Abstract
This article considers the effects of legal protections of creditors within the macro-financial theory of leverage cycles developed by John Geanakoplos. The theory posits that leverage is procyclical. I propose a theoretical framework, ‘Law and Macro-Finance’, comprising two main clams: (1) the strength of legal protections of creditors has an impact on the quantum of debt creditors are willing to underwrite not just the interest rate on that debt and (2) that quantum varies across the cycle in a procyclical fashion. In a boom, when asset prices are higher, leverage decreases, creating incentives for creditors to underwrite additional leverage secured on those assets without increasing the interest rate. The stronger the legal protections of creditors, the stronger the incentives to underwrite additional leverage based solely on the increasing value of the collateral. By creating such incentives, strong legal protections of creditors, associated with claims designated in the law as ‘bankruptcy remote’, will accelerate the boom and increase the vulnerability of the economy to shocks. On the normative side, this article proposes a countercyclical design of strong legal protections of creditors. The design makes the availability of such protections, typically achieved by reliance on the legal doctrine of ‘true sales’, conditioned on the adequacy of the price paid in the transaction. The adequacy, in turn, is determined in reference to the applicable schedule of collateral haircuts determined by the central bank.
I. INTRODUCTION
Leverage, typically measured as a ratio of debt to assets, is a policy problem when it becomes excessive. The build-up of excessive on- and off-balance sheet leverage in the financial system was arguably the principal underlying cause of the Global Financial Crisis (GFC).1 The GFC may have been caused by overleveraged financial institutions, but the Great Recession that preceded it was caused by overleveraged households.2 More recently, policymakers became concerned about excessive corporate leverage.3 Despite the problems that excessive leverage of financial institutions, households, and corporates pose for the financial system and the economy at large, there is little consensus at a theoretical level over why leverage becomes excessive.
In this article, I wish to cast some light on this question by considering the effects of legal protections of creditors within the macro-financial theory of leverage cycles of John Geanakoplos.4 The theory posits that leverage is procyclical. I propose a theoretical framework, ‘Law and Macro-Finance’, comprising two main clams: (1) the strength of legal protections of creditors has an impact on the quantum of debt creditors are willing to underwrite not just the interest rate on that debt and (2) that quantum varies across the cycle in a procyclical fashion.
In a boom, when asset prices are higher, leverage decreases, creating incentives for creditors to underwrite additional leverage without increasing interest rates. The stronger the legal protections of creditors, the stronger the incentives to underwrite additional debt, based solely on the increasing value of the collateral. By creating such incentives, strong legal protections of creditors accelerate the boom, and increase the vulnerability of the economy to shocks.
In contrast, in a bust, when asset prices are lower, leverage increases, creating incentives for creditors to enforce their claims against struggling debtors. In the money market, the enforcement of claims against such debtors creates systemic risk when debtors face the prospect of fire asset sales and illiquidity.5 In the capital market, increasing levels of leverage trip financial covenants, prompting debtors to deleverage, with systematic macroeconomic implications for both the supply and demand side of the economy.6
Law and Macro-Finance implies that the claim that strong legal protections of creditors are positively correlated with growth, attributed to Law and Finance, is, at best, simplistic.7 The excessive focus on agency costs rather than leverage as the central determinant of interest rates, prevents Law and Finance from identifying potential costs associated with strong legal protections of creditors. Law and Macro-Finance suggests that, in the absence of adequate frameworks designed to regulate leverage, economies with legal systems characterized by strong creditor protections are more likely to experience volatile boom-bust cycles, such as the mortgage credit boom and bust cycle of the 2000s in the United States.
On the positive side, Law and Macro-Finance helps cast new light on that cycle’s legal origins by highlighting the fact that the legal protections of creditors of virtually all the financial instruments implicated in that cycle were strengthened in the years leading up to the credit crunch of 2008–08. Under the standard Law and Finance framing, we would expect stronger protection to reduce risks for creditors and presumably for the financial system as a whole.
However, that turned out not to be the case. Instead, secured debt instruments exacerbated or even created risks in the financial system. Law and Macro-Finance helps explain that puzzle in a novel and original way, departing from the more conventional Law and Finance explanations revolving around agency costs.8 While agency costs clearly played a role in facilitating the spectacular misallocation of mortgage credit underpinning the mortgage credit boom and bust cycle of the 2000s, the incentives that strong legal protections created for creditors to lend in a procyclical fashion played an arguably greater role in that regard.9
On the normative side, Law and Macro-Finance suggests that policymakers should seek to adjust the strength of the legal protections of creditors in bankruptcy law to maximize the achievement of their macro-financial policy objectives. legal protections of creditors have different economic effects in different parts of the economic cycle, but they can also be used to steer the cycle if they are adapted in a countercyclical fashion.10
I show how to implement a novel time-varying countercyclical design of legal protections of creditors. The design makes the availability of strongest legal protections, associated under the Law and Macro Finance framework with bankruptcy ‘remoteness’ typically achieved by reliance on bankruptcy ‘safe harbors’ or the legal doctrine of ‘true sales,’ conditioned on the adequacy of the price paid in the transaction. The adequacy, in turn, is determined by courts in reference to the applicable schedule of collateral haircuts determined by the central bank.
I also propose an alternative time-invariant regulatory framework implementing strict limits on leverage on all actors of the economy, ranging from sovereigns, through banks and firms, to households and consumers. The goal of that framework would be to reduce booms and smoothen the economic cycle. The practical implementation of such a framework requires policymakers in both developing and developed countries to adjust a broad range of laws beyond banking and financial law, including consumer, constitutional, and international law.
The theoretical framework presented in this article is related to the theoretical literature examining the economic effects of secured debt. The early literature inspired by financial economics proposed that there are two situations in which debtors are incentivized to grant security.11 First, when the market has substantially inferior information regarding the financial prospects of the debtor. In those cases, security acts as a signal of quality helping overcome the problem of information asymmetry.12 Second, in circumstances where such information asymmetry is not severe, but where the debt is known to have poor enough prospects to make agency problems a significant concern for debt investors. In those cases, security reduces monitoring costs, helping to overcome the problem of agency costs.13
An implicit assumption of the early literature is that creditors can accurately value the asset provided as security or collateral. Later literature suggested this may not always be the case due to informational frictions in markets, in which collateral is valued.14 Even without such frictions, the creditors’ incentives to scrutinize the value of collateral might be limited because information does not play the same role in the case of secured lending as it does in the case of other types of financing, in particular equity financing. Contemporary literature in financial economics conceives of overcollateralized debt as an informationally insensitive instrument. Holmström proposes that such instruments eliminate agency costs instead of simply reducing them.15 Gorton and Ordoñez observe that it is costly to produce information about the prices of assets used as collateral. It is therefore rational that creditors will not produce such information all the time.16 Their model emphasizes the role of information production in fuelling cycles, which differs from the model developed by Geanakoplos, in which cycles are fuelled by shifts in the risk attitudes of creditors. Those shifts are also the driver of the procyclical effects of the legal protections of creditors in my framework. They are the primary justification for countercyclical adaptations of the strength of those protections, which is the most original contribution of my framework on the normative side.
Geanakoplos’s own policy proposal focuses mainly on monetary policy interventions. Singh points to the problem of moral hazard inherent in governmental interventions designed to support collateral markets.17 Ricks proposes a set of measures aimed at structural separation of money and capital markets to address the problem of financial panics.18 Sissoko stresses the risk inherent in building a financial system around secured lending. That risk has to do with the fact that in such a system, some ‘bad’ actors will be able to borrow. Her model showcases the virtues of unsecured, reputational-based lending.19
In the remainder of this article, section II explains why leverage is procyclical using Geanakoplos’s theory of leverage cycles and section III outlines the role of banking regulation and bankruptcy law in exacerbating the procyclicality of leverage. The descriptive and normative elements of the theoretical framework for Law and Macro-Finance are presented in section IV. Section V concludes.
II. MACRO-FINANCE OR THE PROCYCLICALITY OF LEVERAGE
Macro-finance is a strand of macroeconomics emphasizing the role of credit in amplifying and possibly driving the business cycle.20 The main strands of macroeconomic theory—neoclassical, Keynesian, and monetarism—may differ fundamentally, but they have one crucial thing in common—they largely abstract from credit. For analytical convenience, they assume that credit markets work smoothly to allocate capital efficiently among firms and the various factors of production in the economy. If that is the case, what drives the economic cycle?
Macroeconomic theory traditionally identified (1) changes in fundamentals;21 (2) animal spirits;22 and (3) money23 as the drivers of economic cycles. In the 1980s several macroeconomists published the results of research that suggested that the conditions in financial markets, particularly an increase in the availability of credit, could amplify the business cycle.24 More recently, some economists have gone even further and suggested that credit, and in particular collateralized credit, could cause the business cycle through its impact on asset prices.25
Geanakoplos provides the most comprehensive account of the relationship between collateralized credit growth and asset prices: a theory of leverage cycles. There are four mathematical concepts behind the leverage cycle, which, in non-mathematical terms, Geanakoplos lays out as follows.26 The first is that borrowers and lenders choose where they want to be with respect to leverage, meaning that leverage is determined endogenously. ‘In equilibrium, for each level of leverage, there is a separate supply-equals-demand equation and a separate price.’27 Second, leverage increases when volatility—or, more precisely, down risk—decreases, meaning lenders estimate the probability of default to be lower. The third is that higher leverage makes for higher asset prices, all else being equal. Fourth, a highly leveraged economy is vulnerable to crashes stemming from small shocks that create more uncertainty, which he calls ‘scary bad news’.
At its core, the theory of leverage cycles explains why leverage is procyclical. Leverage is high in booms because creditors are optimistic during such periods, underestimating the probability of default and allowing debtors to fund more assets. A greater demand for assets pushes their prices higher, allowing debtors to incur additional leverage at little to no extra cost by borrowing against them.
To illustrate the relationship between leverage and asset prices in a boom, consider a bank, BankA, seeking to fund a portfolio of assets by borrowing from another bank, BankB. Under the transaction, BankA borrows $100 million at 10 per cent for five years against the assets, which, at t1, are valued $100 million. The interest represents the rate at which BankB is willing to lend when the BankA’s leverage was 1×. BankB’s expected interest income is $50 million for the five years the loan will be outstanding.
At t2 the value of the assets increases to $120 million and leverage decreases to 0.8×. BankA can now refinance the loan at a better rate or incur $20 million of additional debt, still at 10 per cent. The price remains unchanged because, even with the additional debt, the BankA’s leverage will remain at 1×. BankB will be incentivized to lend because it can now earn a higher interest income of $60 million.
In contrast, in a bust, pessimistic creditors change their estimates of the probability of default, making it more costly for debtors to rely on debt finance to fund assets. The prices of those assets go down, leverage increases prompting debtors to deleverage.
Consider t3, during which the value of the assets in the above hypothetical decreases to $70 million and the outstanding debt remains $120 million. Leverage has now shot up to 1.7x, making it effectively impossible for BankA to refinance or incur additional debt. Instead, the bank will have to deleverage, probably by selling some of the assets. In an unfavourable market environment such sales could trigger a downward spiral of asset price decreases pushing BankA’s leverage ratio even higher.
The leverage cycle model is driven by unexpected changes in asset returns.28 There is, of course, the extensive literature on the behavioural biases in expectations of investors. Shiller’s work on irrational exuberance is perhaps the most famous example.29 Indeed, the main innovation of the leverage cycle theory can be in suggesting that business cycles ‘can be driven by the changing beliefs of the lenders, in addition to the animal spirits of investors’.30 It follows, as Geanakpolos notes, that in the absence of intervention, leverage becomes too high in boom times and too low in bad times.
The leverage cycles theory tells us that leverage increases asset prices, but should leverage not decrease as asset prices increase? If the price of the assets goes up, the leverage ratio should decrease. The answer to the puzzle is—yes, leverage should decrease as asset prices go up as long as borrowers do not adjust it.
However, in many cases, they do. Mian and Sufi show this dynamic in the context of the US mortgage credit boom and bust of 2002–07.31 The rising value of homeowners’ equity allowed them to borrow against that equity and spend the money on various consumption items. While homeowners’ leverage should have been decreasing, instead it was increasing because they were adjusting it.
The same argument has been made for banks. Adrian and Shin show that during booms, like the mortgage credit boom of 2002–07 in the United States, on which they focus their analysis, banks increase their liabilities by more than their assets have risen, thus raising their leverage.32 ‘During troughs, [banks] reduce their liabilities more sharply than their assets have declined, thus lowering their leverage. Although the term “pro-cyclical leverage” is not one that the banks themselves would use in describing their actions, it does capture the basic nature of their practice.’33
As they further note, the actions of the investment banks are guided through the banks’ models of risk and economic capital dictate active management of their overall value at risk—the risk of loss on banks’ asset portfolios—through adjustments of their balance sheets.34 Banks will adjust assets and liabilities to ensure that their total equity is proportional to the total value at risk of their assets. Thus, for a given amount of equity, a lower value at risk allows banks to expand their balance sheets: leverage is inversely related to value at risk. Since measured risk is countercyclical—low during booms and high during busts—the banks’ efforts to control risk will lead to pro-cyclical leverage.35
III. PROCYCLICALITY OF LEVERAGE AND THE LAW
In Geanakoplos’s theory, the leverage cycle is driven by behavioural attitudes (optimism/pessimism) of creditors. Banking regulation and bankruptcy law can also contribute to the creation of the leverage cycle. As observed by Adrian and Shin, bank leverage is procyclical because banks respond to changes in prices and measured risk by actively managing their balance sheets. The acceptable risk level under their internal risk models is determined mainly by regulation, in particular regulatory capital requirements.
Banks adjust their leverage through collateralized borrowing, mainly through repo and selected types of over-the-counter derivatives. Both types of instruments benefit from bankruptcy safe harbours—ie the creditors of such instruments are exempt from the basic rules that halt creditor collection efforts when the bankruptcy begins.36 Following the GFC, the legal treatment of these instruments has been subject to considerable criticism, but mainly because of their impact on systemic risk considerations rather than their impact on leverage.
In this section of the article, I briefly discuss the extant literature discussing the role of law in exacerbating the procyclicality of leverage.
1. Procyclical banking regulation
Banks’ reliance on their internal risk models dates to the 1980s, when national regulators began imposing regulatory capital requirements. By 1988, most large multinational banks were held to the Basel I standard, which was the first internationally harmonized capital standard developed by the Basel Committee for Banking Supervision at the Bank of International Settlements (BIS) (sometimes called the ‘central bank of central banks’). Basel I imposed on banks an obligation to maintain a specified level of capital or own funds against certain categories of assets they hold.37 The capital requirement was risk-weighted in the sense that banks had to hold more capital against riskier assets. Basel I allowed a certain amount of discretion for banks in determining how to evaluate the riskiness of assets. Basel II, published in 2004, allowed for even greater discretion through reliance on increasingly sophisticated internal risk models adopted by the banks.
Interestingly, some economists at BIS expressed considerable scepticism towards those models, suggesting such models would allow banks to lower capital requirements in moments when the probability of crisis increases. As Borio, Furfine, and Lowe note, market participants tend to react inappropriately to changes in risk over time.38
These inappropriate responses are caused mainly by difficulties in measuring the time dimension of risk, but they also derive from market participants having incentives to react to risk, even if correctly measured, in ways that are socially suboptimal.
The measurement difficulties often lead to risk being underestimated in booms and overestimated in recessions. In a boom, this contributes to excessively rapid credit growth, inflated collateral values, artificially low lending spreads, and financial institutions holding relatively low capital and provisions. In recessions, when risk and loan defaults are assessed to be high, the reverse tends to be the case.
Adrian and Shin showed how risk models contributed to the GFC. Building on these insights, Gerding, a legal scholar, observed that the crisis was caused, in large part, by deregulation but that it was also made worse by the procyclical effects of regulation.39 These procyclical effects occurred in the normal operation of those rules. The interaction of these rules with market cycles contributed to the mismanagement of liquidity by banks. That experience highlights the role of macroeconomic considerations in the design of banking regulation. Banks were lending too much, relative to macroeconomic fundamentals, because regulation did not constrain them.
2. Procyclical bankruptcy law
The GFC also prompted economists and lawyers to reflect on the role of macroeconomic considerations in the bankruptcy law treatment of repos and derivatives. Before the GFC, policymakers commonly assumed that the bankruptcy safe harbours afforded to repos and derivatives mitigate systemic risk (ie the risk that one institution’s failure will trigger the failure of another institution). However, as documented in the economics literature, during the GFC the safe harbours prompted runs rather than limited them, thereby exacerbating systemic risk.40
The problem of runs should not be ignored, but the focus on systemic risk as the main macroeconomic consideration in the bankruptcy law treatment of repos and derivative led to the neglect of its impact leverage. Banks adjust their leverage through the instruments that benefit from the safe harbours, and that, in turn, affects the availability of liquidity in the financial system.41 The dynamic macro-financial effects of such adjustments are entirely neglected in the design of the legal protections for repo creditors, the static design of which exacerbates the procyclical effects of such adjustments and incentivizes them in the first place. My goal in the following section is to show why the legal protections for repo creditors, as well as other creditors, affect their incentives to adopt such adjustments.
IV. LAW AND MACRO-FINANCE
In this section, I develop a theoretical account of the procyclical effects of the legal protections of creditors by considering the effects of such protections within the theory of leverage cycles. Geanakoplos develops the theory around the concept of collateral but does not specify whether he means collateral in the legal sense, ie asset subject to a security interest enforceable in bankruptcy on a priority basis. If he does, what is the role of the law that offers protection to secured creditors in the theory of leverage cycles? When discussing the policy implications of the leverage cycle, he hints at a potential ex post (ie following default) role for bankruptcy law by arguing for debt forbearance during a recession.42 But he does not consider how the ex ante (ie prior to default) incentives that bankruptcy law creates for structuring debt transactions impact the leverage cycle.43
1. A theoretical framework for Law and Macro-Finance
At the core of the Law and Macro-Finance framework is the claim that the legal protections of creditors impact how much creditors are willing to lend, not just the price of credit, as is the case under the standard Law and Finance framing. That impact is different in different parts of the cycle because the behavioural attitudes of creditors are different. In a boom, creditors are optimistic and underestimate the probability of default, making credit more available for debtors. Greater availability of credit, in turn, allows debtors to fund more assets. Greater demand for assets increases their prices. When asset prices are higher, leverage decreases, creating incentives for creditors to underwrite additional leverage. The stronger the rights, the more certain recoveries and, as a result, the incentives to underwrite additional debt without increasing the interest rate.
I distinguish between three levels of legal creditor protections:
strong, associated with protections afforded to secured creditors whose claims are bankruptcy ‘remote’;
moderate, associated with protections afforded to secured creditors whose claims are subject to bankruptcy law; and
weak, associated with protections afforded to unsecured creditors.
In a boom, the incentives of creditors to underwrite additional debt without increasing the interest rate are strong when their claims benefit from bankruptcy remoteness. Policymakers have designated several categories of claims as bankruptcy remote. First, in the United States, the claims of creditors of selected money market instruments, including repurchase agreements and selected types of derivatives, are exempted by virtue of safe harbours.44 These exemptions incentivize creditors to make decisions about how much to lend based on changes in the value of the assets provided as security. In a boom, a collateral of higher value backs a higher promise, irrespective of whether the business situation of the debtor has changed. Going back to the earlier example, BankA will only be able to refinance its debt at a better rate or incur $20 million more of debt at 10 per cent if BankB enjoys such rights, which is why, in the case of the US Bankruptcy Code, the parties would normally structure their relationship to fit the doctrinal requirements of the safe harbours.
Second, creditors of securitization vehicles also benefit from bankruptcy remoteness of the assets that secure their claims. In a securitization, its originator transfers a specific asset into a special purpose vehicle with the intention of separating the asset from risks associated with the originated. The creditors of securitization vehicles may have to prove the assets have been transferred without recourse, or truly sold, but, most of the time, this can be easily demonstrated with a legal opinion to that effect.45
In both cases, bankruptcy costs are either zero or close to zero, creating strong incentives to lend based on the value of the collateral. That is not to say that the business situation of the debtor does not matter in this situation but, at least financially, underwriting of additional leverage becomes a viable option, and some creditors—those most optimistic—will exercise that option, thereby exacerbating the boom.
The incentives of secured creditors who must contend with bankruptcy to underwrite additional leverage in boom are weaker than of those who are not required to deal with bankruptcy. Here, the law incentivizes creditors to make decisions about how much to lend based on changes in the value of the assets provided as security, such as real estate, but those incentives are not as strong as they are in the case of secured claims exempted from bankruptcy law, which makes the procyclical effects of the protections afforded to ordinary secured creditors moderate, which means that the interest rate is more likely to increase with the increase in the quantum of debt in a boom. Bankruptcy costs reduce recoveries and will decrease the quantum of debt creditors are willing to underwrite at a certain level.
The legal protections for unsecured creditors have weak procyclical effects. The creditors of such claims cannot rely on the value of collateral as the sole basis of underwriting of additional leverage. Nevertheless, the legal protections for unsecured creditors have procyclical effects because, in the case of unsecured debt, leverage is driven by changes in earnings expectations. Leverage is commonly measured also as a ratio of debt to earnings, making changes in the expectations concerning earnings a driving force of decisions to lend for unsecured creditors.
The procyclical effects of the legal protections for unsecured creditors are weaker because changes in earning expectations are likely to be partially offset by lower recoveries associated with weaker creditor protections. Creditors of unsecured instruments must contend not only with bankruptcy costs but also the competing claims of other creditors with whom they will be sharing the recoveries, generally on a pro rata basis.
Still, in a boom, greater availability of leverage allows debtors to make more substantial investments increasing the creditors’ earnings expectations further. When those expectations increase, the leverage ratio measured as the ratio of debt to earnings before income taxes and amortization will decrease, creating incentives for unsecured creditors to underwrite additional leverage in a boom.46
In contrast, in a bust, strong legal protections have procyclical effects because they incentivize creditors to enforce immediately and claim the collateral. Going back to the earlier example, at t3, the value of the assets has decreased to $70 million, and the outstanding debt remains $120 million. Leverage has now shot up to 1.7×, making it effectively impossible for BankA to refinance. To maintain the leverage ratio of 1×, BankA must cut down its debt by $50 million to $70 million, representing a lower value at t1, which may be difficult, if not impossible.
Creditors who must contend with bankruptcy may not be able immediately to enforce their claim on the collateral because bankruptcy law will generally prevent them from doing so by way of the automatic stay rules. Still, a sudden change in the expectations concerning asset prices or earning expectations can prompt creditors to foreclose or to force a deleveraging. An isolated instance of such action is likely to be resolved efficiently by bankruptcy courts either by way of restructuring or liquidation, but a large-scale wave of defaults is likely to overwhelm bankruptcy courts and exacerbate the bust.47
Two additional qualifications need to be made. First, in the case of strong and moderate protections, we need to distinguish between collateral comprising assets the value of which tends to be volatile, and collateral comprising assets that do not display such tendencies. Strong and moderate protections will have strongest procyclical effects when the assets used as collateral tend to display volatile swings in prices, as is the case with financial assets. First, the value of such assets is more likely to increase more substantially in a boom. Second, in a bust, changes in the valuations of such assets can be more dramatic and unexpected, resulting in a much greater impact on leverage.48 Historically, we see a reflection of this intuition in the qualitative limitation of the scope of the repo safe harbours to assets perceived as safe, which was motivated by the reduction of risks to the financial system. Prior to 2005, coverage was limited to overnight repos and term agreements up to a year in Treasury and agency securities and selected money market instruments.49 Following 2005, non-traditional collateral, for example non-agency mortgage-backed securities was also included.50
Second, the legal protections of creditors under bankruptcy law are complemented by protections afforded to creditors under contract and enforceable under the general rules of contract law. The design features of those protections can either exacerbate the procyclicality of leverage or mitigate it. For example, while the ability of repo creditors to enforce immediately and claim the collateral is a function of their legal protections under bankruptcy law, the specific parameters of such enforcement, including margin requirements, are a matter of contract rights and their design. The parties can contractually restrict their ability to enforce under certain conditions and, in the past, they have done so prompted by regulators.51
In the context of corporate debt, covenants can also have either procyclical or countercyclical effects. The phenomenon of ‘covenant lite’ is widely believed to contribute to the procyclicality of leverage in the corporate sector.52 Policymakers sought to address the problem by promulgating leverage lending guidelines for banks,53 but there is no evidence that those measures have been successful.54
2. A normative framework for Law and Macro-Finance
The policy implication of Law and Macro-Finance is that, in the absence of other policy measures designed to regulate leverage, policymakers should use bankruptcy law to encourage creditors to lend in a bust but discourage them from lending into a boom or at least make credit less available during such a period. Before I explain how they could do that, I will first address the issue of other policy measures designed to regulate leverage. What are those measures?
First, conventional monetary policy can, in principle, be used to address the problem of procyclicality of leverage. An increase in the policy rate should reduce leverage, mainly through its impact on the interest rate on riskless debt,55 even though the concern is that a small increase in the policy rate would not be effective, and a large increase could do more harm than good in a leveraged financial system.56 By contrast, a decrease in the policy rate should have the effect of increasing leverage. Here, the concern is that, at the zero lower bound, the impact of the policy rate becomes limited. Unconventional monetary policy, in particular quantitative easing, can help address that limitation, but its effect is likely to be more pronounced in the money market than in other segments of the credit markets.
Banking regulation is another important tool for the regulation of leverage. Following the GFC, recognizing the problems with the procyclicality of bank leverage, policymakers put in place a new regulatory regime: Basel III. This focused on the regulation of leverage and liquidity. Bank balance sheets appear to have become stronger as a result of that regulatory deleveraging. Figure 1 shows the ratio of US bank equity to assets and indicates an increase in the ratio of bank equity to assets, particularly for large bank holding companies.57
Leverage of US bank holding companies. Source: Federal Financial Institutions Examination Council, Call Report Form FFIEC 031, Consolidated Reports of Conditions and Income for a Bank with Domestic and Foreign Offices (Figure 3.1 in Board of Governors of the Federal Reserve System, ‘Financial Stability Report–November 2018’).
There is no doubt that the increase in the ratio of bank equity to assets is good for financial stability. At the same time, Figure 2 shows that the leverage of US borrowers receiving loans from banks in 2013–18 increased. How to explain that?
Leverage of US corporate borrowers receiving loans from banks 2013–18. Source: Federal Reserve Board, Form FR Y-14Q (Schedule H.1), Capital Assessments and Stress Testing (Figure 3.3 in Board of Governors of the Federal Reserve System, ‘Financial Stability Report–November 2018’).
Figure 3 shows data on the issuance of non-agency securitized products by asset class and shows an uptick in the issuance of collateralized loan obligations (CLOs)58 in recent years, suggesting that much of the debt underwritten by banks is sold to CLO investors, who benefit from strong legal protections as securitization creditors.
The issuance of non-agency securitized products by asset class. Source: Harrison Scott Publications, Asset-Backed Alert (ABAlert.com) and Commercial Mortgage Alert (CMAlert.com); Bureau of Labor Statistics, consumer price index via Haver Analytics (Figure 3.8 in Board of Governors of the Federal Reserve System, ‘Financial Stability Report–November 2018’).
Banks also frequently lend to hedge funds, mainly through repos also benefitting from strong protections, and the leverage of hedge funds has also increased. Figure 4 shows the gross leverage of hedge funds.
Gross leverage of hedge funds. Source: Federal Reserve Board staff calculations based on Securities and Exchange Commission, Form PF, Reporting Form for Investment Advisers to Private Funds and Certain Commodity Pool Operators and Commodity Trading Advisors (Figure 3.6 in Board of Governors of the Federal Reserve System, ‘Financial Stability Report–November 2018’).
Thus, while the leverage of banks may be down, the leverage of the corporate sector as well several important classes of investors has gone up, suggesting the emergence of another leverage cycle. If the emergence of one of the strictest regulatory frameworks in recent memory was not sufficient to prevent the emergence of the next leverage cycle, we must ask whether the current policy toolkit is sufficient to address the problem of procyclicality of leverage.
I submit that, when considering alternatives to the current regulatory framework, policymakers should consider using bankruptcy law to encourage creditors to lend into a bust but discourage them from lending into a boom. Put differently, the design of the legal protections of creditors, in particular the strength of those protections, should reflect either contractionary or expansionary economic policy objectives.
Contractionary policy objectives are relevant during a boom. Debt claims underwritten in a boom and enforced either in that boom or the subsequent bust, should benefit from weak or, at best, moderate protections. Under a regime of weak/moderate protections, creditors will have weaker/moderate incentives to underwrite additional leverage helping to stabilize it at manageable levels.
In contrast, expansionary policy objectives are relevant during a period of bust. In such a period, the legal protections of creditors should be moderate or strong to increase leverage in the financial system and the economy. In other words, debt claims underwritten in a recession should be strong independently of when they are enforced.
Table 1 illustrates the overarching principles of the normative framework for Law and Macro-Finance.
Countercyclical bankruptcy law
| Period during debt issued | Strength of protections |
| Boom | Weak/Moderate |
| Bust | Moderate/Strong |
| Period during debt issued | Strength of protections |
| Boom | Weak/Moderate |
| Bust | Moderate/Strong |
Countercyclical bankruptcy law
| Period during debt issued | Strength of protections |
| Boom | Weak/Moderate |
| Bust | Moderate/Strong |
| Period during debt issued | Strength of protections |
| Boom | Weak/Moderate |
| Bust | Moderate/Strong |
In Figure 5 the x-axis represents the strength of the legal protections of creditors, and the y-axis represents the phase of the cycle. The strength of the protections is inversely correlated with the phase of the cycle. The protections are weak in a boom period, but their strength increases as the economic situation deteriorates.
Countercyclical bankruptcy law.
For illustrative purposes, in the following sections I discuss examples of time-varying and time-invariant countercyclical designs of legal protections of creditors under bankruptcy law, focusing on repos.
3. Countercyclical bankruptcy law: a time-varying approach
The current expansive design of the protections of repo creditors is of a rather recent vintage dating back to 2005. In the aftermath of the GFC, many commentators argued that the safe harbours should be ‘rolled back’ to their pre-2005 scope, namely limited to overnight repos and term agreements up to a year in Treasury and agency securities and selected money market instruments.59 While that change would have been relatively easy to implement, economists at the Federal Reserve Bank of New York argued that the change would be likely to result in decline of the repo market and the money market, in general.60 The change never materialized, in large part because of concern over the contractionary effects it would have.
The main benefit of a countercyclical design of the legal protections for repo creditors would be to allow policymakers to create both contractionary and expansionary effects depending on the policy needs. What would such a design look like? The structure of the countercyclical design inspired by the normative framework Law and Macro-Finance brings with it the radical proposition of the elimination of the safe harbours. By eliminating the safe harbours, policymakers would prompt market participants to rely on the doctrine of true sales to demonstrate the validity of their security interest and allow the courts, possibly together with other policymakers, to adapt the doctrine to reflect countercyclical objectives.
Such objectives could be reflected in the price formulation of the doctrine as used by some courts in the United States.61 Under the price formulation, transactions are considered true sales only if the value of the assets sold in the transaction is adequate to the money paid. If it is not, the creditor is at the risk of losing the benefit of bankruptcy remoteness of its claim, and the transaction is instead considered a secured loan. In other words, repo creditors would lose the benefit of strong rights and become general secured creditors benefitting from moderately strong rights only if the transaction failed the adequacy test of the price formulation of the true sales doctrine.
For the true sales doctrine to reflect countercyclical objectives, courts should determine the adequacy of the price in reference to standardized haircuts, for example, as set by the Federal Reserve in a countercyclical fashion.62 In general, a haircut is a deduction (in per cent) of the market price of the financial instrument. The Federal Reserve, like other central banks, calibrates haircuts in its lending operations to protect itself against the risk of potential losses during the period in which the collateral is liquidated. By calibrating haircuts in a countercyclical for the purposes of true sale determinations, the Federal Reserve could help mitigate the potential procyclicality of strong legal protections of creditors.
In a boom, when asset prices are higher, haircuts set for the purposes of such determinations should be high to achieve contractionary policy objectives. For example, in a boom, a creditor would only benefit from strong protections if the price it paid for the asset corresponded to 130 per cent of its market value.63 In contrast, in a bust, when asset prices are lower, haircuts set for the purposes of such determinations should be low to achieve expansionary policy objectives. For example, in a bust, a creditor would benefit from strong protections even if the price it paid for the asset corresponded to 70 per cent of its market value.
Institutionally, the countercyclical design of the legal protections for repo creditors puts a lot of responsibility on the courts, requiring them to incorporate macro-financial considerations in their adjudication. Courts may be reluctant to incorporate such considerations, particularly if that would entail the exercise of a significant margin of discretion. Legal policymakers can reduce the amount of discretion courts would enjoy in such cases by setting rules as a form of automatic stabilizers requiring a legislative amendment of the Bankruptcy Code.
The strong protections afforded to repo creditors could also be eroded in a time-varying countercyclical fashion without a legislative amendment of the Bankruptcy Code. Following the GFC, in view of practical difficulties associated with legislative amendment of the Bankruptcy Code, legal policymakers used a combination of regulatory and contract measures to curb temporarily the strong legal protections available to derivatives creditors. Specifically, they adapted the standard contract used in derivatives markets, namely the ISDA Master Agreement, for that purpose.64 In that case, the policy justification for such change was the idiosyncratic situation of a financial institution, not the general macroeconomic conditions.65 Nevertheless, we can easily envisage a similar mechanism being deployed to adapt the strength of the legal protections of creditors in reference to such conditions. In the case of repos, that would require changes to the current industry standard of repo agreements published by the Bond Market Association and International Capital Market Association’s Global Master Repurchase Agreement.66
4. Countercyclical bankruptcy law: a time-invariant approach
It is also possible to conceive of an alternative time-invariant framework for regulation of leverage overcoming the practical challenges of countercyclical adaptations of the legal protections of creditors. In essence, a time-invariant regulatory framework for the regulation of leverage would entail the imposition of strict limits on leverage on all economy actors, ranging from banks and firms to households and consumers. The goal of such a framework would be to avoid excessive booms and help smoothen the cycle.
Banks are already subject to such limits, as alluded to earlier. In the current corporate credit boom, policymakers on both sides of the Atlantic have sought to impose similar restrictions on firms by way of leveraged lending guidelines for banks, with limited success.67 Concerning households, the EU Mortgage Lending Directive seeks to protect certain debtors from the risk of over-indebtedness.68 Crucially, and in line with the policy prescriptions of Law and Macro-Finance, the Directive emphasizes that whilst the ratio of the mortgage amount to property value commonly used in lending decisions is important in the assessment, the main focus should be on the ability of the consumer to repay the credit.69 The argument could be made that the goal of the Directive is to promote responsible lending/consumer protection objectives and not to advance macro-financial goals. Still, if one considers the regulation of leverage as a macro-financial policy goal, measures advancing responsible lending/consumer protection can be viewed as instrumental to the implementation of such a goal.
There is a risk that welfare losses impending if the leverage limits are set too low could easily offset the gains from a smoother credit and economic cycle. Therefore, the impositions of such limits should be subject to an extensive political and economic discussion. We can envisage that the desirability and levels of such limits would depend on the limitations of monetary policy to constrain a boom (as the policy may be focused on other macroeconomic variables, such as unemployment) and banking regulation to do the same. They would also depend on the estimated contribution of strong creditor protections to booms, the measure of which needs to be developed further.
V. CONCLUSIONS
Law and Macro-Finance is a theoretical framework that aims to explain the relationship between law and the macro-financial variables of leverage and liquidity.
The central claim of the theoretical framework for Law and Macro-Finance is that strong legal protections of creditors under bankruptcy law exacerbate the procyclicality of leverage and liquidity and increase the volatility of the cycle. I hope the framework can provide a foundation for empirical analysis of the macro-financial effects of strong legal protections of creditors on leverage and liquidity going beyond the analysis offered in the Law and Finance literature. While pioneering in recognizing the relationship between strong legal protections of creditors and the availability of credit, the literature has incorrectly viewed that relationship as unidirectional and positive. Recent studies showing that above a certain threshold there is a negative relationship between financial deepening (more credit relative to GDP) and economic growth70 create an opportunity for empirical research examining whether law be used instrumentally to explain this negative relationship.
Footnotes
Basel Committee for Banking Supervis ion, Basel III leverage ratio framework and disclosure requirements (January 2014) 1.
Atif Mian and Amir Sufi, House of Debt: How They (and You) Caused the Great Recession, and How We Can Prevent It from Happening Again (1st edn, University of Chicago Press 2014).
International Monetary Fund, Global Financial Stability Report (International Monetary Fund 2019).
John Geanakoplos, ‘The Leverage Cycle’ [2010] NBER Macroeconomics Annual 2009 1.
Cf Jean Tirole, ‘Illiquidity and All Its Friends’ (2011) 49 Journal of Economic Literature 287.
Javier Bianchi, ‘Overborrowing and Systemic Externalities in the Business Cycle’ (2011) 101 American Economic Review 3400.
Rafael La Porta and others, ‘Legal Determinants of External Finance’ (1997) 52 Journal of Finance 1131.
Ronald J Gilson and Reinier Kraakman, ‘Market Efficiency after the Financial Crisis: It’s Still a Matter of Information Costs’ (2014) 100 Virginia Law Review 314.
Cf Carolyn Sissoko, ‘The Legal Foundations of Financial Collapse’ (2010) 2 Journal of Financial Economic Policy 5; Katharina Pistor, ‘A Legal Theory of Finance’ (2013) 41 Journal of Comparative Economics 315.
Cf Yair Listokin, ‘A Theoretical Framework for Law and Macroeconomics’ (2019) 21 American Law and Economics Review 46.
George G Triantis, ‘Secured Debt under Conditions of Imperfect Information’ (1992) 21 Journal of Legal Studies 225. Triantis’s contribution was the culmination of a decade-long debate about the efficiency of secured lending prompted by a provocative 1981 article by Alan Schwartz, in which he challenged bankruptcy priorities on the grounds of economic theory. Alan Schwartz, ‘Security Interests and Bankruptcy Priorities: A Review of Current Theories’ (1981) 10 Journal of Legal Studies 1.
Triantis (n 11) 230.
Ibid.
Gilson and Kraakman (n 8).
Bengt Holmström, ‘Understanding the Role of Debt in the Financial System’ (2015) BIS Working Papers 42.
Gary Gorton and Guillermo Ordoñez, ‘Collateral Crises’ (2014) 104 American Economic Review 343.
Manmohan Singh, ‘“Puts” in the Shadow’ IMF Working Papers WP 12/229 <https://www.imf.org/en/Publications/WP/Issues/2016/12/31/Puts-in-the-Shadow-26264>.
Morgan Ricks, The Money Problem: Rethinking Financial Regulation (University of Chicago Press 2016).
Carolyn Sissoko, ‘Shadow Banking: Why Modern Money Markets Are Less Stable than 19th c. Money Markets but Shouldn’t Be Stabilized by a “Dealer of Last Resort”’ (Social Science Research Network 2014) SSRN Scholarly Paper ID 2392098 <https://papers.ssrn.com/abstract=2392098> accessed 29 February 2020.
The ‘macro-financial’ approach to economics is owed to a group of economists led by members of Princeton’s economics department, the Federal Reserve Bank of New York, and the Bank of International Settlement in Basel, Switzerland. The economic historian Adam Tooze credits Tobias Adrian and Hyun Song Shin for having laid the foundations for the macro-financial approach to economics. Adam Tooze, ‘Framing Crashed II: 2008, the Crisis of the National Macroeconomics and the “Revolution” of Macrofinance’ (July 2018) <https://adamtooze.com/2018/07/05/framing-crashed-ii-2008-the-crisis-of-the-national-macroeconomics-and-the-revolution-of-macrofinance> accessed 5 May 2021. Tooze himself used it in his account of the 2008 financial crisis. Adam Tooze, Crashed: How a Decade of Financial Crises Changed the World (2018). John Cochrane defines ‘macro-finance’ as a field of economic studies addressing the link between asset prices and economic fluctuations. John H Cochrane, ‘Macro-Finance’ (2017) 21 Review of Finance 945.
Finn E Kydland and Edward C Prescott, ‘Time to Build and Aggregate Fluctuations’ (1982) 50 Econometrica 1345.
John Maynard Keynes, The General Theory of Employment, Interest and Money, vol VII (Macmillan 1936).
Milton Friedman and Anna Schwartz, Monetary Statistics of the United States: Estimates, Sources, Methods (National Bureau of Economic Research, Inc 1970).
For an overview, see Mark L Gertler, ‘Financial Structure and Aggregate Economic Activity: An Overview’ National Bureau of Economic Research Working Paper 2559 (1988).
For example, Nobuhiro Kiyotaki and John Moore showed that collateralized debt amplifies and even generates the economic cycle. When credit is secured by collateral, a credit boom is associated with not only a higher leverage ratio but also a higher value of the collateralized assets. Nobuhiro Kiyotaki and John Moore, ‘Credit Cycles’ (1997) 105 Journal of Political Economy 211.
For an accessible, non-mathematical account of the theory, see John Geanakoplos, ‘Leverage Caused the 2007–2009 Crisis’ in Douglas W Arner and others, Systemic Risk in the Financial Sector: Ten Years After the Great Crash (McGill-Queen’s University Press 2019).
Ibid 5.
As Geanakoplos notes in an article co-authored with Ana Fostel, ‘[t]he choice of leverage turns out to be independent of agent preferences but determined exclusively by shocks to anticipated asset returns’. Ana Fostel and John Geanakoplos, ‘Leverage and Default in Binomial Economies: A Complete Characterization’ (2015) 83 Econometrica 2191, 2193.
Robert J Shiller, Irrational Exuberance (2nd edn, Crown Business 2006).
Geanakoplos (n 26) 13.
Atif Mian and Amir Sufi, ‘House Prices, Home Equity-Based Borrowing, and the US Household Leverage Crisis’ (2011) 101 American Economic Review 2132.
Tobias Adrian and Hyun Song Shin, ‘Liquidity, Monetary Policy, and Financial Cycles’ (2008) 14 Current Issues in Economics and Finance, 7.
Ibid 3.
Ibid.
Ibid.
The rule is known as ‘automatic stay’ and can be found in 11 US Code § 362. The safe harbours were codified in 11 US Code § 546. For a discussion of the evolution of that provision, see Edward R Morrison and Joerg Riegel, ‘Financial Contracts and the New Bankruptcy Code: Insulating Markets from Bankrupt Debtors and Bankruptcy Judges’ (2005) 13 American Bankruptcy Law Institute Law Review 641, 644–45.
See Maciej K Borowicz, ‘The Internal Ratings-Based and Advanced Measurement Approaches for Regulatory Capital Under the Basel regime’ in Geoffrey P Miller and Fabrizio Cafaggi, The Governance and Regulation of International Finance (Edward Elgar 2013).
Claudio Borio, Craig Furfine and Philip Lowe, ‘Procyclicality of the financial system and financial stability: issues and policy options’ Bank for International Settlements, Working Paper No 1 (2001) 57; J Danielsson, H Shin and J Zigrand, ‘The Impact of Risk Regulation on Price Dynamics’ (2004) 28 Journal of Banking and Finance 1069–87.
Erik F Gerding, Law, Bubbles, and Financial Regulation (Routledge 2016).
Gary B Gorton and Andrew Metrick, ‘Securitized Banking and the Run on Repo’ National Bureau of Economic Research Working Paper 15223 (2009).
Edward Morrison, Mark Roe and Christopher Sontchi argue, first, that the safe harbours ‘move liquidity around’ towards unstable short-term funding, like repo. Second, they also recognize that the argument assumes that the safe harbours merely ‘move’ liquidity around, favouring some markets (repos) and not others (longer-term financing). The net ‘liquidity effect’ of the safe harbours might not be zero. The safe harbours could have a net positive effect, increasing liquidity overall and lowering the cost of capital of institutions that rely on repo financing. Edward R Morrison, Mark J Roe and Christopher S Sontchi, ‘Rolling Back the Repo Safe Harbors’ (2014) 69 Business Law 34. Erik Gerding argues the same is true of derivatives that also benefit from such protections. As he notes, when credit derivatives are used to hedge loans or bonds and not just to speculate, they can increase the supply of credit to the ‘real’ economy that produces assets and services. In addition, banks can use credit derivatives that hedge bonds to arbitrage regulatory capital rules. A credit default swap that hedges asset-backed securities can allow a bank to reduce the amount of capital it must hold against those securities well below the economic risk that the bank continues to bear even with the hedge. Erik F Gerding, ‘Credit Derivatives, Leverage, and Financial Regulation’s Missing Macroeconomic Dimension’ (2011) 8 Berkley Business Law Journal 29.
‘The policy implication of the leverage cycle is that central banks should smooth the cycle, restraining leverage in booms, and in the acute stage of the crisis, propping up leverage. If, in the aftermath, depressed asset prices are too low relative to debts, debt must be partially forgiven.’ Geanakoplos (n 26) 19.
More formally, Geanakoplos’s neglect of the impact of the law on the leverage cycle is evident in the claim that the link between leverage and asset prices contradicts the famous Modigliani and Miller (MM) theorem. Franco Modigliani and Merton H Miller, ‘The Cost of Capital, Corporation Finance and the Theory of Investment’ (1958) 48 The American Economic Review 261. If he were to consider how the ex-ante incentives bankruptcy law creates for structuring debt transactions impact the leverage cycle, the theory would arguably be consistent with the MM theorem. The crucial institutional implication of the MM theorem is that bankruptcy law can distort financing decisions with both microeconomic and macroeconomic consequences.
11 US Code § 546.The rule is among the proxies used by La Porta and others to determine the relative strength of creditor protection in a given jurisdiction—jurisdictions with higher incidences of no automatic stay are considered more friendly towards creditors. La Porta and others (n 7).
Steven Schwarcz, ‘The Limits of Lawyering: Legal Opinions in Structured Finance’ (2005) 84 Texas Law Review 1.
Adam B Badawi and others, ‘Contractual Complexity in Debt Agreements: The Case of EBITDA’ (6 May 2021) <https://papers.ssrn.com/abstract=3455497> accessed 3 August 2022.
Compare David Skeel, ‘Bankruptcy and the Coronavirus’ (Brookings 2020) <https://www.brookings.edu/wp-content/uploads/2020/04/ES-4.21.2020-DSkeel-2.pdf>.
The cyclical fluctuation of asset returns, or earnings, also matters. Claims on debtors whose earnings tend to fluctuate in a cyclical fashion, for example those involved in the production of durable goods such as raw materials and heavy equipment, will have stronger procyclical effects than the claims on creditors whose earning tend to be acyclical.
Stephen A Lumpkin, ‘Repurchase and Reverse Repurchase Agreements’ (1987) 73 Federal Reserve Bank of Richmond Economic Review <https://econpapers.repec.org/bookchap/fipfedrmo/1998rarr.htm> accessed 10 August 2019.
Fiona Maclachlan, ‘Repurchase Agreements and the Law: How Legislative Changes Fueled the Housing Bubble’ (2014) 48 Journal of Economic Issues 515.
M Konrad Borowicz, ‘Contracts as Regulation: The ISDA Master Agreement’ (2021) 16 Capital Markets Law Journal 72.
Victoria Ivashina and Boris Vallee, ‘Weak Credit Covenants’ National Bureau of Economic Research Working Paper 27316 (2020) <https://www.nber.org/papers/w27316> accessed 3 February 2021.
Derrick D Cephas, Heath P Tarbert and Dimia E Fogam, ‘Bank Regulators Tackle Leveraged Lending’ (2012) 129 Banking Law Journal 495.
Cf M Konrad Borowicz, ‘The Mechanisms of Loan Market Inefficiency’ (2021) 41 Review of Banking and Financial Law.
Monika Piazzesi, ‘Bond Yields and the Federal Reserve’ (2005) 113 Journal of Political Economy 311.
Adrian and Shin (n 32).
Figures 1 through 4 in this article have been reproduced from Board of Governors of the Federal Reserve System, ‘Financial Stability Report–November 2018’ (Board of Governors of the Federal Reserve System 2018) <https://www.federalreserve.gov/publications/2018-november-financial-stability-report-leverage.htm> accessed 23 April 2020.
CLOs are the financial equivalents of MBS in the sense that they are vehicles issuing debt collateralized by debt. In the case of an MBS, that debt is a mortgage loan. In the case of a CLO, that debt is a corporate loan. The main difference between a CLO and an MBS is that, unlike MBS, CLOs are actively managed. In this sense, CLOs are more like collateralized debt obligations, which purchase and manage various MBS and issue debt against MBSs.
Morrison, Roe and Sontchi (n 41).
Victoria Baklanova, Adam Copeland and Rebecca McCaughrin, ‘Reference Guide to U.S. Repo and Securities Lending Markets’ Federal Reserve Bank of New York Staff Report (2015) <https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr740.pdf> accessed 25 March 2020.
For an excellent overview of the different formulation used by different courts, see Heather Hughes, ‘Property and the True-Sale Doctrine’ (2017) 19 University of Pennsylvania Journal of Law and Business 57.
The Federal Reserve is already setting such haircuts, for example, to determine the amount of loans it is willing to make through its discount window against specific collateral.
Economists at the Bank for International Settlements have in the past proposed minimum standards for setting haircuts intended to limit the extent to which haircuts on collateral assets are reduced in benign market conditions and to mitigate the procyclical effects on the build-up of financial leverage. Bank for International Settlements (eds), Asset Encumbrance, Financial Reform and the Demand for Collateral Assets: Report Submitted by a Working Group Established by the Committee on the Global Financial System, the Group Was Chaired by Aerdt Houben, Netherlands Bank (Bank for International Settlements 2013).
Borowicz (n 52).
The bail-in mechanism applicable to debt issued by banks or the temporary stays on the enforceability of derivatives contracts with defaulting counterparties who happen to be systematically important was implemented in a similar manner. Virginia Skidmore Rutledge and others, ‘From Bail-out to Bail-in: Mandatory Debt Restructuring of Systemic Financial Institutions’ IMF Staff Discussion Note 12/03 (2012).
CF Carolyn Sissoko, ‘The Collateral Supply Effect on Central Bank Policy’ (Social Science Research Network 2020) SSRN Scholarly Paper ID 3545546 <https://papers.ssrn.com/abstract=3545546> accessed 18 February 2021.
Cephas, Tarbert and Fogam (n 54).
Directive 2014/17/EU of the European Parliament and of the Council of 4 February 2014 on credit agreements for consumers relating to residential immovable property and amending Directives 2008/48/EC and 2013/36/EU and Regulation (EU) No 1093/2010, [2014] OJ L60/34. For a discussion of the directive and its implementation in the UK and the Netherlands, see Vanessa Mak, ‘What Is Responsible Lending? The EU Consumer Mortgage Credit Directive in the UK and the Netherlands’ (2015) 38 Journal of Consumer Policy 411.
Ibid article 18(3) (‘The assessment of creditworthiness shall not rely predominantly on the value of the residential immovable property exceeding the amount of the credit or the assumption that the residential immovable property will increase in value unless the purpose of the credit agreement is to construct or renovate the residential immovable property.’)
Stephen Cecchetti and Enisse Kharroubi, ‘Reassessing the Impact of Finance on Growth’ BIS Working Paper 381 (2012) <https://econpapers.repec.org/paper/bisbiswps/381.htm> accessed 4 March 2022; Jean Louis Arcand, Enrico Berkes and Ugo Panizza, ‘Too Much Finance?’ (2015) 20 Journal of Economic Growth 105.
Author notes
M Konrad Borowicz, Assistant Professor, Tilburg Law School, and Research Coordinator, Tilburg Law and Economics Center, Tilburg University, PO Box 90153, 5000 LE Tilburg, The Netherlands. Email: [email protected]. This article is based on a chapter of my doctoral dissertation submitted to Columbia University in 2020. Special thanks to Katharina Pistor and Yair Listokin for their inspiration and support, and for very helpful comments provided at different stages of my research. An earlier version of this article under the title ‘The Law and Macroeconomics of Secured Debt’ was presented at the law and economics workshop at Bar-Ilan University in December 2019. Many thanks to Adi Libson, Avi Bell, and other participants for helpful comments. I also benefitted from comments by Alessandro Romano, Suren Gomtsyan, Kenneth Khoo, Eduardo Martino, and other participants in the workshop for Junior Scholars in Corporate Law organized by Oxford and Bocconi , participants in the 4th Law and Macroeconomics Conference held online as well as two anonymous reviewers at the Journal of Financial Regulation. All errors that remain are my own.
