Structural Corporate Degradation Due to Too-Big-to-Fail Finance

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Structural Corporate Degradation Due to Too-Big-to-Fail Finance

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Title: Structural Corporate Degradation Due to Too-Big-to-Fail Finance
Author: Roe, Mark J.
Citation: Mark J. Roe, Structural Corporate Degradation Due to Too-Big-to-Fail Finance, U. Penn. L. Rev. (forthcoming, 2013).
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Abstract: The $6 billion trading loss at JPMorgan Chase — due to the over-sized trading positions taken by the bank’s London trader, colorfully called the London Whale — induced Senate inquiries and hearings earlier this year, embarrassing the bank and its otherwise respected chief, Jamie Dimon. Severe critics saw the bank’s massive loss as showing that banks still do not have their house in order after the 2007–2009 financial crisis, but most viewed the trading debacle as cautionary, not one fundamentally implicating regulatory policy. After all, the losses were only a fraction of JPMorgan’s $20 billion annual earnings. The setback was one for the bank’s shareholders and managers and, hence, one for ordinary corporate governance. Hence, the standard view is that the loss was no major public policy problem, as public funds were never really at risk.

This set-up induces us to analyze the corporate governance of the too-big-to-fail American financial firm — analysis that has not yet been systematically done. For industrial conglomerates that have grown too large, internal and external corporate structural pressures arise to re-size the firm. External activists press the firm to restructure to raise its stock market value. Inside the firm, boards and managers see that the too-big firm can be more efficient and more profitable overall if restructured via spinoffs and sales. But for large, too-big-to-fail financial firms (1) if the value captured by being too-big-to-fail lowers the firms’ financing costs enough and (2) if a resized firm after spin-offs and break-ups would lose that funding benefit , then a major constraint on industrial firm over-expansion breaks down for too-big-to-fail finance.

I argue in this paper that both propositions (1) and (2) have been true and, consequently, a major retardant to industrial firm over-expansion has been missing in the large financial firm. Debt cost savings — the implicit subsidy — in the too-big-to-fail financial sector have a magnitude amounting to a good fraction of the big firms’ profits. Directors contemplating corporate simplification and spin-offs at a too-big-to-fail financial firm face the problem that the spun-off, smaller firms would lose access to cheaper too-big-to-fail funding. Hence, they will be reluctant to push for break-up, for spin-offs and for slowing down firm expansion. They would get a better managed group of financial firms if their restructuring succeeded, but they would lose the too-big-to-fail subsidy embedded in the lowered funding costs. Subtly and pervasively, the internal corporate counterpressures that resist excessive bulk, size, and growth are absent.

This problem of corporate degradation due to too-big-to-fail finance burdens the economy. In addition to the well-known cost of bailouts, too big-to-fail finance induces a hidden but pervasive degradation of financial firm efficiency from the best possible. The analytic here also has policy implications beyond just reducing too-big-to-fail risks. Most post-crisis financial regulation has been command-and-control rules on capital and activities. The corporate governance analytic points us to incentives as unused policy tools. Incentives toward corrective corporate measures degrade, so policymakers could seek to reverse that degradation. By mimicking an effective market with mechanisms offsetting the too-big-to-fail subsidy and, subtly but with long-run staying power, by reproducing the incentives of private parties to make more efficacious market choices,policymakers could harness incentives that too-big-to-fail finance degrades and often destroys in large financial firms. Lastly, the corporate degradation analytic has on-the-ground corporate dealmaking implications: if the command-and-control regulation succeeds, it should lead to sharp corporate restructurings in financial firms. I outline the mechanisms and implications.
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