Repo Markets Across the Atlantic: Similar but Unalike

By Songjiwen Wu (University of Heidelberg) and Hossein Nabilou (Universite du Luxembourg – Faculty of Law, Economics and Finance)

The vulnerabilities in the wholesale funding and in particular short-term (overnight) repurchase agreement (repo) markets were significant sources of systemic risk in the Global Financial Crisis. Numerous studies have investigated the role of repos in the crisis, but only a few scholars have explored why the European repo markets have weathered the crisis better than their US counterparts. With a focus on the underlying legal and structural features of repo markets across the Atlantic, our paper sets out to explain such a different outcome. In doing so, it sketches the key differences in the EU and the US repos by focusing on three main aspects of repo markets that are pivotal to highlighting potential vulnerabilities. First, it highlights the differences in the legal framework governing repos, such as legal construction of repo contracts, special bankruptcy treatment—the reform of which has been a key controversial issue across the Atlantic—and legal treatment of the reuse of collateral. Second, it discusses the composition, structure, and organization of the repo markets, such as differences in the composition of repo participants, maturity of repos, and the composition of the underlying collateral in repo contracts. Finally, it investigates the differences in the issues related to the market infrastructure of repo markets such as differences in the clearing and collateral management stages. The findings of our paper suggest that multiple legal and regulatory divergences, which could still pose challenges to the short-term funding markets, exist in repo markets across the Atlantic.

The full article is available here.


For previous Roundtable posts on repo markets, see Ganduri, “Repo Regret?“, and Morrison, Roe & Sontchi, “Rolling Back the Repo Safe Harbors“.

Bankruptcy Law as a Balancing System – Lessons from a Comparative Analysis of the Interaction Between Labor and Bankruptcy Laws

By Omer Kimhi (Haifa University Faculty of Law) and Arno Doebert (Independent)

The rehabilitation of distressed corporations often requires the reduction of labor costs. In order to regain economic stability, distressed firms need to terminate employees or modify their employment conditions. When employees are protected by statutes or by collective bargaining agreements, however, such measures are not always possible. The employer’s freedom to manage its work force is limited, and it may fail to implement labor reforms necessary for the firm’s recovery.

In the paper, we examine the intersection between bankruptcy and labor laws from a comparative perspective. We study the labor and bankruptcy laws of three different jurisdictions, the Netherlands, France, and Germany, and find a so far unexplored trend. Jurisdictions with high employment protection levels relax their otherwise rigid labor rules through their bankruptcy system. Within bankruptcy, employers enjoy greater flexibility and thus are better situated to decrease their labor costs and to reorganize.

The paper explores this trend vis-à-vis the arguments brought up by the procedural approach to bankruptcy. It looks at the rationale of the bankruptcy-induced modifications to the labor laws, and the effects these changes have on the bankruptcy process. We show that although the modifications are designed to promote the preservation of firms as going concerns, forum-shopping problems may lead to the opposite outcome. The analysis contributes to the ongoing debate between the traditional and procedural approaches, and sheds light on the interpretation of section 1113 of the Bankruptcy Code as well.

The full article is available here.

 

 

 

Valuation Disputes in Corporate Bankruptcy

Kenneth Ayotte (U.C. Berkeley School of Law); Edward R. Morrison (Columbia Law School)

In bankruptcy, valuation drives disputes. Prior bankruptcy scholarship points to disagreements about valuation and judicial valuation error as key drivers of Chapter 11 outcomes. Avoiding valuation disputes and errors is also the underlying driver of most proposed reforms to Chapter 11.

This paper studies all reported bankruptcy court opinions filed between 1990 and mid-2017 that provide detail about a valuation dispute and methodologies employed. We have two goals. The first is to understand how parties and their expert witnesses justify opposing views, and how judges decide between them. The second is to provide practical guidance to judges.

We find sharper disagreement among experts regarding inputs to the discounted cash flow method (DCF) than regarding inputs to multiples-based methods. In nearly half of cases involving DCF, experts fight over the discount rate; in nearly three quarters, they fight over cash flow projections. By contrast, disagreement over inputs to multiples-based methods, such as the choice of comparable companies, occurs in less than a fifth of the cases. This pattern helps explain why many judges view DCF as far more complex and error-prone than multiples-based methods.

There are also surprisingly pervasive (and often self-serving) errors in expert testimony. This is particularly true when valuation experts apply DCF. The choice of discount rates is frequently unsupported by, and often at odds with, finance theory and evidence. We also find experts strategically weighting methods with values most favorable to their clients.

We propose simple strategies based in finance theory that judges can employ to reduce the scope for valuation disagreements in Chapter 11. For example, we argue that courts should reject the use of company-specific risk premia in discount rates and be highly skeptical whenever experts weight some valuation methods more than others in calculating “average” estimated values.

The full article is available here.

 

The Effect of Creditor Rights on Capital Structure, Investment, Profitability, and Risk: Evidence from a Natural Experiment

By Aras Canipek (University of Konstanz), Axel Kind (University of Konstanz; University of Basel; University of St. Gallen), and Sabine Wende (University of Cologne)

Supply-side scholars have argued that laws which mandate managers to leave upon bankruptcy filing and which grant secured creditors strong power to quickly seize their collateralized assets lead to higher recovery rates, lower interest costs, and relaxed financial constraints, and that these consequences ultimately foster economic growth. In contrast, a more recent demand-side view raises the concern that borrowers can feel threatened by such liquidation-oriented regimes. Threatened borrowers may take (economically undesirable) actions to reduce the likelihood of having to bear high distress costs.

We find evidence in favor of the demand-side view by using Germany’s bankruptcy reform (ESUG) of 2012 and studying the causal effects of an exogenous downward shock to creditor rights on firms’ financial and investment policy. ESUG limited the rights of secured creditors by strongly facilitating firm continuation and allowing the manager to stay in unrestricted corporate control. In the study, we show that high-tangible-asset companies – which the reform predominantly affected – turned away from being overly risk-averse at the cost of profitability, relative to low-tangibility control firms. Specifically, weaker creditor rights motivated affected firms to increase financial leverage and to prefer the more flexible unsecured debt. Moreover, affected firms reduced unprofitable but risk-lowering expansions and sold off less profitable but easily-marketable assets that are useful in downturns by providing the liquidity that can prevent bankruptcy. Our results suggest that weaker creditor rights encourage firms to eliminate protection mechanisms formerly constructed to contract around liquidation-oriented bankruptcy provisions. This view is supported by the increased profitability and higher risk of treated firms after the reform.

The stronger pre-ESUG creditor rights not only produced ex post deadweight losses in terms of inefficient liquidation, but also discouraged firms to make profitable investment decisions. This reveals ex ante inefficiencies of creditor rights, an aspect largely ignored in the extant literature.

The article can be found here.

Beyond Common Equity: The Influence of Secondary Capital on Bank Insolvency Risk

By Thomas Conlon (University College Dublin), John Cotter (University College Dublin; UCLA Anderson School of Management); Philip Molyneux (University of Sharjah – College of Business Administration)

Prudential regulation requires banks to hold capital as a buffer in the event of losses and as a means to mitigate risk shifting by shareholders. Under capital regulation, a large menu of securities is permitted to contribute to regulatory capital. While previous studies have predominantly concentrated on the relationship between bank risks and narrow capital measures (such as tier 1 capital or equity capital), we further develop this work by looking at a broader menu of capital components. We examine bank insolvency risk (distance to default) for listed North American and European banks over the period from 2002 to 2014, with a focus on sensitivity to capital other than common equity. Decomposing tier 1 capital into equity and non-core components reveals a heretofore unidentified variation in risk reduction capacity. Greater non-core tier 1 capital is associated with increased insolvency risk for larger and more diversified banks, impairing the risk reducing capacity of aggregate tier 1 capital. Overall, tier 2 capital is not linked with insolvency risk, although a conflicting relationship is isolated conditional on the level of total regulatory capital held. Finally, the association between risk and capital is weakened when the latter is defined relative to risk-weighted assets.

The full article is available here.