Secured Transactions and Financial Stability: Regulatory Challenges

By Steven L. Schwarcz (Duke University School of Law)

Secured transactions traditionally are regulated to protect transacting parties and to increase transactional efficiency. This essay argues they should also be regulated to protect the stability of the financial system. This raises numerous challenges.

In our increasingly complex financial system, for example, regulation to control moral hazard in the originate-to-distribute model of secured loan origination faces the challenge that the relevant market failure is less likely to be asymmetric information than mutual misinformation—neither the originator (i.e., seller) of the loans nor the buyer may fully understand the risks. Non-traditional secured transactions, including securitization and other forms of structured finance, exacerbate the challenges of complexity and the limits of disclosure.

The regulation of collateralization levels and interconnectedness faces fundamentally different challenges than those underlying the (technically) analogous post-Depression regulation of “margin” lending to acquire publicly traded stock. The Fed’s Regulation U then required that stock pledged as collateral be worth at least twice the loan amount. Requiring overcollateralization of home-mortgage lending, however, could be highly regressive.

The potential for the widening gap between the rich and the poor to undermine stability also raises the challenge of whether to recognize de facto rights, in order to enable the poor to use their homes as collateral to raise capital. This challenge is itself partly informed by the Uniform Commercial Code’s innovative disentanglement of commercial and property law, which articulates the former to reflect commercial realities rather than the arbitrary shifting of rights based on property. Innovating secured transactions law to recognize those de facto rights could help to unlock a worldwide entrepreneurial potential.

The full paper can be found here.