Abstract
The governance of finance is replete with challenges as evidenced by the frequent financial crises that have accompanied the growth and development of financial markets. Every crisis can be taken as a symptom of governance failure. The immediate reaction tends to be an attempt to fix the problems that gave rise to the most recent crisis. By definition, such a regulatory approach lags behind actual developments on the financial marketplace, thereby inadvertently sowing the seeds for the next governance failure. A similar lag effect can be observed in current attempts to repair the governance of global finance. This paper argues that reform proposals currently under discussion fail to take into account important changes in the organisation of global financial relations between financial intermediaries, their home governments and sovereign wealth funds (SWFs). They challenge the basic principles that inform conventional regulatory regimes: a clear distinction between public vs. private; regulation vs. firm-level governance; and stakeholding vs. supervision. The paper discusses alternative modes of governance that have emerged during the crisis and are complementing for, if not substituting, more conventional forms of governance.
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References
For a comprehensive historical account of financial crises, see C. Kindelberger, Mania, Panics, and Crashes: A History of Financial Crises, 5th edn. (Wiley 2005).
A deeper reason for this is that law is inherently incomplete, that is, no lawmaker can possibly anticipate all future contingencies. This implies that law cannot be designed to fully deter future actions. Moreover, regulators lack the tools to screen and enjoin actions that might cause systemic harm. See K. Pistor and C. Xu, ‘Incomplete Law’, 35 Journal of International Law and Politics (2003) for details.
On the importance of authoritative figures in initiating institutional change by ‘defecting’ from common patterns of behaviour, see A. Greif, Institutions and the Path to the Modern Economy: Lessons from Medieval Trade (Political Economy of Institutions and Decisions) (Cambridge University Press 2006).
Financial intermediaries tend to have complex capital structure comprising not only common stock, but also hybrid securities. Limiting the analysis only to common stock has the advantage of including only those who exercise formal voting rights. Yet, investors with sizeable stakes in preferred convertible stock are also likely to have a ‘voice’ in critical decisions. On the changing capital structure of banks in response to regulatory requirements, see G. Benston, et al., Bank Capital Structure, Regulatory Capital, and Securities Innovations, 2000 FRB Atlanta Working Paper (2000). On the role of voice in organisations, see A.O. Hirschman, Exit, Voice, and Loyalty; Responses to Decline in Firms, Organizations, and States (Harvard University Press 1970).
The importance of ownership structure for corporate governance is widely recognised. Berle and Means first recognised the fundamental change in the governance of large firms brought about by the spread of dispersed ownership structures. See A.A. Berle and G. Means, The Modern Corporation and Private Property (Council for Research in the Social Sciences, Columbia University 1932). For a discussion of the governance implications of different ownership structures in comparative perspective, see M.J. Roe, ‘Some Differences in Corporate Structure in Germany, Japan, and the United States’, 102 Yale Law Journal (1993), and R.J. Gilson, ‘Controlling Shareholders and Corporate Governance: Complicating the Comparative Taxonomy’, 119 Harvard Law Review (2006).
The perennial und ultimately irresolvable governance question remains, here as elsewhere, quis custodiet ipsos custodes?
For a discussion of bank consolidation and its impact on (rather than the result of) crisis, see T. Beck, et a1., Bank Concentration and Crisis, University of Minnesota Working Papers in Economics (2003). On the capital structure of banks and the function of convertible securities in particular, see J.C. Stein, ‘Convertible Bonds As Backdoor Equity Financing’, 32 Journal of Financial Economics (1992). and F. Cornelli and O. Yosha, Stage Financing and the Role of Convertible Debt, London Business School Working Paper (1997).
The crisis is frequently labeled as the ‘sub-prime mortgage crisis’. Yet mortgages were only one class of assets that was securitised, and securitised assets were only one class of assets with questionable value. Others included collateralised debt obligations (CDOs) and credit default swaps (CDS). For a taxonomy of these instruments and their pros and cons, see F. Partnoy and D.A. Skeel, The Promise and Perils of Credit Derivatives (2007), available at: http://papers.ssrn.comabstract=929747.
There is little doubt that the banks, not the SWFs, initiated these transactions. For an early account of SWF investments in Western banks, see R.J. Gilson and C.J. Milhaupt, ‘Sovereign Wealth Funds and Corporate Governance: A Minimalist Solution to the New Mercantilism’, 60 Stanford Law Review (2008).
Section 721 of the Foreign Investment and National Security Act of 2007 leaves the definition of control to CFIUS. The proposed rule to clarify the meaning of control, 31 CFR 800.203, defines the term as follows: ‘(a) The term control means the power, direct or indirect, whether or not exercised, through the ownership of a majority or a dominant minority of the total outstanding voting interest in an entity, board representation, proxy voting, a special share, contractual arrangements, formal or informal arrangements to act in concert, or other means, to determine, direct, or decide important matters affecting an entity; in particular, but without limitation, to determine, direct, take, reach, or cause decisions regarding the following matters, or any other similarly important matters affecting an entity.’ This definition has received a lot of commentary from foreign investors, including CIC.
For an overview of FDI regulations in 10 countries, see the GAO Report of February 2008, available at: http://www.gao.gov/new.items/d08320.pdf.
L. Summers, ‘Sovereign Funds Shake the Logic of Capitalism’, Financial Times, 30 July 2007, p. 9.
Data on Citigroup’s global expansion are available on the bank’s web site at: http://www.citigroup.com/citi/corporate/history/index.htm (under ‘Citi’s History’).
The investments in Guangdong Development Bank and Shanghai Pudong Development Bank represent minority stakes. See ibid.
CDB is not a ‘sovereign wealth fund’, but a government-owned fund. The term SWFs is mostly used to describe, ‘a state-owned investment fund composed of financial assets such as stocks, bonds, real estate, or other financial instruments funded by foreign exchange assets.’ See: http://www.swfinstitute.org. Note, however, that this definition is not entirely accurate for all intermediaries lumped together as SWFs. In particular, Temasek of Singapore is funded not from foreign exchange assets, but from government surplus subject to a constitutional provision that requires the government to invest surplus that remains at the end of a legislative period. See Art. 146 of the Constitution of the Republic of Singapore, available at: http://statutes.agc.gov.sg.
S. Evans, ‘Overseas Investors Offer £4bn Injection to Boost Barclays’, The Independent, 22 June 2008, available at: http://www.independent.co.uk.
This is true at least for institutional and private investors. Equity funds and other investors with different risk profiles have so far been barred from acquiring troubled banks. However, at least in the US, this may be changing as the government is redrafting the rules for acquirers of troubled banks. See H. Sender and F. Guerrera, ‘US Moves to Spur Bank Buy-Outs’, The Financial Times, 13 June 2009, available at: http://www.ft.com.
The chief executive of GIC has made this explicit in an interview in which he pointed out that GIC needed neither voting rights nor a board seat to ensure that its interests were heard on major issues. See interview by Bloomberg’s Chen Shiyin with the CEO, quoting him as saying: ‘Now with regard to having a say in these two banks, we have not taken up a board seat in either of them. We have been invited by the UBS board to nominate a director, but we have declined for the time being. Our view is that we can make our views known as a shareholder to UBS and Citigroup, and we’re happy that we’re able to give an input, which is generally helpful to the board and management of UBS and Citigroup. So this will be our position for the time being.’ See C. Shiyin, ‘GIC’s NG Says UBS, Citigroup to Offer Good Returns Long Term’, Bloomberg, 23 September 2008, available at: http://www.bloomberg.com.
According to G. Benston, et al., a change in guidelines issued by the Federal Reserve altered the capital structure of banks. In 1996, it allowed preferred stock that was issued by the special purpose vehicle (SPV) of a bank and the proceeds of which were loaned back to the bank (so-called ‘trust-preferred securities’ or TPS) to count at least in part as Tier 1 capital. See Benston, et al., supra n. 4, pp. 7–11, for details.
The latter being the case with regard to the EU, where the banking directives made the Basel standards effectively mandatory for all banks. See A.M. Corcoran and T.L. Hart, ‘The Regulation of Cross-Border Financial Services in the EU Internal Market’, 8 Columbia Journal of European Law (2002), at p. 253 discussing the consolidated banking directive Council Directive 2000/12, previously Council Directive 89/646.
The government’s role as ‘lender of last resort’ has, of course, long been recognised. The use of capital injections in the form of equity capital for financial intermediaries, including non-deposit taking ones, has expanded this role to that of an ‘investor of last resort’. See E. Andrews, ‘A New Role for the Fed: Investor of Last Resort’, The New York Times, 18 September 2008, available at: http://www.nytimes.com.
R. Crew and C. Perres, ‘BofA Gets $7.3 Billion in CCB Sale’, The Wall Street Journal, 9 May 2009, available at: http://online.wsj.com.
D. Reece, ‘Barclays Sale of BGI Ushers in Post Credit-Crunch Rebirth for British Bank’, The Daily Telegraph, 12 June 2009, available at: http://www.telegraph.co.uk.
Reuters reporting ‘China’s CIC Ploughing $1.2 Billion into Morgan Stanley’, as broadcast by CNBC, 3 June 2009, see: http://www.cnbc.com.
J. Croft and P. Jenkins, ‘UK Sounds out Sovereign Funds over Disposal of Its Bank Stakes’, The Financial Times, 19 May 2009, available at: http://www.ft.com.
This has not prevented the government from becoming embroiled in a public scandal over the compensation of the former CEO of RBS, Fred Goodwin. See A. Stratton, ‘UK: Politicians Pile Pressure on Bailed-out RBS to Abandon Plans for a £1bn Bonus for Staff’, The Guardian, 9 February 2009, available at: http://www.guardian.co.uk.
S. Labaton, ‘Treasury to Set Executives’ Pay at 7 Ailing Firms’, The New York Times, 10 June 2009, available at: http://www.nytimes.com. The Treasury appointed Kenneth Feinberg, a Washington-based lawyer and mediator, to this position. Ibid.
The Monitor Group conducted a long-term study of SWF investments in 2008. See their report Assessing the Risks: The Behaviors of Sovereign Wealth Funds in the Global Economy (2008), and for a follow-up, Monitor, Sovereign Wealth Fund Investment Behavior: Analysis of Sovereign Wealth Fund Transactions During Q3 2008 (Monitor Group 2009). The studies concluded that most SWFs are passive, but also noted important differences in investment patterns among SWFs.
On the expansion of Western banks to emerging markets see Bank for International Settlement (BIS) Foreign direct investment in the financial sector of emerging market economies (2004).; see also R. De Haas and I. Van Lelyveld, Internal Capital Markets and Lending by Multinational Bank Subsidiaries, 2008 EBRD Working Papers (2008) for evidence on intra-group lending markets.
At least as far as any influence on firm strategies, such as executive compensation, dividend payments and the geographic scope, is concerned. However, financing conditions have frequently been more demanding. The tension between financial costs and strategic costs came to the fore at Barclays in the fall of 2008, when it opted for SWF funding and rejected government bailout money. The company had to face off a shareholder revolt to finalise the transaction. See P. Inman, ‘Barclays Seeks to Fend off Investor Revolt over Fundraising’, The Guardian, 13 November 2008, available at: http://www.guardian.co.uk.
Report by the High Level Group of Financial Supervision in the EU (2008).
Financial Reform: A Framework for Financial Stability (2009).
Report of the Commission of Experts of the President of the United Nations General Assembly on Reforms of the International Monetary and Financial System (2009).
FSA, The Turner Review: A Regulatory Response to the Global Banking Crisis (2009). See, however, Section 1.3, which points to the lacunae of global governance mechanisms.
Volcker Report (2009), Recommendation 2, discussed at pp. 29 and 59.
Ibid, at p. 17. The report makes several recommendations for identifying which institutions should be deemed to be ‘systematically significant’. Specifically, it deems a focus on notional balance sheet indicators (i. e., the size of assets) to be insufficient. Instead, it recommends to use leverage, the scale of interconnectedness and the systemic significance of certain infrastructure services such as custody, clearing and settlement systems as indicators for ‘systematic significance’. See Box 1, at p. 19. Incidentally, the US federal reserve issued guidelines in the aftermath of 11 September that extended its jurisdiction to organisations posing higher degrees of systemic risk, defined as organisations that will cause other organisations ‘to be unable to meet their obligations when due, causing significant liquidity or credit problems and threatening the stability of financial markets.’ See US Federal Reserve Supervisory Letter of 28 March 2003 (SR 03-9), available at: http://www.gov.boarddocs/SRLETTERS/2003/SR0309.htm.
Ibid, at p. 37: ‘The most pressing and complex of those enhancements relate to making crisis management coordination more effective and operational by agreed protocols.’
Larosière Report, supra n. 31, under IV, at recital 100.
Ibid, Chapter III: EU Supervisory Repair, recitals 156–160. See also the recommendations for a European System of Supervision and Crisis Management, at recital 167 et seq.
Ibid, at recital 231 et seq.
The Swiss National Bank has been the first agency to suggest that financial intermediaries that have grown too large to be regulated would have to be downsized. See J. Hughes and P. Jenkins, The Financial Times, 19 June 2009, available at: http://www.ft.com.
Ibid, at recital 235.
Ibid, at recital 231. See also Financial Stability Forum, FSF Principles for Cross-border Cooperation and Crisis Management (2009).
Ibid, at recitals 167 et seq.
Based on BofA’s most recent financial reports, this would make the US government the largest shareholder. BofA’s own account of its owners, which includes only holders of common shares, lists as the largest three shareholders State Street Global Advisors (3.9%), Barclays Global Investors (2.9%) and Vanguard Group (2.7). See: http://investor.bankofamerica.com/phoemx.zhtml?c=71595&p=irol-ownershipsummary.
T. Braithwaite and F. Guerrera, ‘Ten Banks Set to Leave Tarp’, The Financial Times, 10 June 2009, available at: http://www.ft.com.
Statement by Secretary Henry M. Paulson Jr. on Treasury and Federal Housing Finance Agency Action to Protect Financial Markets and Taxpayers, 11 September 2008, available at: http://treasury.gov/press/releases/hp1129.htm.
See, for example, the AIG Credit Facility Trust Agreement of 16 January 2009. According to Art. 1 of the agreement, the Trust was established ‘for the sole benefit of the Treasury, which, for the avoidance of doubt, means that any property distributable to the Treasury as a beneficiary hereunder shall be paid to the Treasury for deposit into the General Fund as miscellaneous receipts.’
For an overview of the rise and investment strategies of SWFs, see Monitor Group, Sovereign Wealth Fund Investment Behavior: Analysis of Sovereign Wealth Fund Transactions During Q3 (2008).
See ibid, at p. 8. The reports also include information about the legal basis for SWFs and the relevance of advisory committees. However, it is unclear what role these formal legal devices play in relation to informal ties that link SWFs to the authorities.
Letter of the Board of Governors of the US Federal Reserve System to CIC’s legal representative, 5 August 2008, concluding that both CIC and Huijin qualify as bank holding companies under the Act, but that ’it would be in the public interest and not substantially at variance with the purposes of the Act to grant to CIC and Huijin exemptions from the nonbanking restrictions of the BHC act under the authority of section 4(c)(9) of the Act.’
According to Fed data, 20 percent of the US outstanding debt is held by China. Within China, SAFE takes primary responsibility in managing foreign exchange reserves.
Based on Temasek’s financial reports disclosed in September 2008, available at: http://www.temasekholdings.com.
Information about share of investments in the financial sector is based on available information about deals concluded between 2000 and the first quarter of 2008. For details, see Monitor Report summaries for individual SWFs, at pp. 77–84.
Based on deals concluded between 2000 and 2008. See Monitor Report, at p. 77.
A technical term used to refer to highly liquid assets that qualify as capital reserve. See Oxford Dictionary of Economics, ‘High-Powered Money’.
J.R. Barth, et al., ‘Bank Regulation and Supervision: What Works Best?’, 13 Journal of Financial Intermediation (2004).
See B. Black and R. Kraakman, ‘A Self-Enforcing Model of Corporate Law’, 109 Harvard Law Review (1996). This model has been altered to some extent by the Sarbanes-Oxley Act. However, the scope of change of SOX has been more limited than is often asserted. See L.A. Cunningham, ’The Sarbanes-Oxley Yawn: Heavy Rhetoric, Light Reform (and It Just Might Work)’, 35 Connecticut Law Review (2003).
Indeed, the accumulation of exchange reserves is a result of export-led growth strategies and government interventions that sterilise the impact of huge foreign exchange inflows into the domestic economies of these countries. See M. Wolf, Fixing Global Finance (Johns Hopkins University Press 2008).
P. Xie and C. Chen, Sovereign Wealth Funds, Macroeconomic Policy Alignment and Financial Stability, available at: http://papers.ssrn.com (2009).
Ibid, at p. 17.
Note that in the US the threat to the financial system has been named the primary security threat the US is facing at the current moment. Security is undoubtedly a public good and the recognition of finance as a potential security threat has highlighted the centrality of finance for social welfare.
See also Xie and Chen, supra n. 60.
Thus, the US Foreign Sovereign Immunity Act of 1976 extends immunity to ‘instrumentalities’ of foreign, including wholly owned government entities. See 28 U.S.C. § 1603(b).
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The paper is based on a presentation given at the Kick-off Conference of the Doctorate/Ph.D. Program in Law and Economics of Money and Finance, 15–16 May 2009, Goethe University, Frankfurt. I am grateful for comments and suggestions by participants in the Conference. All remaining errors are mine.
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Pistor, K. Sovereign Wealth Funds, Banks and Governments in the Global Crisis: Towards a New Governance of Global Finance?. Eur Bus Org Law Rev 10, 333–352 (2009). https://doi.org/10.1017/S1566752909003334
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DOI: https://doi.org/10.1017/S1566752909003334