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Too big to fool: moral hazard, bailouts, and corporate responsibility

On the 14th December 2016, Steven L. Schwarcz, Stanley A. Star Professor of Law and Business at Duke University School of Law gave the thirteenth Hazelhoff Guest Lecture. Professor Schwarcz questioned the often-heard assumption that systemically important financial institutions engage in excessive risk-taking because they are regarded as “too big to fail” (“TBTF”).

Steven L. Schwarcz
14 December 2016

A critical approach to the regulatory response to “too big to fail”

Prior to the Guest Lecture, the Hazelhoff Centre for Financial Law organised a round table discussion with Professor Schwarcz and senior practitioners, including, general counsel of banks,  partners from various law firms, and staff from the European Central Bank. During this discussion, Professor Schwarcz and the participants touched upon a wide range of subjects, which were linked with the aforementioned assumption.

In a recently published research article, which served as the basis for both the round table discussion and the lecture, Professor Schwarcz examines the current  TBTF related regulation and provides an alternative approach to the problem of excessive risk-taking. The TBTF  theory asserts that certain financial institutions are so large and so interconnected that their failure would be a disaster for the stability of the financial system as a whole, and, therefore,  must be supported when they face potential failure. Such government support is often called a ‘bail-out’. Regulators presume that these institutions might engage in excessive risk-taking because of this bail-out presumption. Yet, according to  Professor Schwarcz, no study convincingly shows any causal relationship between the expectation of a bail-out and excessive risk-taking. He submitted that the problem is more fundamental. Financial institutions engage in excessive risk-taking because of a misalignment between the interest of the firm and its investors and the interest of society.

Professor Schwarcz discussed some TBTF related regulatory responses to excessive risk-taking. He argued that breaking up retail and investment activities of financial institutions undermines the positions of firms within the financial system. Moreover, given that some institutions are limited in size, but still pose systemic risk, the question arises: what is the appropriate size of a firm?.

Another regulatory response relates to higher capital requirements. The widely accepted rationale for imposing capital requirements is to protect financial institutions against losses. However, this does not automatically mean that these requirements avoid excessive risk-taking.

As mentioned above, Professor Schwarcz argued for a more direct approach to correct the  misalignment between the interest of the firm and the societal interest. Managers should have a public duty to society, a so called ‘public governance duty’ not to engage in activities that cause systemic externalities. Institutions should be obliged to balance the expected profit, measured by the expected value of the activities to the firm’s shareholders, against the expected public costs, measured by the expected value of the project’s systemic costs. Professor Schwarcz stated that this solution does not prevent failures in the financial sector. According to Schwarcz, costs to resolve  a failing institution should be borne by a fund,  akin to the Single Resolution Fund in the Euro zone. As such, dependent upon the firms’ risk profile, financial institutions should proportionately contribute to such a fund, which would  only be utilised under strict conditions.

The lecture has been sponsored by the Leiden University Fund/Van Beuningen.

Steven L. Schwarcz

Steven L. Schwarcz is the Stanley A. Star Professor of Law & Business at Duke University and Founding Director of Duke’s interdisciplinary Global Financial Markets Center. Professor Schwarcz has testified before the U.S. Congress on topics including systemic risk, securitization, credit rating agencies, and financial regulation and has advised several U.S. and foreign governmental agencies on the financial crisis and shadow banking. His writings include Systemic Risk, 97 Georgetown Law Journal 193, the second most cited law review article of 2008.

Hazelhoff Centre for Financial Law

The Hazelhoff Guest Lectures are organised by the Hazelhoff Centre for Financial Law. The Hazelhoff Centre for Financial Law. The Hazelhoff Centre for Financial Law provides academic education and performs research in the field of financial law.

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