Why President Obama's Proposed Regulations Subsidize Bank Investment

How should we think about President Obama’s newly proposed financial regulations? I suggest that to do so,investors have to ask a basic question which is this: what is a regulation?

To answer that question, I’d like to reflect on the wisdom of one of my law professors. In his class on tort law, Judge Guido Calabressi would teach his admiring students (including this admiring student) a fundamental point on the true nature of law. Law is merely something that assigns liability for certain behavior to one party or another. The Judge would point out that in one sense, it doesn’t matter which party bears liability, given that parties are free to “contract around” the liability. For example, Judge Calabressi would posit a law that assigned strict liability to car drivers for accidents involving pedestrians. Car drivers could (and do) contract around such liability by purchasing auto insurance, shifting the cost of the liability to an insurance company for a fee. Alternatively, Judge Calabressi imagined, you could structure the law so as to assign strict liability to pedestrians for accidents involving automobiles. In that scenario, pedestrians could contract around the liability by purchasing catastrophic health insurance policies, and policies that would pay car drivers for the dents in their cars caused by running into pedestrians. So in terms of risk allocation, the net effect of how either law allocates risk is identical, because it can always be shifted (at a cost) to an insurance company. So what, students were left to wonder, is the point (if any) of even having a law at all if law doesn’t actually matter?!

Two things follow from Judge Calabressi’s philosophy of law. First, it is clear that having a law, verses having no law, amounts to the same thing: either scenario equates to an allocation of risk. The second thing that follows is something his Honor would present at the following class. He would point out that there is, in fact, a profound consequence of assigning risk to one party or the next, which is that by assigning liability among parties, laws create incentives which, in turn, ultimately influence behavior. If I am a driver in a strict driver-liability state, I might have an incentive to drive with squishy-soft bumpers on my car, if doing so would bring down my insurance costs. Alternatively, if I am a pedestrian in a strict pedestrian-liability state, I might have an incentive to wear armor-plated underwear whenever I cross the street – particularly if doing so might spare me some pain and agony, and lower my insurance costs to boot. The task of the legislature, then, is simply to make a judgment as to which behavior is more worth encouraging: getting people to drive with squishy bumpers, or getting people to wear armor plated underpants.

Squishy bumpers and armor plated underpants are the pure essence of what law is.

With that in mind, let’s now return to the question investors should be asking in light of President Obama’s proposed rules. We now see that like all law, a regulation is something that shifts the risk of liability. The next question is this: how?

Under the previous administration, the risk of financial improvidence on the part of banks was born largely by investors who owned shares of banks. In retrospect, it is clear these entities were subject to little oversight and were virtually free to engage in any sort of risk-taking endeavors their managers saw fit. It was up to investors to judge whether this behavior on the part of their companies would produce profits or lead to losses, assuming the investors could even access the requisite information to make that call. Judge Calabressi’s philosophy might be that a law (or lack thereof, which amounts to the same thing) that assigns risk to investors (as opposed to some other party) is irrelevant in one regard: investors can contract around that risk by owning put options on their bank stock, by owning enough shares to enable them to control the board of directors of the bank, or other means. But on another level, assigning risk to investors must influence investor behavior. How? Perhaps by making investors less eager to pay a high multiple for their banking shares. Indeed, during much of the boom years from 2002 through 2007, the share prices for many banks reflected lower price earnings ratios than the overall equities market.

Under the newly proposed rules, risk has been shifted to some degree from investors to, in effect, the public. Regulatory agencies, rather than private investors, will now have the duty to scrutinize bank practices, and a responsibility to oversee behavior amounts to nothing more than an obligation to bear the risk of such behavior. Or more precisely, an obligation to bear the downside risk of such behavior. Here lies the important part of the analysis. The point of regulation is not to reward the regulated entity for “good” behavior – and in that sense, the regulator bears no risk with respect to good behavior on the part of the regulated entity. The point of regulation is to ferret out and punish, and thereby hopefully prevent, “bad” behavior on the part of the regulated entity. Simply put, regulation is nothing more than shifting the downside risk of “bad” behavior to the government. It should be clear that regulation is, in effect, nothing more than a free call option awarded to the party that, prior to the regulation, bore the downside risk of “bad” behavior.

I believe we can recast the question we started with at the beginning of this article. When investors assess President Obama’s newly proposed regulations, they should be asking how the government’s grant of a free call option to investors effect investor behavior? What multiple of earnings would an investor pay for a company’s shares, if the stock came (at least to some extent) with a free call option?

The answer to that question is less complicated than the actual proposed rules themselves.

Disclosures: the author owns shares of J.P. Morgan and Goldman Sachs.

Comments

[William Gamble:]

You might want to research the Coase Theorum. The origin of the Judge's wisdom

Jun 19 09:39 AM

[John Lounsbury:]

The basic trade-off that will determine how investment in banks will perform is (1) the positive effect of reduced shareholder liability vs. (2) the negative effect of regulation on profitability. If (1) dominates, Alex is correct. If (2) dominates......

The question of regulation centers on what is regulated. If risk taking is limited, and that is the popular view of increased regulation, won't the potential for profit be limited? I don't want to argue that reduced risk taking from some of the extremes we have seen in the past 20 years is not a good thing. I do want to argue about how that should be accomplished.

I would argue that allowing too big to fail institutions to exist with "adequate regulation" is the wrong course to follow. I know the argument that size is needed for the efficient operation of globalized business relationships. (That might be debatable, too, but I'll pass on that for now.) But, from a free market purity point of view, how can markets be free when they are controlled by government regulated monopolies?

Alex has made a very good argument. I just think the argument can be extended. One can take the counter argument that would unleash competition, and ultimately, therefore, increase the universe of earnings. The counter argument would say that it is better to ensure too big to fail can not exist rather than allowing these oligarchs to continue with regulation of risk.

Jun 19 10:26 AM

[Alex Trias:]

Guido had his class read Ron Coase's work. If you asked Guido Calabressi, he would absolutely credit Ronald Coase's work as the foundation for his understanding of tort and contracts law.

Wonderful comment. Are you a lawyer, perhaps? Or simply interested in legal theory?


On Jun 19 09:39 AM William Gamble wrote:

> You might want to research the Coase Theorum. The origin of the Judge's
> wisdom

Jun 19 11:30 AM

[Alex Trias:]

Then, John, there is the cynical view. Give me an accounting rule, a tax law, or a bank regulation, and then give me a few greedy young men who know how to think outside the box, and I will show you a way to arbitrage the rule. And then package that arbitrage up and market it, perhaps making a tidy little sum in the process.

I think option number three is that the so-called "financial engineering" industry - the guys who invented special purpose vehicles to arbitrage bankruptcy law, for instance - will be primed to take off like a rocket, with regulations fueling the ascent. If you want to know my true hunch that investment banking will do well going forward, it has everything to do with "new product" development.

Regulations are not simply a call option for shareholders. It is a direct subsidy for law firms and investment banks! Looking at your profile, I believe both of us might know that first hand.

As hard as I try to be a cynic, the closest I can ever come is be a realist.

Let me think through your comment a bit further today. If I can add anything further, I will update my response.

Thanks again.


On Jun 19 10:26 AM John Lounsbury wrote:

> The basic trade-off that will determine how investment in banks will
> perform is (1) the positive effect of reduced shareholder liability
> vs. (2) the negative effect of regulation on profitability. If (1)
> dominates, Alex is correct. If (2) dominates......
>
> The question of regulation centers on what is regulated. If risk
> taking is limited, and that is the popular view of increased regulation,
> won't the potential for profit be limited? I don't want to argue
> that reduced risk taking from some of the extremes we have seen in
> the past 20 years is not a good thing. I do want to argue about
> how that should be accomplished.
>
> I would argue that allowing too big to fail institutions to exist
> with "adequate regulation" is the wrong course to follow. I know
> the argument that size is needed for the efficient operation of globalized
> business relationships. (That might be debatable, too, but I'll
> pass on that for now.) But, from a free market purity point of view,
> how can markets be free when they are controlled by government regulated
> monopolies?
>
> Alex has made a very good argument. I just think the argument can
> be extended. One can take the counter argument that would unleash
> competition, and ultimately, therefore, increase the universe of
> earnings. The counter argument would say that it is better to ensure
> too big to fail can not exist rather than allowing these oligarchs
> to continue with regulation of risk.

Jun 19 11:38 AM

[Alex Trias:]

I just read your profile. It is now only too clear why you are familiar with the Coase Theorum. I certainly appreciate your taking the time to read my article, and to comment on it. Your background is very impressive, to say the least. I will look forward to following your articles, going forward.

Thanks again!


On Jun 19 09:39 AM William Gamble wrote:

> You might want to research the Coase Theorum. The origin of the Judge's
> wisdom

Jun 19 11:45 AM