More on Wasting Shareholders’ Money

By James Kwak

A few weeks ago I wrote a post about my most recent “academic” paper, on the issue of whether corporate political contributions might constitute a breach of insiders’ fiduciary duty toward shareholders. The thrust of that paper was that some political contributions could be contested as breaches of the duty of loyalty—for example, if a CEO causes the corporation to give money to a candidate who promises to lower the CEO’s individual income taxes—which would result in the courts applying a higher standard of review.

Joseph Leahy, another law professor, recently directed me to a paper that he wrote last year (but is still being edited for publication in the Missouri Law Review) on basically the same topic. He argues first that corporate political contributions do not qualify as “waste” (which has a precise legal definition), barring the kind of extreme facts that you only see in law school hypotheticals. I agree with that, although my only discussion of the point was in a footnote (79).

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Stopping Russia

By Simon Johnson

The rhetoric of confrontation with Russia seems to be escalating, including with the remarkable suggestion – from Mike Rogers, the chairman of the House Intelligence Committee – that the US provide “small arms and radio equipment” to Ukraine.

Encouragement for a military confrontation is not what Ukraine needs.  As Peter Boone and I have argued in a pair of recent columns for the NYT.com’s Economix blog, Ukraine needs economic reform (with a massive reduction in corruption as the top priority).   This reform requires, above all, a massive and immediate reduction in – or elimination of – corruption.

Throwing a lot of external financial assistance at Ukraine’s government, for example with a very large loan from the International Monetary Fund, is unlikely to prove helpful.  Based on recent prior experience, such lending may even prove counterproductive.

And this seems to be exactly the path that our foreign policy elite has placed us on.

Skew

By James Kwak

There is a common phenomenon in legal disputes over the value of something, be it a company, a piece of land, or a person’s expected lifetime earnings. Each side hires an “expert” who produces an estimate based on some kind of model. And miraculously, every single time, the expert for the party that wants a higher number comes up with a high number, while the expert for the party that wants a lower number comes up with a low number. No one is surprised by this.

Yesterday, the Federal Reserve posted the results of the latest periodic bank stress tests mandated by the Dodd-Frank Act. For these tests, the Fed comes up with various scenarios of how things could go badly in the economy, and the goal is to see how banks’ income statements and balance sheets would respond. The key metrics are the banks’ capital ratios; the goal is to identify if, in bad states of the world, the banks would still remain solvent. If not, the banks won’t be allowed to do things that reduce their capital ratios today, like paying dividends or buying back stock.

For the most part, the results look pretty good: capital levels even under the severely adverse scenario should remain above the levels reached during the 2008–2009 crisis. (Of course, there are several huge caveats here. You have to believe: first, that the scenarios are sufficiently pessimistic; second, that the banks’ current financials are accurately represented; third, that the model is sensible; and fourth, that the capital levels set by current law are high enough.)

But there’s something else going on here. As part of the stress testing routine, each bank is supposed to do its own simulation of how it would respond to the scenarios specified by the Fed, using its own internal model. And—surprise, surprise!—the banks virtually uniformly predict that they will do better than the Fed.

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Whiskey Costs Money

By James Kwak

A few days ago I wrote a post that began with New York Fed President William Dudley talking tough about banks: “There is evidence of deep-seated cultural and ethical failures at many large financial institutions.” The thrust of that post was that I’m not very encouraged when regulators talk about culture and the “trust issue” but don’t indicate how they are going to actually affect industry behavior.

As they say, talk is cheap, whiskey costs money. What’s more important than what regulators say is what they do—and don’t talk about. Peter Eavis (who wrote the earlier story about bank regulators that my previous post was responding to) wrote a new article detailing how that same William Dudley has delayed the finalization of the supplementary leverage ratio: the backup capital standard that requires banks to maintain capital based on their total assets, not using risk weighting.

Dudley has said, “I do not feel that I in any way hold any allegiance or loyalty to the financial industry whatsoever.” That may be true; he certainly made enough at Goldman that he has no real financial incentive to continue to make nice with Wall Street.* Yet at the same time he appears to be parroting concerns raised by some of the big banks, raising a concern about the leverage rule that Felix Salmon calls “very silly” and that, according to Eavis, the Federal Reserve mother ship in Washington didn’t consider significant.

In the grand scheme of banks and their allies weakening and slowing down new regulation, this is probably not a particularly momentous battle. But it does put things in perspective.

* Of course, we know that among some people (many of whom live in New York and work in finance), no amount of money is ever enough.

There’s No Substitute for the Government

By James Kwak

Mike Konczal wrote an excellent article for Democracy about the problems with a voluntary safety net and the superiority of government social insurance. The article draws on serious historical research (by other people) to prove two main points: first, there never was a Golden Age of purely voluntary charity; second, and more important, what charitable support mechanisms existed were not up to the challenges of the Second Industrial Revolution of the late nineteenth century and completely collapsed with the onset of the Great Depression.

This shouldn’t come as a surprise. There are basic economic reasons why public social insurance is superior to voluntary charity. The goal here is to protect people against risk: of unemployment, of health emergency, of outliving one’s savings, and so on. For a risk-mitigation scheme to work, there are a few things that are necessary. One is that people actually be covered. This is something you can never have with a private system (unless it’s regulated to the point of being essentially public), since charities get to pick and choose whom they want to help. As Konczal says of private agencies before the Depression,

“They were also concerned they’d lose their ability to stigmatize—or to protect—various populations; by playing a role in determining who wasn’t deserving of assistance, they could shield those they felt worthy of their support.”

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You Don’t Say

By James Kwak

Last week Peter Eavis of DealBook highlighted a statement made last year by New York Fed President William Dudley (formerly of Goldman Sachs, then a top lieutenant to Tim Geithner): “There is evidence of deep-seated cultural and ethical failures at many large financial institutions.” There was a point, say in 2008, when many people probably thought that our largest banks were just guilty of shoddy risk management, dubious sales practices, and excessive risk-taking. Since then, we’ve had to add price fixing, money laundering, bribery,  and systematic fraud on the judicial system, among other things. 

Eavis also tried to make something positive out of a couple of other recent comments. Dudley said, “I think that trust issue is of their own doing—they have done it to themselves,” while OCC head Thomas Curry said, “It is not going to work if we approach it from a lawyerly standpoint. It is more like a priest-penitent relationship.”

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Insurance Companies and Systemic Risk

By James Kwak

The systemic risk posed by insurance companies is something that I’ve never been entirely clear about. I know it’s an enormous issue for large insurers who want to avoid additional oversight by the Federal Reserve. I’m well aware of the usual defense, which is that insurers are not subject to bank runs because their obligations are, in large measure, pre-funded by policyholder premiums, and policyholders must pay a price in order to stop paying premiums. But this has never seemed entirely convincing to me, because some insurers are enormous players in the financial markets, and the nature of systemic risk seems to be that it can arise in unusual places.

So I find very helpful Dan and Steven Schwarcz’s new paper discussing the ins and outs of systemic risk and insurance. Because it’s written for a law review audience, it covers all the basics, so you can follow it even if you know little about insurance. They cover the usual arguments for why insurers do not pose a threat to the financial system, but then posit a number of reasons for why they could pose such a threat.

A big reason is that insurers make up a large proportion of the buy side, especially for particular markets—owning, for example, one-third of all investment-grade bonds. Furthermore, insurers tend to concentrate their purchases within certain types of securities that provide them with regulatory benefits (sound familiar?)—such as the structured products that promised higher yield while providing the investment-grade ratings that insurers needed. The big fear is that large numbers of insurers could be forced to dump similar securities at the same time, causing prices to fall and harming other types of financial institutions. This may seem unlikely, since insurers only have to make cash payouts when insurable events occur (houses burn down, people die). But insurers have to meet capital requirements just like banks, so falling asset values will require them to adjust their balance sheets.

Another major problem is that it’s not clear that insurers are prepared for those insurable events. For example, insurers are not prepared for a global pandemic, just like they weren’t prepared for large-scale terrorist attacks prior to September 11, 2001.

Finally (and I’m skipping several factors), it’s possible that entire segments of the insurance industry are under-reserving for certain types of risks. This stems from the usual cause: companies compete for market share, and the way to win share is to charge lower prices, and the way to charge lower prices is to underestimate risk. This is all good in the short term, resulting in larger bonuses, and bad in the long term, when the risk actually materializes. Yet it seems that insurance regulators are shifting to “a process of principles-based reserving (‘PBR’), which would grant insurers substantial discretion to set their own reserves based on internal models of their future exposures.” For even a casual observer of the last financial crisis, this sounds like the system is taking on a large amount of model risk and regulatory competency risk, and we know how that story ended last time.

Schwarcz and Schwarcz conclude that the federal government should play a larger role in monitoring systemic risk in the insurance industry, which will make them just about the least popular people in most insurance circles. Given the downside risks, though, it seems like pretending that there’s no reason to worry about insurers is not a good long-term strategy.