Person:

Roe, Mark

Legal origin - civil vs. common law - is said in much modern economic work to determine the strength of financial markets and the structure of corporate ownership, even in the world''s richer nations. The main means are thought to lie in how investor protection and property protection connect to civil and common law legal origin. But, I show here, although stockholder protection, property rights, and their supporting legal institutions are quite important, legal origin is not their foundation.

Modern politics is an alternative explanation for divergent ownership structures and the differing depths of securities markets in the world''s richer nations. Some legislatures respect property and stock markets, instructing their regulators to promote financial markets; some do not. Brute facts of the twentieth century - the total devastation of many key nations, wrecking many of their prior institutions - predict modern postwar financial markets'' strength well and tie closely to postwar divergences in politics and policies in the world''s richest nations. Nearly every core civil law nation suffered military invasion and occupation in the twentieth century - the kinds of systemic shocks that destroy even strong institutions - while no core common law nation collapsed under that kind of catastrophe. The interests and ideologies that thereafter dominated in the world''s richest nations and those nations'' basic economic tasks (such as postwar reconstruction for many) varied over the last half century, and these differences in politics and tasks made one collection of the world''s richer nations amenable to stock markets and another indifferent or antagonistic. These political economy ideas are better positioned than legal origin concepts to explain the differing importance of financial markets in the wealthy West.

We here bring forward strong evidence that political instability impedes financial development, with its variation a primary determinant of differences in financial development around the world. As such, it needs to be added to the short list of major determinants of financial development. First, structural conditions first postulated by Engerman and Sokoloff (2002) as generating long-term inequality are shown here empirically to be exogenous determinants of political instability. Second, that exogenously-determined political instability in turn holds back financial development, even when we control for factors prominent in the last decade’s cross-country studies of financial development. The findings indicate that inequality-perpetuating conditions that result in political instability are fundamental roadblocks for international organizations like the World Bank that seek to promote financial development. The evidence here includes country fixed effect regressions and an instrumental model inspired by Engerman and Sokoloff’s (2002) work, which to our knowledge has not yet been used in finance and which is consistent with current tests as valid instruments. Four conventional measures of national political instability - Alesina and Perotti’s (1996) well-known index of instability, a subsequent index derived from Banks’ (2005) work, and two indices of managerial perceptions of nation-by-nation political instability - persistently predict a wide range of national financial development outcomes for recent decades. Political instability’s significance is time consistent in cross-sectional regressions back to the 1960’s, the period when the key data becomes available, robust in both country fixed-effects and instrumental variable regressions, and consistent across multiple measures of instability and of financial development. Overall, the results indicate the existence of an important channel running from structural inequality to political instability, principally in nondemocratic settings, and then to financial backwardness. The robust significance of that channel extends existing work demonstrating the importance of political economy explanations for financial development and financial backwardness. It should help to better understand which policies will work for financial development, because political instability has causes, cures, and effects quite distinct from those of many of the key institutions most studied in the past decade as explaining financial backwardness.

Chrysler entered and exited bankruptcy in 42 days, making it one of the fastest major industrial bankruptcies in memory. It entered as a company widely thought to be ripe for liquidation if left on its own, obtained massive funding from the United States Treasury, and exited via a pseudo sale of its main assets to a new government-funded entity. The unevenness of the compensation to prior creditors raised considerable concerns in capital markets, which we evaluate here. We conclude that the Chrysler bankruptcy cannot be understood as complying with good bankruptcy practice, that it resurrected discredited practices long thought interred in the 19th and early 20th century equity receiverships, and that its potential, if followed, for disrupting financial markets surrounding troubled companies in difficult economic times is more than small.

Legal origin has been brought forward as a key influence on modern finance, because common law institutions protect investors better than do civil law institutions, it is claimed. These institutional differences are said, in the legal origin explanation, to have been hard-wired into nations centuries ago. Daniel Klerman and Paul Mahoney challenge the legal origin description of the jury as emerging and achieving prominence in 12th- and 13th-century England while remaining unimportant in France. That contrast has been offered as a key difference between common and civil law, one dependent on the differences in relative power between the English monarch and the French one in the 13th century. But the investigation of the jury here should give pause to those promoting the overall legal origin thesis. The first reason to hesitate is that the jury is not central to protecting outside investors in common law nations. Indeed America's premier corporate court—the Delaware Chancery court—sits without a jury, and the usual view in legal circles is that the jury's absence (and the resulting decision-making by expert judges, not juries) is a strength of the court, not a weakness. The second reason is that Britain did not generally transfer the jury system to its colonies, because to have done so would have conflicted with its colonial goals. That is not a secondary point: political economy issues regularly trump issues like legal origin—colonial policy was just one example of how political goals displace secondary institutions. The third reason is that analysis for the jury differences between civil and common law nations depends on political economy differences centuries ago. But if political economy differences determined institutional differences in the earlier centuries, it is plausible that political economy differences in the intervening centuries would also have affected financial outcomes. Indeed modern political economy differences that lead some nations to support capital markets and others to denigrate them could explain modern financial differences as much as, or more than, 13th century political differences.

Industrial organization affects the relative effectiveness of the shareholder wealth maximization norm in maximizing total social wealth. In nations where product markets are not strongly competitive, a strong shareholder primacy norm fits less comfortably with social wealth maximization than elsewhere because, where competition is weak, shareholder primacy induces managers to cut production and raise price more than they otherwise would. Where competition is fierce, managers do not have that option. There is a rough congruence between this inequality of fit and the varying strengths of shareholder primacy norms around the world. In Continental Europe, for example, shareholder primacy norms have been weaker than in the United States. Historically, Europe's fragmented national product markets were less competitive than those in the United States, thereby yielding a fit between their greater skepticism of the norm's value and the structure of their product markets. As Europe's markets integrate, making its product markets more competitive, pressure has arisen to strengthen shareholder norms and institutions.

Regulatory reaction to the 2008-2009 financial crisis focused on complex financial instruments that deepened the crisis. A consensus emerged that these risky financial instruments should move through safe, strong clearinghouses, which would be bulwarks against systemic risk, and that the destructive impact of the failures during the crisis of AIG, Lehman Brothers, and the Reserve Primary Fund could have been softened or eliminated had strong clearing-houses been in place. Via the Dodd-Frank Wall Street Reform Act, Congress instructed regulators to construct clearinghouses through which these risky financial instruments would trade and settle. Clearinghouses could cut financial risk, reduce contagion, and halt a local financial problem before it becomes an economy-wide crisis.

But clearinghouses are weaker bulwarks against financial contagion, financial panic, and systemic risk than is commonly thought. They may well be unable to defend the economy against financial stress such as that of the 2008-2009 crisis. Although they are efficient financial platforms in ordinary times, they do little to reduce systemic risk in crisis times. They generally do not reduce the core risk targeted-that the failure of a financial firm will cause other firms to fail-but rather transfer that risk of loss to others. The major reduction in risk among the inside-the-clearinghouse traders is largely achieved by pushing that risk elsewhere, often to a systemically dangerous spot. Financial contagion can thus side-step the clearinghouse fortress and bring down other core financial institutions. Worse, clearinghouses could not have readily handled the major stresses that afflicted the economy in 2008-2009, could well have transmitted and magnified them, and can only weakly affect the type of financial stress that Congress targeted with Dodd-Frank. When we add in the other weaknesses of the new clearinghouses-as too-big-to-fail institutions, as institutions whose members' incentives to contain clearinghouse riskiness are weaker than the public's, and as institutions that will not be easy to regulate-even the direction of clearinghouses' impact on systemic risk is uncertain.

The stakes are high in correctly assessing the value of clearing-houses in containing systemic risk. Much like an overconfidence inspired by powerful military fortresses that an invading enemy can side-step, the reigning overconfidence in clearinghouses lulls regulators to be satisfied that they have done much to arrest problems of contagion and systemic risk by building up clearing-houses, when they have not.

A revisionist consensus among corporate law academics has begun to coalesce that, after a century of academic thinking to the contrary, states do not compete head-to-head on an ongoing basis for chartering revenues, leaving Delaware alone in the ongoing interstate charter market. The revisionist view pushes us to consider how free Delaware is to act. Where and when would it come up against boundaries, punishments, and adverse consequences? When do other states (and Washington) constrain Delaware? Recent state corporate lawmaking helps us to define those boundaries in terms of potential state competition and to see that the critical actors are not other states’ lawmakers directly, but Delaware’s own corporate constituents who, if disgruntled, can induce other states to enact new laws. Moreover, analysis of previously unassembled chartering revenue data from Delaware’s Secretary of State’s office displays a vital dimension of state competition, once thought to be relatively unimportant, but that’s becoming increasingly powerful: Delaware’s tax base is eroding, and it’s eroding faster in the past decade or so than ever.

Delaware must move ever faster to replenish that erosion. The dynamism of American business interacts with even a lackluster state-based corporate chartering market to put powerful pressure on Delaware, whose business base is persistently eroding as firms merge, close, and restructure.

American corporate law scholars have long focused on state-to-state jurisdictional competition as a powerful engine in the making of American corporate law. Yet much corporate law is made in Washington, D.C. Federal authorities regularly make law governing the American corporation, typically via the securities law - from shareholder voting rules, to boardroom composition, to dual class stock, to Sarbanes-Oxley - and they could do even more. Properly conceived, the United States has two primary corporate lawmaking centers - the states (primarily Delaware) and Washington. We are beginning to better understand how they interact, as complements and substitutes, but the foundational fact of American corporate lawmaking during the past century is that whenever there has been a big issue - the kind of thing that could strongly affect capital costs - Washington acted or considered acting. Here I review the concepts of the vertical interaction, indicate what still needs to be examined, and examine one Washington-Delaware interaction in detail over time. Overall, we cannot understand the governmental structure of American corporate lawmaking well just by examining the nature, strength, and weaknesses of state-to-state jurisdictional competition.

By treating derivatives and financial repurchase agreements much more favorably than it treats other financial vehicles, American bankruptcy law subsidizes these arrangements relative to other financing channels. By subsidizing them, the rules weaken market discipline during ordinary financial times in ways that can leave financial markets weaker than they would be otherwise, thereby exacerbating financial failure during an economic downturn or financial crisis emanating from other difficulties, such as an unexpectedly weakened housing and mortgage market in 2007 and 2008. Moreover, and perhaps unnoticed, because the superpriorities in the Bankruptcy Code are available only for short-term financing arrangements, they thereby favor short-term financing arrangements over more stable longer term arrangements. While proponents of superpriority justify the superpriorities as reducing contagion, there’s good reason to think that they in fact do not reduce contagion meaningfully, did not reduce it in the recent financial crisis, but instead contribute to runs and weaken market discipline. A basic application of the Modigliani-Miller framework suggests that the risks policymakers might hope the favored treatment would eliminate are principally shifted from inside the derivatives and repurchase agreement markets to creditors who are outside that market. The most important outside creditor is the United States, as de jure or de facto guarantor of too-big-to-fail financial institutions.

An enduring inquiry for American corporate law scholars is why the small state of Delaware dominates corporate chartering in the United States. Several theories explain the result. I add another partial explanation: size alone makes Delaware attractive to reincorporating firms by making the state’s corporate law more important to the American economy - and corporate interest groups - than that of other states. Any single state with a small number of incorporations could disrupt their firms’ corporate structures without inducing any repercussions in Washington. But Delaware - or really its corporate law - is “too big to fail.” Damaged players in other states would be unable to enlist Washington to reverse the result. Nor would the low volume players be wary of Washington’s attention and the possibility of it over-reacting if a major corporate issue reached its agenda. Delaware, though, as home to about half of the American corporate economy, could not seriously disrupt American business without repercussion.