and hire more independent outside advice.206 Moreover, board engagement often occurs not after, but before a pay vote takes place – a win-win, conflict-minimizing outcome for all concerned that may, across successive years, prompt an “internalization” of better pay practices. The production of a body of best practices such as the soft law sources discussed above further “socializes” corporate actors toward such norms.207 Not all, however, are convinced that the new participatory environment is a positive development. One concern is the potential “politicization” of the paysetting process, with one commentator noting that an across-the-board “just vote no” campaign against allegedly-excessive pay levels could be especially destructive to shareholder value.208 The early evidence, however, suggests that such a problem is distant. Rather, shareholders have accepted companies’ existing plans by fairly wide margins. Indeed, Andrew Lund posits that shareholders appear interested only in punishing excessive pay when it is tied to failure, being too frightened of providing mixed incentives to an overpaid CEO at a well-performing firm.209 That quite opposite concern appears more realistic at this juncture, although it may also represent an efficient and proper response to uncertainty about the “proper” level of pay packages and executive retention concerns. The cases of greatest governance concern remain those of pay for failure, and the evidence suggests that say on pay, across jurisdictions, is working to curb at least a substantial subset of those cases, with or without public shaming.210 That is much more than legislators and regulators can claim to have accomplished with disclosure alone. A more legitimate issue may be the dominating influence of proxy firms such as ISS and Glass, Lewis & Co. in the new regime. For years prior to say on pay, these firms provided services reviewing company and shareholder proposals before annual meetings and offering advice to institutional investors on 206  Davis, supra note 86 at 11. 207  Sandeep Gopalan, “Say on Pay and the SEC Disclosure Rules: Expressive Law and CEO Compensation” (2008) 35 Pepp. L. Rev. 207 at 241. 208 That is Joseph Grundfest’s view, quoted in Michael Connor, “Politicizing the Board: Directors Face Powerful Pressures” Business Ethics (13 June 2010), online: . 209  Andrew C.W. Lund, “Say on Pay’s Bundling Problems” (2011) 99 Ky. L.J. 119 at 122. 210  Ibid.

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how to vote their shares. For many fund-managing institutional investors, that voting constitutes a fiduciary obligation undertaken on behalf of their members. Owing to institutional investors’ limited expertise, financial incentive (given small relative shareholdings) and resources with respect to such voting, a substantial “outsourcing” to ISS and other firms took hold. That reliance increased with the advent of securities-law requirements for mutual funds to disclose their voting policies and actual votes.211 Given that say on pay demands even more engagement by shareholders – not least on a complex, comparative issue few funds have the capacity to meaningfully study – the reform has been a clear boon for the proxy firms’ business models, which quickly adapted to offer additional pay vote-tailored services. The proxy firms’ sway over voting has been remarkable. For instance, in the first year of say on pay, David Larcker, Allan McCall and Gaizka Ormazabal found that firms with a negative ISS sayon-pay vote recommendation received an average of 68.7 per cent support from shareholders, whereas firms with a positive recommendation received an average of 93.4 per cent support.212 Numerous large funds voted over 99 per cent of the time with ISS, and others expressly disclosed to shareholders that following ISS’s recommendations was their policy.213 This influence disturbs some observers. Prior to say on pay, Lynn Stout argued that “there is reason to doubt whether ISS analysts have particularly good insight into what makes for ‘good corporate governance’” and that the company, rather, “seems to follow governance fads and fancies.”214 For Tamara Belinfanti, institutional shareholders’ dependency on ISS “presents the hallmark problem of ‘agency cost’ that has plagued corporate law scholars for years,” with ISS making the decisions – with “virtually no accountability” – and shareholders bearing the risks.215 ISS has a 61 per cent share in its industry, the economies of scale of which favour its incumbency.216 Moreover, it bundles its services with its governance-rating business, and further advises companies 211 See Securities and Exchange Commission, “Mutual Fund Proxy Voting Records and Policies” (18 January 2005), online: . 212  David F. Larcker, Allan L. McCall & Gaizka Ormazabal, “Outsourcing Shareholder Voting to Proxy Advisory Firms”(10 May 2013) (unpublished) at 7, online: SSRN . 213  Ibid. at 5–6. 214  Lynn A. Stout, “Why Should ISS Be the New Master of the Corporate Governance Universe?” Corporate Governance (4 January 2006) at 14–15. 215 Tamara C. Belinfanti, “The Proxy Advisory and Corporate Governance Industry: The Case for Increased Oversight and Control” (2009) 14 Stan. J.L. Bus. & Fin. 384 at 406. 216  Ibid. at 397.

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with respect to improving such ratings – an enterprise some have characterized as “opportunistic,” if not conflict of interest-laden.217 Critics have also honed in on perceived gaps in proxy firms’ disclosures that inhibit a closer look at their voting recommendations.218 Numerous governmental bodies have latched on to these concerns, including in the United States,219 the European Union, France and Canada.220 In September 2013, the Canadian Securities Administrators, the organization representing Canada’s provincial securities regulators, announced that its members would be adopting a “policy-based approach” to regulating proxy firms “that would give guidance on recommended practices” and require disclosure to “promote transparency and understanding in the services provided.”221 In our view, while the governance concerns relating to proxy firms are real, it remains the fact that say on pay, under their watch, has led to tangible, substantial and often immediate improvements in board engagement on executive compensation issues. While say on pay cannot erase the structural issues of monitoring cost-based “rational apathy” underpinning the proxy firms’ market position, it provides a far more reliable framework for board accountability than the prior, disclosure-centred regime, which enabled a far more troubling form of entrenchment. We believe that the development of transparencybased oversight of proxy firms should go some way toward assuring the legitimacy of say on pay’s soft law-based process which, by and large, is still in its early stages of development. V

Finding the Soft Law Sweet-Spot: Enforcement versus Transparency

Say on pay laws represent a “hybridized”222 fusion of hard and soft law, employing the legislative mandate of a shareholder vote to buttress a soft law-driven 217  Ibid. at 402. 218  Ibid. at 418. 219 See e.g. Securities and Exchange Commission, “Proxy Advisory Services Roundtable” (5 December 2013), online: . 220  For the Canadian Securities Administrators’ discussion of the issues, see Consultation Paper 25–401, “Potential Regulation of Proxy Advisory Firms” (21 June 2012). For a summary of the French and EU-level initiatives, see Appendix A to the Consultation Paper. 221 See CSA Notice 25–301, “Update on CSA Consultation Paper 25–401, ‘Potential Regulation of Proxy Advisory Firms’” (19 September 2013), online: . 222  One scholar notes the rise of a “hybridity” camp in the hard-soft law debate in the EU context, proponents of which “call for combinations of traditional hard law and soft law

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network encompassing both board-level private governance and the “best practices” norms of shareholders, proxy firms, compensation consultants and others. Yet, as canvassed above, not all say on pay laws are made alike. Some countries have opted for more “hard” components, such as the Nordic binding vote or the Australian “two strikes” rule. Which approach strikes the best balance? This question goes to a matter of significance for soft law more generally: how can regulators or legislators determine the “optimal” level of soft law in any regime? In this Part, we explore an evolving, pragmatic model of soft law and consider it in light of the say on pay movement. (1) A Pragmatic Theory of Hard Law-Soft Law Balance In our view, the most compelling theory of hard-soft “balance” is offered by John Wright and Brian Head, who rather than launching into a comparative, pro-and-con assessment of hard and soft law in the abstract, frame the matter as follows: Given the great diversity of institutional frameworks, policy issues, industry sectors and national contexts, empirically grounded researchers have argued that the only sensible answer to the question of ‘what is the optimal combination’ of regulatory and governance arrangements is that ‘it depends’.223 Wright and Head instead offer a “learning” approach to regulation, drawing from the pragmatic tradition in philosophy and leading from the position that “a priori advice is inferior to case-by-case analysis.”224 The development of a once-andfor-all regulatory platform, building from unchallengeable assumptions, is a quixotic endeavour often blind to unintended consequences; better, instead, to embrace “a spirit of self-correction built into the regulatory process by means of a well-developed organisational capacity to learn from experience.”225 As explored in Part II, hard law and soft law each have their distinct advantages and disadvantages, and the question of which better suits the regulatory

processes.” Some, for instance, see hard law as “securing a regulatory bottom-line below which soft law may not fall; soft standards and guidelines complement a base of binding hard norms securing rights and determining fundamental policy directions.” See Anna Di Robilant, “Genealogies of Soft Law” (2006) 54 Am. J. Comp. L 499 at 507. 223 John S.F. Wright & Brian Head, “Reconsidering Regulation and Governance Theory: A Learning Approach” (2009) 31 L. & Pol’y 192 at 193. 224  Ibid. 225  Ibid. at 195.

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task at hand largely turns on industrial context and subtle – even interpersonal – dynamics. A soft approach that promotes industry norm-internalization in one context may be a recipe for regulatory capture in another. John Braithwaite’s influential model of “Responsive Regulation” presents a way to navigate this thicket: for Braithwaite, regulators should leave their options open by leading with the soft solutions of cooperation, education and capacity-building first, resorting to hard enforcement solutions only when dialogue fails. In other words, regulators (or here, legislators) should give “the cheaper, more respectful option a chance to work first.”226 Such an approach is consistent with Rupp and Williams’ plea for a more psychologically-rich compliance model that goes beyond payoff-matrix analyses and considers the possibility that corporate actors may, in the right circumstances, be inclined to actively pursue higher standards.227 Braithwaite’s account also, however, acknowledges that companies will occasionally become “rational calculators” about compliance and must be taken progressively up a “pyramid of sanctions,” even if the “nuclear option” – such as the loss of a licence – is required.228 In Braithwaite’s words: [W]hat we want is a legal system where citizens learn that responsiveness is the way our legal institutions work. Once they see law as a responsive regulatory system, they know that there will be a chance to argue about unjust laws (as opposed to being forced into a lower court production line or a plea bargain). But they will also see that game-playing to avoid legal obligations, and failure to listen to arguments about the harm their actions are doing and what must be done to repair it, will inexorably lead to regulatory escalation. The forces are listening, fair, and therefore legitimate, but are also seen as somewhat invincible. …229 Braithwaite uses the example of privatizing airlines to describe how “Responsive Regulation” might work at a law-reform level: [A] state might decide to privatize civil aviation – allowing international competition of airlines from other nations to persuade consumers with better prices, services, and safety performance – but with tough new regulation of the private airlines that enter the market. In time, bad outcomes might 226  John Braithwaite, “The Essence of Responsive Regulation” (2011) 44 U.B.C. L. Rev. 475 at 484. 227  Rupp & Williams, supra note 29 at 595. 228 Braithwaite, supra note 223. 229  Ibid. at 488.

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lead to further escalation of that regulation and limits on entry of further international competitors, and if that fails, to re-nationalization of the airline industry. Alternatively, better-than-expected outcomes might lead to relaxation of the tough regulatory standards that accompanied privatization, and the licensing of even more international competitors. …230 (2)

Striking the Right Balance on Say on Pay

(i) The Importance of Context The move from disclosure rules to say on pay – from Brandeisian “sunlight” to direct shareholder empowerment – presents an interesting real-world analogue to Braithwaite’s aviation example. While part of the move toward say on pay can be described in terms of “political entrepreneurship” in response to public outrage over ballooning CEO pay and inequality generally (such as in 1990s Britain and the post-financial crisis United States),231 the evaluation of say on pay across jurisdictions has also been informed by a considerable amount of policy debate, data analysis and industry consultation. For example, the initial British reform arose out of the Cadbury, Greenbury and Hampel reports on corporate governance;232 in Australia, the Productivity Commission assessed the country’s post-say on pay progress in some depth, ushering in its move toward “two strikes”;233 and Canada is currently launching a federal government-led consultation process on adopting an advisory vote.234 At least part of the ongoing story of say on pay, then, reflects a “learning” approach to regulation where legislators revisit their assumptions (such as disclosure yielding certain governance outcomes, for instance) over time with the benefit of experience. Yet jurisdictions’ divergent paths on say on pay clearly drives home the importance of context in shaping such reactions. The cases of Britain and Canada present a useful contrast in this regard. As noted above, a series of pay scandals in the 1990s built up political pressure for reform in Britain. The Conservative government’s response, in the Greenbury Report, was “soft,” and, consistent with Braithwaite’s theory, tailored to grant industry an opportunity to demonstrate the sufficiency of 230  Ibid. at 490. 231  See generally Culpepper, supra note 167. 232  See ICAEW, Library and Information Service, “Codes and reports,” online: . 233  Thomas, supra note 117 at 8. 234  See note 148 and accompanying text.

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voluntary self-regulation. When Tony Blair’s Labour government was elected in 1997, “third way” solutions to the matter were sought out and the notion of an advisory vote on pay was born – empowering shareholders with a new channel of dissent but keeping government out of the picture.235 While companies improved their disclosure practices post-Greenbury, the U.K. experience saw companies largely flout recommendations for increased shareholder engagement.236 The Labour government’s enactment of an advisory pay vote in 2002, then, can be understood as a responsive solution both signalling the government’s expectations and preserving board discretion. When such discretion was shown prone to abuse,237 as executive pay continued its upward creep,238 and in the context of a major post-financial crisis shift in public opinion, Britain hardened its regime further by imposing a binding vote in 2013. Canada’s experience provides a different story. As a starting-point, “Cedric the Pig”-style scandals were largely absent from Canada, whose CEOs have consistently been paid less than their American counterparts.239 Changes in Canada’s executive pay disclosure rules in 1994 and 2008 largely tracked those of the SEC in 1992 and 2006,240 rather than being tied to homegrown political phenomena. And while the financial crisis made inequality a live topic of political discussion in Canada,241 “fat cats” sentiment was far less intense than in the United States. This was especially the case with respect to the banking industry, which, unlike the United States and other countries, did not receive “bailout” funds and was ranked “soundest in the world” by the World Economic Forum 235  Davis, supra note 86 at 9. 236  Delman, supra note 61 at 589. 237  The U.K. government noted how numerous companies, despite high (yet still below 50 per cent) levels of dissent in their vote, took no action in response to shareholder ­concerns: see UK Consultation Report, supra note 103 at 15. As noted above, the case of Shell illustrates the companies may still resist change after a failed vote. 238  Ibid. at 10 (where the government notes that “executive pay in the UK’s largest listed companies has quadrupled with no clear link to performance”). 239  See e.g. Steven Balsam, ed., An Introduction to Executive Compensation (San Diego: Academic Press, 2002) at 279 (noting several studies confirming a substantial difference in executive pay between the two countries in the 1990s); “Canadian CEOs Making Less than U.S. Peers” (27 November 2013), online: Advisor.ca . 240  See note 135. 241  See e.g. Tim Harper, “The Occupy Movement enters its What Now? phase” (30 October 2011), online: .

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from 2008 to 2013.242 Yet despite say on pay’s lack of political salience in Canada, a post-crisis drive by Canadian institutional investors toward voluntary adoption of say-on-pay votes largely succeeded: the number of large Canadian issuers to adopt votes rose from 71 in 2011 to 99 in 2012 to 126 in 2013.243 The success of a “voluntarist” model in Canada could be attributed to the “small pond” nature of corporate Canada, facilitating the spread of norms among more closely-aligned director and officer networks. It may also, however, be linked to Canada free-riding on the shadow of the “harder” solution south of the border, both owing to the large number of dual-listed entities on the Toronto Stock Exchange and the historically-close economic ties between the two countries more generally. Finally, Canadian issuers may be “rationally calculating” that voluntary compliance is a better bet than stoking a “harder” political solution less congenial to their interests. Thus, whereas the U.K. experience saw progressively harder political solutions fail to satisfy public demands for reform, Canada’s experience poses a different question: if “internalization” appears to be happening, why regulate further? One reason may be to secure better governance at smaller companies, which have by and large not adopted the vote.244 While compensation is hardly extreme at such companies, there is no reason to believe that they will be immune to many of the structural concerns present at their larger counterparts. Still, it may well be that Canada’s unique set of circumstances renders a solution lower on Braithwaite’s “enforcement pyramid” optimal, even if such a solution is not available in differently-situated countries. Overall, we resist ranking the relative success of countries’ approaches and the superiority of harder to softer models of say on pay at this juncture. It is simply too early to tell, by and large, whether a “one-size-fits-all” regulatory best-practice exists. For one, only a small number of studies have been made on say on pay, largely confined to the U.S. and U.K. models rather than the binding models of the Netherlands and the Nordic countries. Other countries may have idiosyncrasies justifying a differential approach. Luca Enriques, Henry Hansmann and Reinier Kraakman, for instance, note how accepted corporate governance “best 242  Canada, Department of Finance, News Release 2013–113, “World Economic Forum Ranks Canadian Banks Soundest in the World for Sixth Consecutive Year” (5 September 2013), online: . 243  See Paul D. Davis & Richard Yehia, “Testing the Waters: The Litigation Risk Implications of Failed Say on Pay Votes for Canadian Companies” (July 2013), online: McMillan LLP . 244  David Milstead, “Say on pay doesn’t guarantee smaller pay packets” The Globe and Mail (23 August 2012), online: .

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practices” often reflect manager-shareholder concerns paramount only in diffuse-shareholding jurisdictions such as the United States and Britain.245 In contrast, shareholders on the continent, which exhibits higher levels of “block” ownership, can often voice their concerns without resort a proposal or vote,246 as can many shareholders in Canada, which also has a substantial controllingshareholder tradition.247 In such contexts, pay issues may be rooted in agency problems between deferential majority shareholders (who can always out-vote the “against” side) and aggrieved minority shareholders, rather than between nepotistic or inattentive boards and a broader shareholder base. Still, trends in ownership dispersion248 and fairness for companies that are widely-held may still justify mandatory say on pay outside of wide-ownership contexts. (ii) Lessons Learned What is clear across the board of say-on-pay adopting countries, however, is that the reforms – however implemented – are achieving a governance “good” that disclosure alone could not. It is unclear, however, whether reduced pay levels or pay growth are necessarily part of that story. While some early research confirms that say on pay laws can, in fact, reduce compensation growth249 – supporting the theory that a lack of shareholder voice, and not tacit shareholder consent, lies behind the numbers – other research fails to find such an effect, reporting continued increases.250 Nearly all studies, however, appear to 245  Kraakman et al., supra note 59 at 87. 246  Ibid. 247  May, supra note 144. 248  See e.g. Julian Franks et al., “Evolution of Family Capitalism: A Comparative Study of France, Germany, Italy and the UK” (September 2008) (unpublished), online: (noting a “dramatic increase in widely held ownership among listed firms in Continental Europe” from 1996 to 2006); John C. Coffee, “The Rise of Dispersed Ownership: The Role of Law in the Separation of Ownership and Control” (Columbia Law School Center for Law and Economic Studies Working Paper No. 182, January 2001), online: . 249  See e.g. Ricardo Correa & Ugur Lea, “Say on Pay Laws, Executive Compensation, CEO Pay Slice, and Firm Value Around the World” (Federal Reserve International Finance Discussion Papers, No. 1084, July 2013), online: < http://www.federalreserve.gov/pubs/ ifdp/2013/1084/ifdp1084.pdf>. 250  See e.g. Vincente Cuñat, Mireia Gineé & Maria Guadalupe, “Say Pays! Shareholder Voice and Firm Performance” (European Corporate Governance Institute Working Paper No. 373/2013, July 2013), online: SSRN ; Fabrizio Ferri & David A. Maber, “Say on Pay and CEO Compensation: Evidence from the U.K.” (2013) 17 Rev. Fin. 527; Thomas, supra note 117 at 10.

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draw two findings that suggest that say on pay should be preferred to a model relying on transparency alone. First, a consensus exists that say on pay has increased, often by wide margins, boards’ engagement with shareholders and proxy firms on pay matters. Some have gone so far as to deem this a “shareholder spring.”251 For instance, a 2004 Deloitte report found that over 70 per cent of U.K. shareholders believed that their pay vote’s enactment had a significant impact on board attitudes and behaviours.252 A 2009 study confirmed that sentiment, reporting that the U.K. reform had “improved the dialogue between companies and their investors,” creating significant goodwill.253 Likewise, an ISS report concerning the Netherlands’ binding vote describes compensation committee members being more concerned about their reputations, more interested in shareholder views and more aware of the consequences of their compensation plan.254 Towers Watson, otherwise critical of Australia’s approach, describes it as a “significant success” from the perspective of facilitating board-shareholder communication.255 Even after the first proxy season of the U.S. reform, observers noted a fundamental “shift in the management-shareholder dynamic.”256 Subject to concerns regarding proxy firms’ influence in this process, this change has gone some way toward improving the legitimacy of a decision-making process, the structure of which – for all of the reasons discussed in Part IV, above – is cause for concern whether one views executive pay to be “excessive” or closer to market. Secondly, notwithstanding continued growth in average pay, say on pay has cleared out many of the worst cases of “pay for failure.” As Citibank and other cases demonstrate, soft-law “shaming” has been a remarkably effective deterrent 251  See e.g. J.F. Corkery & Sabina Medarevic, “Executive Compensation Under Scrutiny: The Cutting Edge of the ‘Shareholder Spring’” (Bond University Corporate Governance eJournal, 2 Feburary 2013), online: ; Kate Burgess & Dan McCrum, “Boards Wake Up to a Shareholder Spring” Financial Times (4 May 2012), online: ; and “Welcome Shareholder Spring that Holds Bosses to Account” Bloomberg (22 May 2012), online: . 252  Gopalan, supra note 207 at 234. 253  Larcker et al., supra note 110 at 4. 254  Gopalan, supra note 207 at 236. 255  Stephen Burke, “Why There’s Not Much to Learn From Australia’s Approach to Say on Pay” (26 February 2013), online: Towers Watson . 256  Cotter, Palmiter & Thomas, supra note 129 at 970.

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to large payouts at low-performing companies. Beyond sending a signal to firms with failed votes, such firms’ “examples” lead other boards to be increasingly diligent in avoiding failure by engaging with their shareholders at an earlier stage. Akin to Braithwaite’s case for “Responsive Regulation,” this “softer” sanction is also cheaper: as one observer notes, “shaming can decentralize the enforcement of the norm and facilitate investor protection without the need for regulatory expenditure.”257 At the same time, the vote is not a perfect mechanism. Its most serious problem is that it appears to do little to check ever-higher levels of compensation at successful companies – a somewhat less troubling problem, but an equally-important contributor to the “ratcheting” up of pay year-after-year.258 The unattainability of the perfect, however, is no reason to spurn the good. And while some boards have ignored failed votes, the paradigmatic case has largely been of a board willing to listen and sensitive to its market reputation. To the extent recidivism and opposition poses a concern, a binding model presents a “harder” option, as does the Australian “board spill” vote. With generally positive dynamics in place, however, we caution a move to “harder” law (such as cap arrangements or substantive pay regulation), which may engender a culture of resistance and impede the internalization of pay norms in the corporate community. Akin to Braithwaite’s model, legislators should give the “cheaper, more respectful option a chance to work first,” and react to hard evidence rather than populist pressures. In particular, the political capital from more generalized popular forms of dissent – the clamour against “fat cats” and inequality – may be better spent in places other than in the regulation and re-regulation of executive pay. This is not to claim that the state has no role in the executive compensation area. Consistent with our theory above, we believe that any regulatory approach that depends so heavily on private actors to provide the requisite “social sanctioning” should be closely monitored as to whether it is calibrated in the public interest. States should continue to monitor the influence of proxy firms on executive compensation outcomes and consider whether additional hard or soft outcomes (such as credit rating agency-like oversight) are warranted. While early signs suggest that proxy firms have provided a substantial, soft lawdriven boost to the shareholder empowerment movement, historical experience with governance “gatekeepers” suggests the need for careful eyes to monitor problematic trends.259 Further “hardening” options may include what 257  Gopalan, note 207 at 246. 258  The “Lake Wobegone” effect. See notes 80 and 202 and accompanying text, above. 259  See generally John C. Coffee, Jr., “Gatekeeper Failure and Reform: The Challenge of Fashioning Relevant Reforms” (Columbia Law and Economics Working Paper No. 237,

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Ian Ayres and John Braithwaite call a “tripartist” model, whereby governance actors are co-opted into state-assigned monitoring or sanctioning functions in a kind of regulatory partnership.260 At the same time, proxy firms’ incentives may be differently-situated than those of the credit rating agencies that failed to capture subprime-related risks in the companies they monitored. According to one commentator, for instance, the danger lies not in proxy firms’ abandoning their private oversight role in the pay area (causing the vote’s power to decline over time), but in their intensifying their efforts and demanding that boards adopt the “latest and greatest” metrics.261 Until the second wave of say on pay reforms has had a chance to play out, we believe it is premature to countenance tougher, more substantive regulation of pay. By and large, say on pay – by leveraging industry dynamics conducive to the “pro-governance” operation of private soft law – has been a regulatory success-story to date. VI Conclusion As a mixed hard-soft mechanism of regulation, say on pay “offers a model of how procedural reforms…can catalyze company-by-company negotiations and reforms”262 in a way that disclosure, alone, could not for executive compensation. In particular, while the importance of “sunlight” to the realization of a board-centric governance model cannot be understated, disclosure provided a weak check against the structural, economic and social motivators affecting compensation decisions. Indeed, the power of disclosure is a particular conceit in executive pay if one accepts the “Lake Wobegone” or “ratcheting” effect of publicized compensation tables on company structures, an effect only aggravated by transparency. A “harder” solution on pay was needed, and that which policymakers have found – the empowering instrument of a shareholder vote – has presented a soluble means of avoiding the risks of substantive state regulation while demanding higher private governance standards. Say on pay thus represents the best traditions of soft law, both in facilitating

September 2003), online: SSRN . 260  See generally Ian Ayres & John Braithwaite, “Tripartism: Regulatory Capture and Empowerment” (1991) 16 L. & Soc. Inq. 435. 261  Charles Nathan, “Myths and Realities of Say on Pay ‘Engagement’” (8 December 2012), online: . 262  Cotter, Palmiter & Thomas, supra note 129 at 1011.

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greater private participation in shaping governance outcomes, in relying more on principles to deter “box-checking” and in retaining a flexibility that leaves room for proper regulatory tweaks. By and large, jurisdictions have also taken a “responsive” approach to implementing such reforms, moving from more detailed disclosure rules, to advisory votes, and then to binding votes or lower approval thresholds after private entities have had an opportunity to set their own standards. While reform may not have been possible without the political impetus of pay-related scandals and the financial crisis, such an approach avoids the worst of regulatory overreach while leveraging the possibility of norm-internalization. Soft law has attracted most of its attention in the international sphere, where its use was borne from necessity, given wide gaps between states on fundamental issues of governance. Yet we posit, similarly to other scholars, that soft law has a vital place in domestic law as well, provided it is supported by an active regulator and not mistaken for self-regulation – an important risk exposed by the regulatory models allotted fault after the financial crisis. When combined with active, “Responsive Regulation”-type strategy, soft law-fused methods can be an optimal first response to many regulatory phenomena, particularly where evidence is scare and industry dynamics are amenable to normative influences. Regulation should be guided by experience, not by zeal, and soft law, when weaved into existing enforcement processes, may be an especially effective tool with which to approach its vital tasks.

Other Features

Frequency?

Mandatory or Voluntary Regime? Binding or Advisory Vote? Package or Policy Vote?

Upon changes

Upon changes

Annual

Policy

Policy

Policy

Binding

Binding

Binding

Mandatory

Denmark (2007)

Mandatory

Netherlands (2005)

Sweden (2006), Norway (2007)

Mandatory

Hardened

New law

Hardened

Annual

Package

Advisory

Mandatory

Change from 2004?

Triannual on policy; annual on package

Binding on policy; advisory on package Both (see above)

Mandatory

Australia (2011)

“2 strikes” rule; if