Author: Kristin Johnson

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Until We Meet Again

I want to thank the authors of Concurring Opinions for allowing me to join as a guest blogger for the past month. It has been a wonderful experience. I also want to thank the readers who provided thought-provoking and insightful comments to my posts. I enjoyed our dialogue.

My posts concentrated largely on the economic crisis. Our efforts to address concerns regarding the recent turmoil in domestic and international financial markets and governance systems are crucial to preventing or even weathering future financial instability. There are new opportunities and motivations for inter-agency collaboration in the domestic administrative state and international collaboration across jurisdictional boundaries. As we anticipate the President signing the most sweeping financial reform bill of our time, we should reaffirm our commitment to understanding and investigating the causes of the crisis and embrace opportunities to interpret and apply the legislation in a manner that effectively forecasts or promptly addresses events that have the potential to engender such pervasive social and economic losses in the global community.

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Are We There Yet? Driving The Financial Reform Bill Home

This morning, at 5:39am, a conference committee comprised of 43 lawmakers from the House and the Senate agreed upon a final version of the financial reform bill. The bill is expected to pass in both chambers of Congress and to be signed into law on July 4th by President Obama. As anticipated, the final version reflects critical compromises that may alter the bill’s ability to mitigate the systemic risk in the financial system that inspired  the bill’s creation.

Earlier versions of the bill included provisions proposed by former Federal Reserve Chairman Paul Volcker and Senator Blanche Lincoln. These provisions aimed to prohibit federally insured banks from engaging in riskier investment activities, such as investments in hedge funds or private equity funds, and required banks to limit and isolate their proprietary trading activities and to discontinue their origination and trading of nontraditional or exotic investment products, such as derivatives contracts. In the face of strong and well-financed opposition, the conference committee has adopted a less restrictive version of the proposed regulation.

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New View of Citi

Previously, I suggested that one of Congress’s central goals for adopting financial market reform is to limit systemically significant financial institutions’ risk taking to levels where the capital and assets of each business covers its losses. In other words, the reform bill aims to require businesses to internalize both their successes and the consequences of their failures. Some question the federal government’s expertise in risk management matters, while others challenge the appropriateness of government intervention into a corporation’s internal affairs. These challenges raise important questions. Before reaching these questions, however, it may be useful to consider a recent example of failed risk management that has prompted government intervention and the proposed reform bills’ potential impact on enterprise risk management.

In November of 2008, the federal government agreed to invest $45 billion (later converted into $25 billion of Citigroup common stock) and agreed to guarantee $306 billion in Citigroup’s loans and securities. (See here and here.) After suffering devastating losses beginning in the final three months of 2007 and continuing through the end of 2008, the esteemed investment bank with a 100-plus year history teetered on the brink of collapse. How had Citi’s star fallen so far so fast?

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In the End-Zone

As the legislators work to put the final touches on the farthest reaching financial reform bill since the Great Depression, the fervent activities of the financial markets industry and its lobbyists evokes images of teams battling for a World Cup-like prize. Legislators and regulators drive the ball (read: football) down the field to score and the lobbyists valiantly defend the end-zone.  The recent efforts by Paul Volcker, former Federal Reserve chairman, to defend the provision that he proposed limiting banks’ ability to engage in the higher risk, nontraditional private equity and hedge fund investment activities (appropriately named the Volcker Rule) illustrates this contest. There is skill and trickery involved.  Depending on one’s allegiance, descriptions of the “end-zone” vary, but cries of paternalism, liberalism, moral hazard and “too big to fail” are clearly voiced by factions in the boisterous crowd. A common thread, however, runs through the arguments articulated and underlies many of the provisions in the legislation; the chief focus in each instance is the ability of systemically significant institutions to adopt and implement effective enterprise risk management policies.

An oversimplified definition might describe risk management as a quantitative calculation of potential profit weighed against possible loss (among other factors).  This definition accurately describes the internal guidelines that a company may adopt to limit a business unit or an employee’s authorized investment decisions, such as the appropriate amount of risk to take in connection with an interest rate, currency, commodity, securities or similar trade or underwriting activity. Enterprise risk management, however, describes a more comprehensive view of the entire body of risks involved in an enterprise – the operational, investment and strategic risks. The difficulties with regulating enterprise risk management are many and well documented. (For a broad summary, see here.) Some rightly challenge the accuracy of quantitative risk models. Other theorists question the effectiveness of risk management to overcome cognitive biases such as market participants’ inclination to be overly optimistic despite evidence of severe losses or errors or the significant influence of their individual short-term interests. (See e.g., herehere and here.)

Eagerly awaited as a political response to the crisis, the financial reform bill will hopefully restore confidence that businesses will be better guided in their enterprise risk management decisions. Even if the strictest version of the Volcker Rule and similar provisions are adopted,  enterprise risk management will likely remain a central concern for financial market participants and regulators. Rumors abound that financial institutions and certain of their investors are already investigating gaps in the proposed legislation that will allow them to continue to invest in exotic financial products.

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Virtually Better or Worse?

National concerns regarding the impact of technology-related issues in financial markets (see here) should inspire reflection on recently adopted state statutes that allow corporations to host electronic shareholder meetings.  Over the last ten years, several states have adopted statutes that permit corporations to allow virtual shareholder participation in annual shareholder meetings. Some states even permit corporations to hold electronic “remote access only” annual shareholder meetings — meaning, in lieu of a meeting at a physical location, shareholders may only participate in an annual meeting through electronic media.

Because we are a technology-dependent generation, many applaud the idea of virtual shareholder participation or electronic annual shareholder meetings. Supporters argue that virtual meetings are less expensive than in-person meetings and virtual communication engenders enhanced participation by a broader shareholder demographic. Opponents, however, challenge the assumption that virtual participation and electronic meetings are less expensive, pointing to the fixed and recurring expenses that a company incurs in order to transition to virtual meetings and to maintain the necessary electronic meeting technology. In addition, some have expressed concerns that management or directors may use virtual meetings to insulate themselves from disgruntled shareholders or to disregard hostile questions submitted via email in advance of electronic meetings. Other concerns arise directly from the use of technology, such as the ability to verify shareholders’ identity and to assess and record accurately shareholder votes during an electronic meeting. While some states have adopted statutes attempting to address concerns related to virtual shareholder participation and electronic meetings, many of these concerns remain unresolved.

Lisa Fairfax has insightfully surveyed the states that have adopted virtual participation or electronic meeting statutes and concludes that the number of states addressing virtual participation and/or electronic meetings signals the significance of virtual alternatives. Fairfax and other scholars, however, remain skeptical about the proposed benefits of virtual participation and electronic meetings. In addition, the small number of corporations that have attempted to hold electronic shareholder meetings indicates that corporations are also gingerly approaching this wave of innovation. Until some of the more critical concerns regarding electronic shareholder meetings can be addressed, corporations’ caution may well be prudent.

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A New World of Possibilities

As Congress labors to adopt financial markets reform, it is not surprising that the legislation that members have proposed centers on addressing moral hazard concerns – fears that institutions deemed “too big to fail” seek government assistance when facing threats of insolvency. Proposed reform provisions and amendments suggest, among other measures, segregating business lines that engender excessive risk from commercial and individual savings or deposit businesses and limiting the size of banks. These valuable and important suggestions are newsworthy because of what they aim to accomplish (whether or not the goals are feasible – see here): the prevention of  future credit and liquidity crises. Another story receiving less fanfare, is, however, developing in the margins. The G-20 has initiated efforts to gather international banking regulators, finance scholars and banking executives together to revisit the Basel accords and adopt international capital requirements for banking institutions. These efforts focus on creating a more resilient banking sector and preventing the collapses and near-collapses witnessed in the most recent crisis. As predicted, regulators from differing countries have a diversity of viewpoints regarding issues such as the appropriate amount of leverage that institutions may use, banks inclusion of commercial and individual savings deposits as a factor in calculating liquidity or simply, the timing of the implementation of reforms.

Hopefully, the international banking regulators will identify all of the correct concerns and adopt effective resolutions. Even if banking regulators fail to adopt and implement ideal reforms, their collaborative process may offer a critical illustration of the necessary coordination that must occur for any individual nation to obtain safety and soundness within its national banking sector. The cooperative efforts of the G-20 illustrate the benefits of the theory of transgovernmentalism, a model that posits that regulatory networks present an increasingly invaluable element in resolving threats to international infrastructure systems such as finance markets or the environment. Resting upon the notion of “disaggregated sovereignty,” the theory of transgovernmentalism suggests that the sum of different nations’  bureaucratic parts – regulatory agents and agencies, scholars and professionals- is greater than the whole.“[U]nbundling the state–and reconnecting the constituent parts across national borders” establishes networks of relationships among the many crucial interests in a regulated industry. (See here.) Appropriate oversight of increasingly interwoven finance markets requires greater efforts to establish collaborative regulation within our federal administrative network and the broader international network.

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Germany’s Ban on Short Sales and Derivatives Contracts: A Cry for Solidarity Among National Financial Market Regulators

On May 18, 2010, the euro, a currency shared by sixteen of the twenty-seven member states of the European Union, hit a four-year low . In response, on May 19th, German regulators announced a ban on credit default swaps and naked short sales. In a previous post, I describe the mechanics of a credit default swap. A traditional short selling strategy involves the sale of a security that is borrowed or owned by an investor who will sell the security at a future date. In a short-sale, the investor assumes that the market has inaccurately valued a security. To profit from the anticipated decline in the security’s price, the investor borrows shares of the security. When the price of the security falls, the investor can purchase a security equal to the one borrowed under the earlier arrangement and profit from the difference between the price set out in the borrowing/lending arrangement and the current market price. In a naked short sale, the investor sells shares that it has not purchased or borrowed. Naked short sales eliminate investors’ economic exposure to the appreciation of the security if their strategy fails and the price of the security increases.

The fear of contagion following Greece’s national sovereign debt woes triggered Germany’s regulatory decree.  According to a recent Financial Times article, the German securities market regulator explained that the the ban was necessary because of the ‘“exceptional volatility’” in eurozone bonds and the considerable widening of spreads on credit default swaps. Large-scale short-selling could have “endangered the stability of the entire financial system.’” Germany drew a line in the sand.

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A World of Contributions

In the United States, each March we celebrate women’s current and historic contributions to various disciplines and professions. (See here.) This year, there may be cause for international commendations.

For financial solutions that help Greece overcome its current credit woes and bring stability to the EuroZone, Christine Lagarde, French Finance Minister (see here and here) , and Angela Merkel, German Chancellor (see here).  For a description of concerns regarding Greece’s default see here, herehere, and here).

For service in the wake of an unimaginable tragedy, Michelle Bachelet, President of Chile see here.

For unparalleled athletic talents, Japanese figure skater Mao Asada and South Korean figure skater Kim Yu-na (see here ).

For courage in the face of personal tragedy, Canadian figure skater Joannie Rochette (see here).

Please share your suggestions here _____.

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Wheel of Fortune? Not Your Family Board Game

Wheel of Fortune: Not Your Typical Board Game

In the wake of the recent financial crisis, many now ask whether we should blame the Board of Directors of investment banks, commercial banks and other financial services firms for failing to manage the economic risks associated with their market activities. (See  here , here,  and here. In teaching the Business Associations course, I find that we have the most interesting discussions when we cover the role of the Board of Directors and Management. The conflicts among the cast of corporate characters – the board, managers, employees, creditors and shareholders (to name a few)- intrigue students. In assessing risk management, we typically do not expect the Board to have a direct role in monitoring risk on a transaction-by-transaction basis or determining the day-to-day operating procedures that reduce risk. We do, however, expect the Board to have a role in establishing policies that address enterprise risk management. When we juxtapose the danger of risks of loss related to certain market activities (think AIG’s financial products group) with our traditional expectations of the Board’s role in firm oversight, we find ourselves asking if it may be prudent to require that the Board be more informed and active in monitoring enterprise risk management.

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A Greek Tragedy

A Greek Tragedy

Finance markets defend derivative contracts by pointing to their long history. One of the oldest recorded references to a derivative contract appears in ancient Greek literature. In Chapter 9 of Aristotle’s Politics, a philosopher gains a handsome profit by agreeing to place a deposit on olive presses one year in advance of the next olive harvest. In securing rights to the presses prior to the harvest, the buyer, Thalus ensures that if the harvest is bountiful, he will have access to the presses at the lower negotiated rate that press operators are grateful to receive in advance of the harvest.

Investigations reveal that derivatives played a critical role in Greece’s recent credit woes, threatening to collapse the country’s economy and de-stabilize neighbors. (See here.) Financial markets use the term derivative to describe a transaction that derives its value from an independent reference asset. Finance literature identifies four basic types of derivatives contracts –futures,  forwards, options  and swaps. Futures and forwards involve agreements to deliver goods at a stated contract price on a specified future date. Thalus’s right (assuming he has no obligation to exercise the right but may suffer the loss of the deposit if he does not exercise the right) to elect to access the olive presses at a price negotiated in advance, illustrates features of a classic option contract. Swap agreements allow counterparties to exchange a series of cash flows over time. The market classifies derivatives based on the reference asset used to determine the value of the agreement. For example, we refer to a swap agreement for which the reference asset is an agricultural product (corn, soybeans, cotton, grain) or a raw material (copper, crude oil, natural gas) as a commodity swap. The reference asset for a financial swap likely involves one of the following: foreign currencies, bonds, stocks, and other financial assets and liabilities. Thus, the jargon evolves and we have foreign currency swaps, interest rate swaps and equity swaps among the many varietals.

While commodity derivatives may date back to Mesopotamia (see here), the Dojima rice futures exchange in shogunate Japan (see here), or the tulip bubble in Holland, financial derivatives are the product of financial innovation. In the 1980’s, derivatives traders at Salomon Brothers engineered a foreign currency swap.  The transaction allowed the World Bank and IBM to swap risk exposure to foreign currency exchange rates; the two entities exchanged bond payment obligations and bond earnings denominated in Swiss Francs and German Deutsche marks, respectively, in a $210 million transaction.  Parties using derivatives attempt to limit their exposure to or predict future movements in the price of the reference asset.

Futures and options trade on registered exchanges. Other derivatives are privately negotiated, bi-lateral agreements that trade over-the-counter among dealers and financial intermediaries. There is often little or no record of the parties originating the instruments. The ability to originate and trade these instruments in the shadows may have motivated some actors to make bad bets.

Greece’s concerns stem from the use of interest-rate and foreign currency swaps. These instruments serve useful and important functions in allowing parties to manage their exposure to volatile interest rate and foreign currency markets. The complexity of pricing the instruments and the opacity of the market, however, engendered grave concerns. According to reports, Greece used derivative transactions that involved securitized rights to cash flows from national projects to conceal mounting debt. Greece’s current troubles exemplify the need for greater transparency and accountability in derivative markets.

The Greek debacle with swaps illuminates the need to address oversight of derivatives from a global perspective. The markets for derivatives involve financial services firms that may be domiciled in the United States or Europe but whose influence and relationships are undeniably international. The financial instability of systemically significant private institutions (investment banks or international insurance firms or sovereign debtors) threatens global market disruptions. We are left pondering the effectiveness of any domestic derivative market reform that lacks international collaboration. (See here.)