Structural Corporate Degradation Due to Too-Big-To-Fail Finance
Mark J. Roe
Harvard Law School
April 9, 2014
University of Pennsylvania Law Review, Forthcoming
European Corporate Governance Institute (ECGI) - Law Working Paper No. 253/2014
Corporate governance incentives at too-big-to-fail financial firms deserve systematic examination. For industrial conglomerates that have grown too large to be efficient, internal and external corporate structural pressures push to resize 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 if restructured via spin-offs and sales. But a major corrective for industrial firm overexpansion fails to constrain large, too-big-to-fail financial firms when (1) the funding boost that the firm captures by being too-big-to-fail sufficiently lowers the firm’s financing costs, and (2) a resized firm or the spun-off entities would lose that funding benefit.
Propositions (1) and (2) have both been true and, consequently, a major retardant to industrial firm overexpansion has gone missing for large financial firms. Because Debt cost savings from this implicit subsidy have amounted to a good fraction of the big firms’ profits, Directors contemplating spin-offs at a too-big-to-fail financial firm have faced the problem that the spun-off, smaller firms would have lost access to cheaper funding. Hence, directors should have been, and may well still be, reluctant to push for operationally sound break-ups, spin-offs, or slowed expansion. Subtly but pervasively, a too-big-to-fail subsidy degrades internal corporate counterpressures that elsewhere resist excessive bulk, size, and growth.
The impact of the lower financing cost from the too-big-to-fail subsidy resembles that of a poison pill, the corporate governance defense that managers and boards use to ward off unwanted takeovers. Worse, this shadow financial poison pill impedes restructurings more widely than does the conventional version: It impedes outsiders, as does the conventional pill, but it also impedes insiders — a controlling shareholder where there is one, or the board of directors and the CEO where there is no controlling shareholder — even if restructuring the firm would be operationally wise.
The resulting corporate degradation burdens the economy, reducing financial firm efficiency. And the mechanism identified here has policy implications beyond reducing too-big-to-fail risks, as regulators aimed to do after the financial crisis. Most postcrisis financial regulation has been command-and-control rules on capital and activities, but the analytic here points us to unused incentives-based policy tools. the corporate degradation analytic also has on-the-ground corporate -dealmaking implications: if the command-and-control regulation moving forward is succeeding, and big finance is losing that large too-big-to-fail boost, then that change should lead to sharp, sua sponte corporate restructurings in the big financial firms.
Number of Pages in PDF File: 43
Keywords: financial crisis, too-big-to-fail, corporate governance, bank regulation, bank capital, international finance
JEL Classification: E44, G18, G21, G28, G33, G34, G38, K22, L25Accepted Paper Series
Date posted: May 10, 2013 ; Last revised: April 17, 2014
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