MALCOLM P. BAKER, Harvard Business School, National Bureau of Economic Research (NBER)
Email: mbaker@hbs.edu
JEFFREY WURGLER, NYU Stern School of Business, National Bureau of Economic Research (NBER)
Email: jwurgler@stern.nyu.edu

Minimum capital requirements are a central tool of banking regulation. Setting them balances a number of factors, including any effects on the cost of capital and in turn the rates available to borrowers. Standard theory predicts that, in perfect and efficient capital markets, reducing banks’ leverage reduces the risk and cost of equity but leaves the overall weighted average cost of capital unchanged. We test these two predictions using U.S. data. We confirm that the equity of better-capitalized banks has lower systematic risk (beta) and lower idiosyncratic risk. However, over the last 40 years, lower risk banks have higher stock returns on a risk-adjusted or even a raw basis, consistent with a stock market anomaly previously documented in other samples. The size of the low risk anomaly within banks suggests that the cost of capital effects of capital requirements may be considerable. Assuming competitive lending markets, banks’ low asset betas implied an average risk premium of only 40 basis points above Treasury yields in our sample period; a calibration suggests that a ten percentage-point increase in Tier 1 capital to risk-weighted assets may have increased this to between 100 and 130 basis points per year. In summary, the low risk anomaly in the stock market produces a potentially significant cost of capital requirements.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

GUILLERMO L. ORDOÑEZ, University of Pennsylvania - Department of Economics, National Bureau of Economic Research (NBER)
Email: ordonez@econ.upenn.edu

Commercial banks are subject to regulation that restricts their investments. When banks are concerned for their reputation, however, they could self-regulate and invest more efficiently. Hence, a shadow banking that arises to avoid regulation has the potential to improve welfare. Still, reputation concerns depend on future economic prospects and may suddenly disappear, generating a collapse of shadow banking and a return to traditional banking, with a decline in welfare. I discuss how a combination of traditional regulation and cross reputation subsidization may enhance shadow banking and make it more sustainable.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

ROBERT E. KRAINER, University of Wisconsin - Madison - Department of Finance, Investment and Banking
Email: rkrainer@bus.wisc.edu

In this paper I compare a traditional demand oriented model of bank lending with its focus on short-term interest rates in the money market, to a non-traditional capital budgeting model of bank lending based on movements in share valuations for the Euro area. Using non-nested hypothesis tests, omitted variables tests, and Granger Causality tests, I reject the traditional demand oriented model of bank lending and fail to reject the capital budgeting model of bank lending for Monetary Financial Institutions in the Euro area. Even though Europe is a bank-based financial system, it appears the stock market plays a key role in the lending decisions of banks and the allocation of capital in Europe. One possible implication of this research is that central banks should try and stabilize the stock market in order to stabilize bank lending in Europe.

VIKAS AGARWAL, Georgia State University, University of Cologne - Centre for Financial Research (CFR)
Email: vagarwal@gsu.edu
KEVIN MULLALLY, Robinson College of Business, Georgia State University
Email: kmullally1@gsu.edu
YUEHUA TANG, Georgia State University - Robinson College of Business
Email: ytang9@gsu.edu
BAOZHONG YANG, Georgia State University - Robinson College of Business
Email: bzyang@gsu.edu

This paper studies the impact of mandatory portfolio disclosure of mutual funds on the liquidity of disclosed stocks and on fund performance. We consider a theoretical model of informed trading with different mandatory disclosure frequencies. Using a regulation change in May 2004 that increased the frequency of mandatory disclosure, we find evidence consistent with the model’s predictions. First, stocks with higher fund ownership experience a larger increase in liquidity as compared to other stocks subsequent to the mandatory increase in disclosure frequency, especially for stocks disclosed by more informed funds or subject to greater information asymmetry. Second, better performing funds experience a greater drop in their abnormal performance following the regulation change, particularly when they hold stocks with greater information asymmetry or when they take longer to complete their trades. Taken together, our evidence suggests that mandatory portfolio disclosure improves market quality by increasing stock liquidity but imposes costs on informed investors.

STEPHEN G. DIMMOCK, Nanyang Technological University - Division of Finance
Email: dimmock@ntu.edu.sg
WILLIAM CHRISTOPHER GERKEN, University of Kentucky - Finance
Email: will.gerken@gmail.com

In 2004, the SEC passed Rule IA-2333, which required most U.S. hedge fund advisors to register. In 2006, a federal court revoked Rule IA-2333. Differences-in-differences tests using these two changes in the regulatory regime show that increased regulatory oversight reduces return misreporting by hedge funds. Following Rule IA-2333, misreporting by newly registered funds decreased relative to previously registered funds. After Rule IA-2333 was revoked, misreporting significantly increased for the funds that chose to deregister. These effects are stronger for funds with illiquid portfolios, custody of clients’ securities, stronger performance incentives, more experienced SEC examiners, and that are nearer to an SEC regional office. Tests of both the level and the performance sensitivity of flows suggest that investors value registration.

BENJAMIN J. RICHARDSON, University of British Columbia - Faculty of Law
Email: richardson@law.ubc.ca

Can investors lawfully engage in socially responsible investment (SRI)? The legal context to SRI is a complex and detailed subject. This chapter canvasses selected issues. It focuses on the fiduciary and trust law duties that govern finance in the institutional sector, including consideration for case law and academic commentary. The chapter concludes with a discussion of some recent statutory reforms that affect fiduciary finance and SRI. The chapter does not consider the legal issues that arise in the retail sector that caters directly to individual investors. Other legal issues that may affect SRI, such as corporate governance, contract law and securities law, are also not examined. Throughout the chapter, a multijurisdictional approach to the subject mater is taken, with some emphasis on legal precedents from the major common law jurisdictions (i.e United States and United Kingdom), which have among the most developed financial markets and legal rules for SRI.

EDYTA M. DORENBOS, Tilburg Law School
Email: miecia70@yahoo.com
ALESSIO M. PACCES, Erasmus School of Law, Erasmus University Rotterdam - Rotterdam Institute of Law and Economics, European Corporate Governance Institute
Email: pacces@law.eur.nl

In the context of corporate governance reforms following the global financial crisis, policymakers have focused on how to reduce the bank manager’ incentives to take risks in order to promote financial stability. On both sides of the Atlantic, legislation seeks to pursue this goal by enhancing the independence of boards of banks, particularly with regard to the remuneration committees.

This paper shows that, even though regulatory intervention in the design of bankers’ remuneration is economically justified, it is doubtful that assigning independent directors the task to discipline bank managers can solve the problem. Particularly, the independence of remuneration committees from the management is unhelpful so long as shareholders ultimately appoint the members of those committees. Both shareholders and bankers profit from the implicit subsidy of governments bailing out systematically relevant financial institutions. While the variable remuneration of bankers effectively induces them to take more risk than socially optimal, shareholders do not have the incentives to stop this behaviour.

To address this externalities problem, we advocate a different approach to the corporate governance of banks, relying on uninsured creditors rather than on the shareholders. We propose to confer upon uninsured creditors the right to appoint a minority of members of the remuneration committee. This solution aims at enabling debt-holders to better monitor the pay structure and the risk management policies of a bank and protect their investment accordingly. This mechanism, however, is effective only if debt-holders are credibly committed not to ever benefit from a bailout. In order to overcome the moral hazard generated by the governments’ safety net, the appointment rights of debt-holders should be conditional on the subscription of bail-in instruments.

FRANCOIS LAFARGE, Ecole Nationale d'Administration, University of Strasbourg
Email: francois.lafarge@ena.fr

Les trois autorités européennes de surveillance (AES), l’Autorité bancaire européenne, l’Autorité européenne des assurances et des pensions professionnelles et l’Autorité européenne des marchés financiers, créées en 2010 et en 2011, peuvent être considérées comme les premières autorités de régulation au niveau européen, en dehors de la Banque centrale européenne, et, à ce titre, comme des nouveautés institutionnelles importantes dans l’UE. Issues des comités Lamfalussy, elles ont été insérées dans un système de régulation financière plus large, le Système européen de sécurité financière, qui inclut d’autres autorités ou organes aussi bien européens que nationaux et établit entre eux des relations d’interdépendance. Les compétences des AES sont certes plus larges que celles des agences européennes de la précédente génération (les agences liées aux politiques de l’Union). Elles restent toutefois limitées par rapport à l’ampleur des crises bancaires et financières actuelles : concernant principalement la coordination des autorités nationales de surveillance, ce n’est qu’à la marge qu’on peut considérer qu’elles constituent une surveillance européenne. En particulier, elles sont handicapées par les règles en vigueur en matière de délégation dans l’UE (règles issues de la jurisprudence Meroni). Les délégations possibles ne sont pas suffisantes pour exercer de « véritables » régulations ; celles qui leur seraient nécessaires à cette fin sont mises en place parcimonieusement et en outre sous forme de délégations retenues (au profit de la Commission) et non pas de délégations en tant que telles. Ces lacunes expliquent, entre autres, que les projets en cours d’union bancaire, qui retirent aux autorités nationales de surveillance leurs compétences de surveillance au profit d’une surveillance européenne, n’aient pas retenu l’AES compétente en matière de régulation bancaire, l’Autorité bancaire européenne, pour exercer cette surveillance européenne, mais plutôt la Banque centrale européenne.

The three European Supervisory Authorities (ESA), the European Banking Authority, the European Insurance and Occupational Pensions Authority and the European Securities and Markets Authority, created in 2010 and 2011, may be considered as the first regulatory authorities existing at European level, outside the European Central Bank. EAS are undoubtedly important institutional novelties in the EU. They originate from the Lamfalussy committees, and are a part of a broader system of financial regulation, the European System of Financial Security, which includes other authorities or bodies, either at European or national levels, acting in interdependence relationships. They enjoy larger competencies than those other existing European agencies. These competencies are nevertheless limited compared to the magnitude of the current banking and financial crises that they should help to tackle: mostly circumcised to the coordination of national supervisory authorities, they constitute a European supervision only on a very limited scale. Moreover, they are still constrained by the delegation rules of the EU (according to the Meroni case). Authorised delegations under Meroni don’t grant them with enough power to fulfill regulatory activities; the necessary delegations to do so are sparingly set up under the scheme of “restrained delegations� which maintain the Commission’s last word. All that explains at least in part why the current project of a European Banking Union, intending to withdraw supervisory powers from the national authorities to transfer them into the hands of a European supervisor, did not chose the competent ESA, i.e. the European Banking Authority (EBA), to be the body in charge of such European supervision, but the European Central Bank instead.