Alessio M. Pacces

Regulation of Banking and Financial Markets

This comprehensive volume provides a state-of-the-art overview of regulatory economics and reviews the main theories, tools, and domains of regulation

Financial intermediation in the securities markets law and economics of conduct of business regulation

Abstract The economic theory explains the role performed by intermediaries in financial markets. In securities markets, in particular, intermediaries act as facilitators of the financial exchange. In this context, conduct of business regulation is justified on the basis of structural problems of asymmetric information affecting the relationship between securities professionals and the individual investor. In this paper, two major conduct of business rules are analysed in the light of the kind of market imperfections they should be intended to address: the suitability and the anti-churning rules. From a functional perspective, the analysis merges major insights of financial theory with a comparative discussion of the legal rules in both the U.S. and the European Union. Law and economics approach to the matter leads to a much broader and more economically sound interpretation of the “churning” problem. This is related to an agency-based explanation of one of the most topical puzzles under debate in financial economics: the problem of noise trading.

The Case for an Unbiased Takeover Law (with an Application to the European Union)

Takeover regulation should neither hamper nor promote takeovers, but instead allow individual companies to decide the contestability of their control. Based on this premise, we advocate a takeover law exclusively made of default and menu rules supporting an effective choice of the takeover regime at the company level. For reasons of political economy bearing on the reform process, we argue that different default rules should apply to newly public companies and companies that are already public when the new regime is introduced. The first group should be governed by default rules crafted against the interest of management and of controlling shareholders, because these are more efficient on average and/or easier to opt out of when they are or become inefficient for the particular company. The second set of companies should instead be governed by default rules matching the status quo even if this favors the incumbents. This regulatory dualism strategy is intended to overcome the resistance of vested interests towards efficient regulatory change. Appropriate menu rules should be available to both groups of companies in order to ease opt-out of unfit defaults. Finally, we argue that European takeover law should be reshaped along these lines. Particularly, the board neutrality rule and the mandatory bid rule should become defaults that only individual companies, rather than member states, can opt out of. The overhauled Takeover Directive should also include menu rules, for instance a poison pill defense and a time-based breakthrough rule. Existing companies would continue to be governed by the status quo until incumbents decide to opt into the new regime.

Controlling the Corporate Controller’s Misbehaviour

The corporate governance debate mainly deals with the effectiveness of techniques to protect shareholders from the controllers’ misbehaviour. This paper takes a different approach. Focussing on self-dealing, it shows that effective strategies to protect investors from expropriation differ, and some may be more efficient than others. The inefficiency of an effective discipline of self-dealing stems from the constraints it imposes on the discretion of controlling managers and shareholders. This paper shows that both the US litigation-based model and the UK governance-based model are effective against expropriation, but their efficiency can be improved. To this purpose, the paper recommends restricting the influence of non-controlling shareholders to the selection of a minority of independent directors, whose task should be limited, in turn, to monitoring and validating self-dealing. These findings can be extended from self-dealing to similar conflicts of interest that may lead to shareholder expropriation, and to their regulation in other jurisdictions.

Regulation and Economics

This comprehensive volume provides a state-of-the-art overview of regulatory economics and reviews the main theories, tools, and domains of regulation

The Law and Economics of Corporate Governance

In this timely book, the law and economics of corporate governance is approached from various angles. Alessio Pacces shows that perspectives are evolving and that they differ between the economic and the legal standpoint, as well as varying between countries. A group of leading scholars offers their views and provides fresh empirical evidence on existing theories as well as developing new theoretical insights based on empirical puzzles. They all analyse the economics of corporate governance with a view to how it should, or should not, be regulated.

Exit, Voice and Loyalty from the Perspective of Hedge Funds Activism in Corporate Governance

This article discusses hedge funds activism based on Hirschman’s classic. It is argued that hedge funds do not create the loyalty concerns underlying the usual short-termism critique of their activism, because the arbiters of such activism are typically indexed funds, which cannot choose short-term exit. Nevertheless, the voice activated by hedge funds can be excessive for a particular company. Furthermore, this article claims that the short-termism debate cannot shed light on the desirability of hedge funds activism. Neither theory nor empirical evidence can tell whether hedge funds activism leads to short-termism or long-termism. The real issue with activism is a conflict of entrepreneurship, namely a conflict between the opposing views of the activists and the incumbent management regarding in how long an individual company should be profitable. Leaving the choice between these views to institutional investors is not efficient for every company at every point in time. Consequently, this article argues that regulation should enable individual companies to choose whether to curb hedge funds activism depending on what is efficient for them. The recent European experience reveals that loyalty shares enable such choice, even in the midstream, operating as dual-class shares in disguise. However, loyalty shares can often be introduced without institutional investors’ consent. This outcome could be improved by allowing dual-class recapitalisations, instead of loyalty shares, but only with a majority of minority vote. This solution would screen for the companies for which temporarily curbing activism is efficient, and induce these companies to negotiate sunset clauses with institutional investors.

A Strict Liability Regime for Rating Agencies

This paper argues that a mitigated strict liability regime can incentivize Credit Rating Agencies (CRAs) to produce ratings as accurate as the available forecasting technology allows. A damage cap based on objective factors is introduced in order to avoid crushing liability. Moreover, CRAs are allowed to choose how much to commit to their predictions. CRAs may opt out of liability even entirely, unless their ratings are relevant for regulation. Finally, corrections in the relevant timeframe for the imposition of liability are introduced in order to protect CRAs from systemic risk.

The Role and the Future of Regulation in the Financial Crisis: The Uncertainty Perspective

This paper analyzes the last financial crisis in the perspective of financial innovation focussing on the dynamics of systemic externalities in banking. After discussing the peculiar nature of banking and its external effects to society, it shows that one major determinant of the financial crisis was the failure of regulation to address the evolution of financial intermediation under uncertainty. Differently from the standard explanations, which are variously based on unanticipated opportunism and/or irrationality of financial intermediaries, this analysis suggests that regulation has not been insufficient. On the contrary, regulation has been so overly demanding towards traditional banking to promote unregulated forms of financial intermediation, thereby exacerbating the externalities of financial innovation. In contrast to the initiatives of regulatory reform on both sides of the Atlantic, which address the accidental aspects of the last financial crisis, this paper contends that the overhaul of financial regulation should focus on the general problem of banks’ dealing with uncertainty. As uncertainty makes externalities in banking most dangerous, this approach could fare better in preventing the next crisis. Three major implications are derived from this analysis. First, regulation should avoid inducing banks to make leveraged bets on new forms of short-term funding in order to compete with unregulated intermediaries. The latter should be prevented from engaging in the functional core of banking, maturity transformation, which is the recurrent source of systemic externalities. Second, in relying upon ratings, regulation should correct the incentives it provides to rating agencies to inflate their grades by making them liable for rating intractable uncertainties instead of measurable risks. Finally, regulation should avoid tampering with the corporate governance of banks. Allowing bank managers to protect their autonomy via contractual choices is a more promising solution to short-termism in carrying out financial innovation than regulation of bankers’ pay.

The Law and Economics of Shadow Banking

This essay discusses the economic case for regulating shadow banking. Focusing on systemic risk, shadow banking is defined as leveraging on collateral to support liquidity promises. Regulating shadow banking is efficient because of the negative externality stemming from systemic risk. However, because uncertainty undermines the precise measurement of systemic risk, quantity regulation is preferable to a Pigovian tax to cope with this externality. This paper argues that regulation should limit the leverage of shadow banking mainly by imposing a minimum haircut regulation on the assets being used as collateral for funding.