762. Mark J. Roe, Structural Corporate Degradation Due to Too-Big-To-Fail Finance, 2/2014; forthcoming in University of Pennsylvania Law Review.
Abstract: Corporate governance incentives at too-big-to-fail financial firms deserve systematic examination. For industrial conglomerates that have grown too large, internal and external corporate structural pressures push to re-size the firm. External activists press it 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 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 or the spun-off entities would lose that funding benefit, then a major constraint on industrial firm over-expansion breaks down for too-big-to-fail finance.
Propositions (1) and (2) have both been true and, consequently, a major retardant to industrial firm over-expansion has been missing in the large financial firm. Debt cost savings from the implicit subsidy can amount to a good fraction of the big firms’ profits. Directors contemplating spin-offs at a too-big-to-fail financial firm accordingly face the problem that the spun-off, smaller firms would lose access to cheaper too-big-to-fail funding. Hence, they will be relatively more reluctant to push for break-up, for spin-offs, or for slowing expansion. They would get a better managed group of financial firms if their restructuring succeeded, but would lose the too-big-to-fail subsidy embedded in any lowered funding costs. Subtly but pervasively, internal corporate counterpressures that resist excessive bulk, size, and growth degrade.
The recent travails of JPMorgan Chase — including its now well-known $6 billion trading loss after the financial crisis — fit well with this analytic. Analysts initially 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 in much of the conventional wisdom was one for the bank’s shareholders and managers and, hence, in one view, an issue for ordinary corporate governance. But by systematically examining the incentives, we can see how such missteps can link to, and follow from, a too-big-to-fail boost from the realities of government financial policy. It’s not just that some firms are too-big-to-fail, some are too-big-to-manage, and some are both, but that the two characteristics link together, with any implicit too-big-to-fail subsidy pushing firms to be too-big-to-manage.
These lower financing costs from the too-big-to-fail subsidy are a shadow poison pill — the corporate governance defense that managers and boards have used to ward of unwanted takeovers in the industrial sector. Worse, the shadow financial pill impedes restructurings more strongly than a conventional poison pill. It impedes not just outsiders, as does the conventional pill, but insiders as well — a controlling shareholder where there is one, 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. In addition to the well-known costs of bailouts and economic contraction if major financial firms fail, too-big-to-fail finance degrades financial firm efficiency. The mechanism identified here has policy implications beyond adding to the reasons to reduce too-big-to-fail risks. Most post-crisis financial regulation has been command-and-control rules on capital and activities, but the analytic here points us to unused incentives-based policy tools. Lastly, the corporate degradation analytic has on-the-ground corporate dealmaking implications: if the command-and-control regulation moving forward is succeeding, it should lead to sharp corporate restructurings in financial firms if large financial firms lose their too-big-to-fail boost. I outline the mechanisms and implications.