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December 3, 2012 By wpengine

Shale Gas Development: The Implications of the Shale Gas Revolution for the Natural Gas Industry

Mark R. Haskell * and Levi McAllister ^†

In the last ten years, new extraction techniques including hydraulic fracturing promise to expand domestic natural gas production substantially.[1] Shale gas is currently estimated to account for approximately twenty-five percent of domestic natural gas production.[2]

Shale gas has the potential to create new producing regions,[3] but it requires the creation of new infrastructure or the redesign and redeployment of existing infrastructure to access markets.[4] Shale gas also carries with it the potential for the transformative disruption of existing supply and transportation networks.[5]

This article explores some of the implications of the “shale gas revolution.” As explained below, the development of hydraulic fracturing and the production of shale gas fields promise to change the domestic and global natural gas industry in several ways. Due to the increased access to domestic gas resources through shale gas production, the price that gas marketers can receive for the sale of dry natural gas has been declining, which has prompted many marketers to focus increased attention to marketing natural gas globally through natural gas exports. [6] Due to the geographic location of shale gas fields, the historical relationship between natural gas basis differentials is changing, and a need for the construction of new natural gas infrastructure (or the realignment of existing infrastructure) is becoming apparent.[7]

A. Volatility in Natural Gas Prices

In 2009, as natural gas producers began to produce shale gas by applying hydraulic fracturing extraction techniques, natural gas prices rapidly declined.[8] According to the Energy Information Administration, natural gas prices in the first seven months of 2012 are 70.3% lower than the average annual wellhead price of 2008.[9]

Natural gas now appears to be plentiful and abundant.[10] Utilities, manufacturers and other end users are looking at record low prices.[11] Further, the petrochemicals industry has seen a revival, which is driven in large part by the record low gas prices resulting from the abundance of shale production.[12]

However, the downtrend in natural gas pricing has also been a cause for concern for production companies. Some production companies may have entered into leasing arrangements prior to 2009 when gas prices were at record highs.[13] With low gas prices, many shale gas developers are facing financial challenges, and production companies are finding it unprofitable to pursue shale gas production.[14] As Maynard Holt, co-president of Tudor Pickering Holt & Company reportedly said, “[w]e just killed more meat than we could drag back to the cave and eat.”[15] Declining prices can inhibit investment in infrastructure and cause the delay or deferral of drilling programs. Low prices have caused some industry participants to divert investment from shale formations producing dry natural gas into natural gas liquids.[16]

B. Renewed Interest in Natural Gas Exports

Increased supplies of natural gas resources coupled with declining domestic natural gas prices has created a separate, but related, issue with respect to shale gas development: the possibility of exporting natural gas.[17] Prior to the shale gas revolution, the United States was historically an importer of natural gas.[18] However, that perspective could be changing.

Natural gas may be exported in liquid form if the necessary infrastructure is developed and the required regulatory approvals are obtained. The process of exporting natural gas first requires the gas to be cooled in order to become liquefied natural gas (LNG), which is then pumped into natural gas tankers that are used to ship the LNG overseas.[19] Currently, however, the United States only has one operational processing plant that is able to liquefy gas and load it into such tankers.[20] That facility, the Kenai LNG Plant, is located in Nikiski, Alaska and currently exports LNG to Asia.[21]

The decreased availability of nuclear power post-Fukushima has contributed to an international interest in LNG.[22] To tap into that market, industry participants must first obtain the necessary regulatory approvals required to develop the infrastructure and export natural gas.[23] Federal law requires that approval be obtained from the Department of Energy (DOE) prior to exporting natural gas.[24] The authorization necessary to export depends on the country to which the gas will be exported. For example, the DOE possesses no discretion to deny an export application if the natural gas is to be exported to a country with which the United States has a Free Trade Agreement (FTA).[25] In contrast, the DOE performs a broader review of an export application if the natural gas is to be exported to a country with which the United States does not have a FTA.[26]

About a dozen applications seeking authorization to export LNG to non-FTA countries are currently pending before the DOE.[27] Companies seeking export authorization have argued to DOE that exports would lead to more jobs in the United States, and the revenues would help reduce the trade deficit.[28] Despite such possible benefits, the DOE has stated that it will not make any further decision on whether or not to approve such applications until it conducts an analysis into the economic impact of LNG exports.[29] The DOE has been commissioned to examine that impact, and an initial report was anticipated to have been issued in March 2012.[30] The report continues to be delayed.[31]

C. A Shift in Basis Relationships

The shale revolution affects not only the absolute level of natural gas prices but the relative locational value of natural gas in local markets. In other words, shale gas development disrupts historical basis relationships.

The term “basis differential” refers to the difference between daily natural gas spot prices at regional hubs compared to the Henry Hub.[32] A large sustained basis demonstrates an opportunity to profitably construct a pipeline. Such differentials can occur due to congestion and bottlenecks between markets, which could be attributed to insufficient supply in a particular market.

Because the majority of domestic natural gas supply originated in the Gulf Coast region, obtaining natural gas in the Northeastern United States, for example, required transporting gas to that region from the Gulf Coast.[33] The price for natural gas in the Northeast United States would often be higher than the price for that same gas in the Gulf Coast region, reflecting, among other things, the cost of transportation and related services.[34] In turn, the basis differential with respect to a Northeastern hub would differ from a differential with respect to a Gulf Coast hub.

The shale revolution changes these historical basis relationships. Significant shale gas resources are located in geographic locations that have not been accustomed to producing natural gas.[35] North Dakota, Michigan, New York, Pennsylvania, Ohio, and West Virginia all hold significant amounts of natural gas that could be extracted through hydraulic fracturing.[36]

Recall that a large sustained basis differential demonstrates an opportunity to profitably construct a pipeline. As basis differentials shift, geographic regions where bottlenecks and/or constraints exist will also shift. [37] As a result, it may no longer be as profitable for a developer to construct a pipeline in a particular location. Instead, new strategies must be considered in light of the changing relationship among differentials.

D. Infrastructure Development

The production of natural gas resources from shale plays affects the development of natural gas infrastructure in the United States. These implications concern both the need for new infrastructure in certain regions as well as impact on existing infrastructure with respect to the recovery of its costs.

In order to efficiently utilize natural gas extracted from shale plays, the necessary infrastructure must exist. This includes sufficient pipeline capacity to transport the extracted gas to a processing facility, processing facilities to process that gas, and pipeline capacity to transport processed gas to the market.[38] In many plays, this infrastructure has not yet materialized.

For example, Ohio is currently struggling with how to address such challenges with respect to the gas available for extraction from the Utica shale play. [39] Since December 2009, over 320 drilling permits have been issued by the Ohio Department of Natural Resources.[40] However, only slightly more than 110 wells have been drilled and, of those, only fourteen are currently producing natural gas or oil.[41] A lack of processing plants and pipelines has been cited as one of the reasons that production is not rapidly increasing.[42]

The development of new infrastructure comes with its own set of challenges. Depending on the proposal, state and perhaps federal regulatory approvals are required from the applicable regulator.[43] Those approvals relate to, among other things, the siting of the proposed project, an inquiry into whether the public interest requires the proposed project and, whether environmental risks warrant rejection of the proposed project.[44] Collectively, obtaining all required approvals and constructing a project is a time-intensive process that can take several years before the requisite infrastructure becomes operational.

Aside from new infrastructure development, the shale gas revolution creates challenges for existing infrastructure owners and developers. Because natural gas supplies historically originated in the Gulf Coast region, natural gas was delivered to markets through interstate transportation pipelines.[45] Those pipelines, and the rates that they charge shippers of natural gas on their systems, are regulated by the Federal Energy Regulatory Commission (FERC).[46] The FERC employs a cost-of-service rate design approach whereby a natural gas pipeline is permitted to recover the cost of providing service plus a reasonable return on its investment.[47] As a result, the rates a natural gas shipper pays depend on the cost the pipeline incurs to provide transportation services. As shale gas production increases in geographic regions that historically received gas supplies by interstate transport, those regions will require that less gas be transported via interstate pipelines originating in the Gulf Coast. In turn, owners of existing interstate pipelines could have lower demand for long-haul capacity over time. Changes in usage patterns could in theory change existing pipeline rate structures and lead to the adoption of new rate zones or new rate designs. These changes will pose challenges for pipelines and customers alike and affect depreciation of existing facilities, and increase competition between pipeline primary service offerings and the secondary market for released capacity.

E. Conclusion

Shale gas production has been heralded as a positive development by many.[48] The existence of previously unanticipated natural gas resources in areas that historically have not been hotbeds for natural gas production creates jobs for those regions and provide financial injections into local economies.[49] Similarly, increased natural gas supplies have resulted in lower natural gas prices for consumers of that gas.[50]

The long-term effective and efficient development of shale gas resources carries with it both opportunity and significant risk. Pipelines, pipeline customers, consumers, and marketers will be coping with the consequences of this fundamental shift in supply conditions over the coming years.

We are in midst of a significant transition of the domestic natural gas industry. Will natural gas development continue at current levels given depressed pricing conditions? Will regulators facilitate the development of a truly international market for natural gas by approving LNG export projects? How do changes in basis differentials interact with the need for infrastructure development? How will the costs of infrastructure idled by new sources of production be paid? Only when some of these questions are answered can we realistically assess the true impacts of the shale revolution.

Preferred Citation: Mark R. Haskell & Levi McAllister, Shale Gas Development: The Implications of the Shale Gas Revolution for the Natural Gas Industry, 3 Harv. Bus. L. Rev. Online 33 (2012), https://journals.law.harvard.edu/hblr//?p=2611.

* Mark R. Haskell is a Partner with the law firm of Morgan, Lewis & Bockius in Washington, DC. He is a 1982 graduate of the University of Maine and a 1985 graduate of Harvard Law School. His practice has focused primarily on regulatory compliance, enforcement, litigation, and dispute resolution affecting market participants in the natural gas, oil, petrochemical, and electric industries. The views expressed in this article are those of the authors alone and do not necessarily reflect those of the authors’ law firm or its clients. The authors and their firm represent, among other clients, natural gas producers and marketers, local distribution companies, end-users, and one developer of an LNG export terminal project.

† Levi McAllister is an Associate with the law firm of Morgan, Lewis & Bockius in Washington, DC. He is a 2003 graduate of the University of Texas at Austin and a 2008 graduate of American University’s Washington College of Law.

[1] Elisabeth Rosenthal, U.S. Is Forecast to Be No. 1 Oil Producer, N.Y. Times, Nov. 13, 2012, at B6, available at http://www.nytimes.com/2012/11/13/business/energy-environment/report-sees-us-as-top-oil-producer-in-5-years.html?ref=us.

[2] Deloitte Ctr. for Energy Solutions, Public Opinions on Shale Gas Development 1 (2012), available at http://www.deloitte.com/assets/Dcom-UnitedStates/Local%20Assets/Documents/Energy_us_er/us_er_ShaleSurveypaper_0412.PDF.

[3] See Deloitte MarketPoint LLC & Deloitte Ctr. for Energy Solutions, Made in America: The Economic Impact of LNG Exports from the United States 6 (2011), available at http://www.deloitte.com/assets/Dcom-UnitedStates/Local%20Assets/Documents/Energy_us_er/us_er_MadeinAmerica_LNGPaper_122011.pdf [hereinafter Deloitte, Made in America].

[4] See David L. Goldwyn, Making an Energy Boom Work for the U.S., N.Y. Times, Nov. 12, 2012, http://www.nytimes.com/2012/11/13/business/energy-environment/making-an-energy-boom-work-for-us.html?pagewanted=all.

[5] See Deloitte, Made in America, supra note 3.

[6] Daniel Gilbert & Tom Fowler, Natural Gas Glut Pushes Exports, Wall St. J., Oct. 5, 2012, at A1, available at http://online.wsj.com/article/SB10000872396390444223104578036403362012318.html.

[7] See Deloitte, Made in America, supra note 3.

[8] Matthew Philips, Is Natural Price Too Cheap to Drill?, Bloomberg Businessweek, Apr. 17, 2012, http://www.businessweek.com/articles/2012-04-17/is-natural-gas-too-cheap-to-drill.

[9] See Energy Info. Admin., U.S. Dep’t of Energy, Monthly Energy Review Nov. 2012 131 tbl. 9.10 (Nov. 2012), available at http://www.eia.gov/totalenergy/data/monthly/pdf/mer.pdf. Table 9.10 provides the annual average wellhead price of natural gas since 1973 through 2009. Id. Table 9.10 also provides the average wellhead price of natural gas for each month during 2010, 2011 and the first seven months of 2012. Id. In 2008, the average wellhead price of natural gas was $7.97. Id. In contrast, the average wellhead price of natural gas for the first seven months of 2012 was $2.37. Id.

[10] Gilbert & Fowler, supra note 6.

[11] Id.

[12] See Molly Ryan, Houston Sees Resurgence in Manufacturing Due to Petrochemical Rebirth, Hous. Bus. J., July 27, 2012, http://www.bizjournals.com/houston/print-edition/2012/07/27/petrochemical-rebirth.html?page=all.

[13] See Clifford Krauss & Eric Lipton, After the Boom in Natural Gas, N.Y. Times, Oct. 20, 2012, at BU1, available at http://www.nytimes.com/2012/10/21/business/energy-environment/in-a-natural-gas-glut-big-winners-and-losers.html?pagewanted=all.

[14] See id.

[15] Id.

[16] Valerie Wood, Natural Gas Price Picture May Change by Late 2012, Pipeline & Gas J., Sept. 2011, at 16.

[17] Gilbert & Fowler, supra note 6.

[18] Id.

[19] See, e.g., Rebecca Smith & Mari Iwata, Japanese Buyers Line Up for U.S. Shale Gas, Wall St. J., May 24, 2012, at B8, available at http://online.wsj.com/article/SB10001424052702303505504577406061245167558.html (describing export process, which requires cooling and liquefying gas before loading it onto tankers).

[20] Yereth Rosen, ConocoPhillips Restarts LNG Exports from Alaska, Reuters, June 14, 2012, available at http://www.reuters.com/article/2012/06/14/us-conoco-lng-idUSBRE85D06C20120614.

[21] Id.

[22] See Smith & Iwata, supra note 19.

[23] See id.

[24] 15 U.S.C. § 717b (2006).

[25] See U.S. Dep’t of Energy, Fossil Energy: How to Apply, Energy.gov, http://www.fossil.energy.gov/programs/gasregulation/How_to_Obtain_Authorization_to_Import_an.html (last updated Nov. 6, 2012).

[26] See id.

[27] Office of Oil & Gas Global Sec. & Supply, Office of Fossil Energy, U.S. Dep’t of Energy, Applications Received by DOE/FE to Export Domestically Produced LNG from the Lower-48 States (as of Nov. 29 2012), http://fossil.energy.gov/programs/gasregulation/reports/Long%20Term%20LNG%20Export%20Concise%20Summary%20Table%2011-29-12.nwood.pdf.

[28] See, e.g., LNG Development Company, LLC; Application for Long-Term Authorization To Export Liquefied Natural Gas Produced From Canadian and Domestic Natural Gas Resources to Non-Free Trade Agreement Countries for a 25-Year Period, 77 Fed. Reg. 55,197-02, 55,198 (Sept. 7, 2012) (describing creation of new construction jobs and projected reduction in trade deficit).

[29] See Susan L. Sakmar, Politics and US LNG Export Project Heat Up, Nat. Gas & Electricity J., Oct. 2012, at 1, available at http://www.naturalgaselectricitynews.com/sample-articles/politics-and-us-lng-export-projects-heat-up.aspx.

[30] U.S. Government Further Delays LNG Export Decision, ICIS Heren (Mar. 30, 2012, 10:51 AM), http://www.icis.com/heren/articles/2012/03/30/9546199/us-government-further-delays-lng-export-decision.html.

[31] Id.

[32] See, e.g., Deloitte, Made in America, supra note 3, at 15 (describing differential between Henry Hub and New York City prices).

[33] See id. at 6.

[34] Id. at 13.

[35] See, e.g., John A. Sullivan, Thanks to Bakken, North Dakota Could Surpass California Output, Nat. Gas. Wk., May 31, 2010, at 8, available at 2010 WLNR 12262297 (describing North Dakota’s rising production of Bakken shale gas).

[36] Id.See also Ben Casselman & Russell Gold, Cheap Natural Gas Gives Hope to Rust Belt, Wall St. J., Oct. 24, 2012, http://online.wsj.com/article/SB10000872396390444549204578020602281237088.html.

[37] See Deloitte Ctr. for Energy Solutions & Deloitte MarketPoint LLC, Navigating a Fractured Future Insights into the Future of the North American Natural Gas Market 14 (2011), available at http://www.usea.org/sites/default/files/event-file/511/Natural_Gas_Study_Presentation_for_USEA.pdf.

[38] See Liam Denning, Pipe Dreams in America’s New Energy Landscape, Wall St. J., July 30, 2011, http://online.wsj.com/article/SB10001424053111904800304576476154127256730.html.

[39] Jeff Bell, Ohio’s Shale Play Delayed by Infrastructure Needs, Columbus Bus. First, Aug. 10, 2012, http://www.bizjournals.com/columbus/print-edition/2012/08/10/infrastructure-needs-delay-drilling-in.html?page=all.

[40] Id.

[41] Id.

[42] Id.

[43] See, e.g., Regulations Implementing the Energy Policy Act of 2005: Coordinating the Processing of Federal Authorizations for Applications Under Sections 3 and 7 of the Natural Gas Act and Maintaining a Complete Consolidated Record, 71 Fed. Reg. 30632-01 (proposed May 30, 2006) (to be codified in 18 C.F.R. pt. 153, 157, 375, 385) (describing collaboration necessary to harmonize regulatory requirements in natural gas projects).

[44] See Jeremy Knee, Rational Electricity Regulation: Environmental Impacts and the “Public Interest,” 113 W. Va. L. Rev. 739, 758 (2011).

[45] See Deloitte, Made in America, supra note 3, at 6, 13.

[46] Fed. Energy Regulatory Comm’n, What FERC Does, http://www.ferc.gov/about/ferc-does.asp (last visited Nov. 13, 2012).

[47] See Knee, supra note 44, at 747.

[48] See, e.g., Jim Efstathiou Jr., Fracking Will Support 1.7 Million Jobs, Study Shows, Bloomberg Businessweek, Oct. 23, 2012, http://www.businessweek.com/news/2012-10-23/fracking-will-support-1-dot-7-million-jobs-study-shows (describing President Obama’s support of hydraulic fracturing to increase jobs in the United States).

[49] Id.

[50] Gilbert & Fowler, supra note 6.

November 24, 2012 By wpengine

America’s Natural Gas: From Shale Gas to LNG Exports

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Susan L. Sakmar^*

According to the U.S. Energy Information Administration’s (EIA) Annual Energy Outlook 2012, U.S. natural gas production is expected to increase almost twenty-nine percent from 21.6 trillion cubic feet in 2010 to 27.9 trillion cubic feet in 2035. Almost all of the increase is due to the projected growth in shale gas production, which is expected to account for forty-nine percent of total U.S. natural gas production in 2035, more than double its twenty-three percent share in 2010.

Figure 1: U.S. Natural Gas Production 1990-2035 (in trillions of cubic feet)^{^[1]}

Much has been written about shale gas being either an “energy game changer” or an environmental hazard depending on whom you ask. In contrast, far less attention has been focused on whether the U.S. should export its newfound abundance of shale gas as liquefied natural gas (LNG)^{^[2]} to foreign countries.

Overview of the U.S. Regulatory Approval Process for U.S. LNG Exports

At the outset, it is important to note that under existing U.S. law, export applications to export to most free trade agreement (FTA) countries are deemed to be in the public interest and such applications are quickly authorized by the Department of Energy, Office of Fossil Energy (DOE/FE).^{^[3]} Most, though not all,^{^[4]} countries that have an FTA with the U.S. require national treatment for trade in  natural gas, including Australia, Bahrain, Canada, Chile, Colombia, Dominican Republic, El Salvador, Guatemala, Honduras, Jordan, Mexico, Morocco, Nicaragua, Oman, Peru, Republic of Korea and Singapore.^{^[5]} In addition, the U.S. has ratified a FTA that requires national treatment for trade in natural gas with Panama, which has not taken effect as of May 15, 2012.^{^[6]}

With the exception of the Republic of Korea, most of the FTA countries are not likely to be significant importers of natural gas so the real prize for a company is the authorization to export natural gas to any country, which the DOE/FE refers to as “non-FTA” countries. Applications for export authorization to non-FTA countries involve greater scrutiny and require a determination of whether the proposed exports are in the “public interest.” In evaluating whether a proposed export is within the public interest, the DOE/FE applies certain Policy Guidelines issued in 1984 that focus the analysis on:^{^[7]}

The domestic need for the natural gas proposed to be exported;
Whether there is a threat to the domestic security of supply; and
Other factors to the extent they are shown to be relevant to a public interest determination.

Politics and Pending LNG Export Applications

In August 2012, a bipartisan group of lawmakers, including ten Democrats and thirty-four Republicans from Texas, Louisiana, Arkansas, and Oklahoma increased pressure on the Obama administration to speed up DOE/FE approval for a number of pending LNG export applications. In a letter to Energy Secretary Steven Chu, the lawmakers pointed out that the DOE/FE “does not seem to have a set timeline for decisions or a sense of urgency,” which has left a growing number of companies and projects waiting in limbo.^{^[8]}

Table 1: Applications Received by DOE/FE to Export Domestically Produced LNG from the Lower-48 States (as of October 26, 2012)^{^[9]}

But, in an election year, it seems that politics dominates everything and the prospect of exporting U.S. LNG has increasingly become a political hot button. The political debate over whether the U.S. should export LNG began to mount last fall when concerns were raised that allowing LNG exports would lead to an increase in the domestic price of natural gas.^{^[10]} Exports are one of many factors that can have a bearing on the price of domestic gas, since they represent an additional source of demand. At the same time, over the long run, an increase in demand also tends to increase supply. The extent to which the price of natural gas interacts with its supply and demand has been a cause of much speculation in the U.S., leading to a U.S. Senate hearing in November 2011 to address the issues raised by the possibility of U.S. LNG exports.^{^[11]}

Chairman Bingaman noted in his opening remarks that the last time the Senate held a hearing on LNG was in 2005, when the U.S. anticipated the need to import growing quantities of LNG, whereas the current hearing was meant to discuss the role that LNG exports might play in the energy future of the U.S..^{^[12]} There were two main objectives of the Senate hearing.^{^[13]} The first was to understand the laws and regulations that govern LNG exports generally since those laws were put into place assuming the United States would be an importing country, not an exporting country.^{^[14]}

The second objective was to understand how LNG exports might affect the domestic market for natural gas.^{^[15]} While the implications of increased gas exports for U.S. job creation and balance of payments could be very positive, Chairman Bingaman also noted that U.S. energy security requires reliable and affordable energy prices, not just reliable supply.^{^[16]} Since U.S. gas prices are considerably lower than prices than those in much of the world, Chairman Bingaman questioned how the U.S. could “ensure that our export policy is consistent with our continued ability to reap the benefits of our newfound abundance of natural gas?”^{^[17]}

The Impact of U.S. LNG Exports on U.S. Natural Gas Prices

At the Senate Subcommittee hearing, several Senators expressed concern about the impact LNG exports could have on domestic natural gas prices, including U.S. Senator Ron Wyden (D-OR) who noted,

[I]t’s very understandable why North American natural gas producers would want to build LNG export terminals so they can sell natural gas to Asia and other overseas markets at four or five times the prices here. What’s less clear is how this is going to be beneficial for our businesses and our consumers who are going to have to compete with these prices? [sic]^{^[18]}

In response to questions about the price increase that DOE/FE would find acceptable, the DOE/FE acknowledged the analysis was complicated and when the DOE/FE makes a public interest determination, it considers a range of factors such as the impact on jobs, balance of trade, and the impact on price.^{^[19]} Since some of the factors are influenced by price itself, the DOE/FE explicitly recognized the importance that price holds.^{^[20]}

In order to address the potential cumulative impact of granting the pending export applications, the DOE/FE indicated that it had commissioned two pricing studies that, taken together, “will address the impacts of additional natural gas exports on domestic energy consumption, production, and prices, as well as the cumulative impact on the U.S. economy, including the effect on gross domestic product, jobs creation, and balance of trade, among other factors.”^{^[21]}

What Do The Pricing Studies Show?

In January 2012, the U.S. EIA released the first pricing study analyzing the impact of U.S. LNG exports on the domestic energy market.^{^[22]} As requested by the DOE/FE, the EIA’s study reviewed the impact of specified scenarios of natural gas exports on U.S. energy markets, focusing on consumption, production, and prices.^{^[23]} The study was not intended to give an estimate of what LNG exports would likely be in the future, but to assume that the levels of exports would be either six billion cubic feet per day (Bcf/d) or twelve Bcf/d, discounting other possible scenarios.^{^[24]} In summary, the U.S. EIA concluded that, “increased natural gas exports lead to higher domestic natural gas prices, increased domestic natural gas production, reduced domestic natural gas consumption, and increased natural gas imports from Canada via pipeline.”^{^[25]}

On the issue of the impact of exports on U.S. natural gas prices, the EIA noted that U.S. natural gas prices are expected to increase even before considering the possibility of additional exports.^{^[26]}Nonetheless, increased natural gas exports are expected to lead to higher domestic natural gas prices, although the precise amount depends on the ultimate level of exports and the rate of phasing in increased exports.^{^[27]} For example, under the low-slow scenario, it is assumed that six Bcf/d of exports are phased in at a rate of one Bcf/d per year over six years.^{^[28]} Under this scenario, the wellhead price impacts peak at about 14% ($0.70/Mcf) in 2022, but the wellhead price differential falls below 10% by about 2026.^{^[29]} Although the impact of LNG exports varies depending on the assumptions about resource availability and economic growth, the basic assumption remains the same: “higher export levels would lead to higher prices, rapid increases in exports would lead to sharp price increases, and slower export increases would lead to slower but more lasting price increases.”^{^[30]}

In contrast to the potentially severe impacts on price found in the EIA study, an independent assessment done by Deloitte MarketPoint LLC found that any price increase resulting from U.S. LNG exports would be quite minimal.^{^[31]}

In May 2012, the Brookings Institution released a report analyzing the various pricing studies that have been conducted so far on the impact of U.S. LNG exports on the domestic price of natural gas.^{^[32]}

Table 2: Study-by-study comparison of the Average price Impact from 2015-2035 of 6 bcf/day of LNG exports (unless otherwise noted)^{^[33]}

* Price impact figure for EIA study reflects the reference case, low-slow export scenario.

** The Navigant study did not analyze exports of 6 bcf/day.

*** Navigant (2010 and 2012) and ICF International studies are based on Henry Hub price.

As indicated by the Brookings analysis, while the exact pricing impact of U.S. LNG exports is unclear, there is some consensus that LNG exports will lead to an increase in the domestic price of natural gas.^{^[34]} The impact of such price movements on U.S. energy policy and regulatory framework is unclear. Brookings advocates for the approval of export applications assuming that the nature of the LNG sector (in terms of the costs associated with producing, processing, and shipping the gas) and the global market in which it will compete, will place upper bounds on the amount of LNG that will be economically advantageous to export from the U.S.^{^[35]}

Pending Congressional Bills to Limit LNG Exports

While the delay in the DOE approval process for pending LNG export applications has caused market uncertainty for projects awaiting approval, it has also allowed more time for other opponents to voice concerns about the impact of U.S. LNG exports. For example, U.S. Representative Ed Markey (D-Mass.) has introduced two bills in Congress with the stated purpose of protecting U.S. consumers from increased natural gas prices and ensuring that America’s natural gas stays in America.^{^[36]} The first bill, the “North America Natural Gas Security and Consumer Protection Act”^{^[37]} would preclude the Federal Energy Regulatory Commission from approving new LNG export terminals. The second bill, the “Keep American Natural Gas Here Act,”^{^[38]} would require natural gas extracted from federal lands to be resold only to American consumers. Subsequent to the approval of Cheniere’s Sabine Pass project, Congressman Markey issued a press release continuing to express his concern that U.S. LNG exports would increase domestic prices for natural gas, harming individual and industrial users of natural gas.^{^[39]}

Congressman Markey is not alone in his view that “America should exploit her competitive advantage with lower natural gas prices to create jobs in the United States.”^{^[40]} Leaders from other industries have called on the U.S. to use its cheap natural gas to convert to products for export, as opposed to exporting the natural resource itself. For example, the CEO of Dow Chemical has argued that U.S. LNG exports should be limited since there is up to eight times more value in using America’s abundant and cheap natural gas as the raw material to create high-value products that can be exported, as opposed to simply exporting the natural gas itself.^{^[41]}

Will Environmental Opposition to Shale Gas Development Hinder LNG Exports?

In additional to political opposition to U.S. LNG exports, there is some risk that environmental opposition to shale gas development will spill over into opposition to U.S. LNG exports. For example, the Sierra Club has opposed a number of LNG export projects and has argued that the environmental impacts associated with natural gas production must also be considered in determining whether U.S. LNG exports are in the “public’s interest.”^{^[42]} While the Sierra Club contends that all environmental impacts from natural gas production need to be considered, their brief highlighted particular environmental concerns pertaining to hydraulic fracturing and shale gas development.^{^[43]} In summary, the Sierra Club maintains that DOE’s approval for LNG exports could have “major environmental impacts through the [United States], and especially in the Northeast, where [U.S. LNG exports] will intensify Marcellus Shale extraction activities.”^{^[44]}

The Sierra Club’s opposition to LNG export projects coincides with its intensified effort to ensure that, as coal fired power plants are retired, they are not replaced with natural gas power plants.^{^[45]} To that end, the Sierra Club recently announced that it is launching a new “Beyond Gas” campaign that represents a significant expansion of the group’s on-going efforts against other major fossil fuels and is modeled after the decade-old “Beyond Coal” campaign that sought to phase out coal fired power plants.^{^[46]} According to the Sierra Club, it will seek to “prevent new gas plants from being built wherever we can.”^{^[47]}

It remains to be seen whether the environmental opposition to U.S. LNG exports will intensify. However, some reports have acknowledged that since the case for U.S. LNG exports depends on the continued development of shale gas, the public’s concerns over the environmental impacts of shale gas development must be resolved.^{^[48]}

Will Political Pressure Spur Action on Pending Export Applications?

Some policymakers and business leaders have urged the U.S. to approve the export licenses and have expressed the view that the market should dictate whether U.S. LNG exports happen or not.^{^[49]} For example, at the November 2011 Senate hearing, Senator Lisa Murkowski (R-Alaska), indicated she is inclined to let the market sort out the issue and stated that “our proper course won’t be sweeping legislation or layers of new regulation. Instead, it will be to ensure a degree of comfort that our newfound energy security can be maintained under current export rules.”^{^[50]}

The DOE/FE appears to be in no hurry to decide the pending export applications or release a much-anticipated second study addressing the economic impacts of LNG exports, which was originally expected in early 2012, but is now delayed until sometime later in 2012.^{^[51]} Moreover, DOE/FE recently posted an update on its website indicating that the economic impacts study will be open to public comment which will likely result in additional delays.^{^[52]} In the meantime, it is open to debate whether U.S. LNG exports are in the “public’s interest” or not.

Preferred Citation: Susan L. Sakmar, America’s Natural Gas: From Shale Gas to LNG Exports, 3 Harv. Bus. L. Rev. Online 22 (2012), https://journals.law.harvard.edu/hblr//?p=2572.

* Visiting Assistant Professor and Andrews Kurth Energy Law Scholar, University of Houston Law Center; Adjunct Professor, University of San Francisco School of Law; licensed attorney in State of California.

[1] U.S. Energy Info. Admin., Annual Energy Outlook 2012 (Early Release) fig. 2 (Jan. 2012), available at http://www.eia.gov/forecasts/aeo/er/pdf/0383er%282012%29.pdf.

[2] LNG is natural gas that has been cooled until it reaches a liquid state, which then allows it to be transported. LNG is usually shipped on special LNG tankers but it can also be transported via truck or container.

[3] 15 U.S.C. § 717b (2006).

[4] For example, Costa Rica and Israel do not require national treatment for trade in natural gas. U.S. Dep’t of Energy, How to Obtain Authorization to Import and/or Export Natural Gas and LNG (Sept. 26, 2012), http://www.fossil.energy.gov/programs/gasregulation/How_to_Obtain_Authorization_to_Import_an.html.

[5] Id.

[6] Id.

[7] Policy Guidelines and Delegation Orders Relating to the Regulation of Imported Natural Gas, 49 Fed. Reg. 6,684 (Feb. 22, 1984).

[8] Letter from James Lankford, U.S. Rep., et al., to Steven Chu, Sec’y, Dep’t of Energy (Aug. 7, 2012), http://lankford.house.gov/sites/lankford.house.gov/files/Sec%20Chu%20LNG%20Export%20Suppport%20Letter%20TX%20OK%20LA%20AR0001.pdf.

[9] Office of Oil and Gas Global Sec. and Supply, Office of Fossil Energy, U.S. Dep’t of Energy, Applications Received by DOE/FE to Export Domestically Produced LNG from the Lower-48 States (as of Oct. 26, 2012), http://www.fossil.energy.gov/programs/gasregulation/reports/Long_Term_LNG_Export_10-26-12.pdf.

[10] See, e.g., Benjamin Lefebvre, Should the U.S. Export Natural Gas?, Wall St. J., Sept. 16, 2012, at R10, available at http://online.wsj.com/article/SB10000872396390444226904577561300198957854.html (featuring debate on potential price increases by two energy analysts).

[11] LNG Export Approvals, Market Impact: Hearing Before S. Subcomm. on Energy and Natural Res. (Nov. 8, 2011) (opening statement of Chairman Bingaman), http://www.energy.senate.gov/public/index.cfm/democratic-news?ID=242b6b91-cb66-49f5-a4bb-8b2dc54d89e1.

[12] Id.

[13] Id.

[14] Id.

[15] Id.

[16] Id.

[17] Id.

[18] Susan L. Sakmar, Politics and US LNG Export Project Heat Up, Natural Gas & Electricity Journal, Sept. 18, 2012, http://www.naturalgaselectricitynews.com/sample-articles/politics-and-us-lng-export-projects-heat-up.aspx.

[19] Id.

[20] The Department of Energy’s Role in Liquefied Natural Gas Export Applications: Hearing Before S. Subcomm. on Energy and Natural Res. (Nov. 8, 2011) (statement of Christopher Smith, Deputy Assistant Sec’y for Oil and Natural Gas Office of Fossil Energy, U.S. Dep’t of Energy), http://www.energy.senate.gov/public/index.cfm/files/serve?File_id=58b62501-e2e1-40aa-b024-8e45ab3d4569.

[21] Id.

[22] U.S. Energy Info. Admin., Effect of Increased Natural Gas Exports on Domestic Energy Markets (Jan. 2012), available at http://www.eia.gov/analysis/requests/fe/pdf/fe_lng.pdf.

[23] Id. at 1.

[24] Id.

[25] Id. at 6.

[26] Id.

[27] Id.

[28] Id. at 8.

[29] Id.

[30] Id. at 9.

[31] Deloitte MarketPoint LLC and the Deloitte Ctr. for Energy Solutions, Made in America: The economic impact of LNG exports from the United States (Dec. 2011), available at http://www.deloitte.com/assets/Dcom-UnitedStates/Local%20Assets/Documents/Energy_us_er/us_er_MadeinAmerica_LNGPaper_122011.pdf.

[32] Charles Ebinger et al., Brookings Institution Energy Security Initiative, Liquid Markets: Assessing the Case for U.S. Exports of Liquefied Natural Gas (May, 2012), available at http://www.brookings.edu/research/reports/2012/05/02-lng-exports-ebinger.

[33] Id. at 33.

[34] Id.

[35] Id. at vi–vii.

[36] Press Release, Natural Res. Committee, Markey Introduces Legislation to Keep American Natural Gas in America (Feb. 14, 2012), http://democrats.naturalresources.house.gov/press-release/markey-introduces-legislation-keep-american-natural-gas-america.

[37] H.R. 4024, 112th Cong., 2nd Sess. (2012), http://www.govtrack.us/congress/bills/112/hr4024.

[38] H.R. 4025, 112th Cong., 2nd Sess. (2012), http://www.govtrack.us/congress/bills/112/hr4025.

[39] Press Release, Congressman Ed Markey, Markey: Sabine LNG Export Facility Approval Would Help Export U.S. Manufacturing Jobs (Apr. 17, 2012), http://markey.house.gov/press-release/markey-sabine-lng-export-facility-approval-would-help-export-us-manufacturing-jobs.

[40] Kate Winston, Senators question price impact of LNG exports, Platts Energy Week, Nov. 9, 2011, http://www.wusa9.com/news/local/story.aspx?storyid=174167.

[41] Christopher Helman, Dow Chemical Chief Wants to Limit U.S. LNG Exports, Forbes, Mar. 8, 2012, http://www.forbes.com/sites/christopherhelman/2012/03/08/dow-chemical-chief-wants-to-limit-u-s-lng-exports/ (citing Dow Chemical CEO Andrew Liveris).

[42] Sierra Club’s Motion to Intervene, Protest, and Comments, Dominion Cove Point LNG, LP., FE Docket No. 11-128-LNG, (Feb. 6, 2012), http://www.fossil.energy.gov/programs/gasregulation/authorizations/2011_applications/Motion_to_Intervene_Sierra_Club_02_06_12.pdf.

[43] Id. at 22–24.

[44] Id. at 47.

[45] Amy Harder, War Over Natural Gas About to Escalate, Nat’l Journal, May 3, 2012, http://www.nationaljournal.com/energy-report/war-over-natural-gas-about-to-escalate-20120503.

[46] Id.

[47] Id.

[48] See Ebinger, supra note 32, at 9–10.

[49] Tennille Tracy, U.S. Gas Exports Put on Back Burner, Wall St. J., May 31, 2012, at B3, http://online.wsj.com/article/SB10001424052702304821304577436470209675022.html.

[50] See Sakmar, supra note 18.

[51] Id.

[52] U.S. Dep’t of Energy, Status of LNG Export Study, Natural Gas Import & Export Regulation, http://fossil.energy.gov/programs/gasregulation/ (last visited Nov. 14, 2012).

October 2, 2012 By wpengine

SPACs and the JOBS Act

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Usha Rodrigues ^†

Public Inroads in Private Equity

The law has long confined the average investor to trading in public securities^{^[1]} while allowing wealthy—or “accredited”^{^[2]}—individual investors access to a panoply of private securities, including investment vehicles such as hedge funds and private equity funds. Nevertheless, pressure to let the general public into private equity has been growing. Two forces have contributed to this mounting pressure. First, public investors are eager to try their hand at investing in private enterprise. Second, private firms need capital. In the face of these forces, the sharp line that has long separated public and private firms has become increasingly blurred.^{^[3]}

Consider the story of the emerging growth company (EGC), or “Initial Public Offering (IPO) on-ramp,” provision of the Jumpstart Our Business Startups Act (JOBS Act). In its first few months on the books, this provision had effects far different from what its drafters envisioned. The JOBS Act’s IPO on-ramp was intended to ease regular companies’ path to going public; instead, it has inadvertently made it easier for the average investor to get a taste of private equity via special purpose acquisition corporations (SPACs). This piece will briefly describe SPACs, the IPO on-ramp, and how shell companies have taken advantage of a legislative provision intended to bring cash-hungry young companies directly to market. This piece will close with a few thoughts on lessons the story of SPACs’ interaction with the JOBS Act may offer regarding the increasingly indistinct line that divides public and private investment.

Introducing SPACs

A SPAC is a type of “blank-check” company that goes public to raise a pool of cash and then begins a hunt for a target.^{^[4]} The bulk of the IPO proceeds are locked up in a trust account, invested in government-backed securities, and kept safe from the interference of the managers.^{^[5]} Once a target is identified, the SPAC managers disclose material financial information about it to shareholders, who then have a say on whether the acquisition occurs by way of voting or opt-out rights.^{^[6]} If no suitable target is found, or if a shareholder is unhappy with the deal, she can receive most of her money back—an average of ninety-eight cents on the dollar—from the trust account.^{^[7]} But if a SPAC shareholder does like the deal, then she will end up having owned a piece of an acquisition vehicle—in essence, a one-off private equity fund.^{^[8]}

The beauty of the SPAC model is that it bifurcates the process of going public, making it faster and cheaper. When the SPAC itself goes public, it is basically an empty shell, so any disclosures required under the Securities Act of 1933 (1933 Act) are minimal and cheap.^{^[9]} The SPAC’s Securities Exchange Act of 1934 (Exchange Act) filings are likewise minimal; in essence, they involve nothing more than reporting the rate of return generated in the trust account.^{^[10]} If and when the SPAC acquires a target—usually a private company—that target immediately becomes public without the hassle, disclosures, and delay that accompany a typical IPO.^{^[11]}

JOBS Act and SPACs

SPACs offered a rare chance for the average investor to participate in the rarified world of investing in private targets, while simultaneously offering those targets an easy route to an IPO. The JOBS Act took a decidedly different approach to blurring the line between public and private investment. Rather than letting the general public into private equity investments, the drafters tried the converse: encouraging more private firms to go public. Yet despite the JOBS Act’s focus on making it easier to bring traditional operating companies to the public market, its provisions have proven unexpectedly appealing for SPACs. Thus, legislation intended to help conventional companies go public is also facilitating a form of private equity investment.

SPACs’ business structure was in place long before the passage of the JOBS Act; indeed, they predated the Act by more than a decade.^{^[12]} The whole point of the JOBS Act’s EGC provision was to coax small-cap companies into going public by reducing the burdens of public disclosure and ongoing federal regulation, thereby providing the benefit of access to the public capital markets previously unavailable to them. I thought surely the passage of the JOBS Act was bad news for SPACs. Why agree to be acquired by a SPAC when you can easily go public on your own? The JOBS Act, however, had an unanticipated effect on the SPAC market because the JOBS Act’s IPO on-ramp provision makes it easier and cheaper for any small corporation to go public.^{^[13]}

As it turned out, the JOBS Act was not all bad news for SPACs because many SPACs themselves decided to go public using the IPO on-ramp. Indeed, in the eight weeks after the JOBS Act’s passage, over a dozen of the companies taking advantage of the new on-ramp option were SPACs.^{^[14]} Four months after the JOBS Act’s passage, one out of every nine EGCs was a SPAC.^{^[15]} The trend has not abated; in the first half of August 2012, one out of five firms that made use of the IPO on-ramp provision were SPACs.^{^[16]} To say the least, SPACs are making good use of the EGC option.

At first blush, SPACs’ use of the JOBS Act’s on-ramp seems counter-intuitive. It already was, and still is, easy for SPACs to go public under the conventional 1933 Act registration process. After all, SPACs’ disclosures at the start-up phase are largely boilerplate, along the lines of “this is who we are, this is how much money we plan to raise, this is how much we are setting aside in trust.”^{^[17]} If it is so easy for SPACs to register under the 1933 Act, why should they bother with the on-ramp provision offered by the JOBS Act?

The answer to this question stems from economic realities. As it turns out, successful SPACs—that is, SPACs that complete acquisitions—can save a lot of money in securities regulation compliance costs by making use of the IPO on-ramp. The payoff comes from greatly reduced ongoing reporting requirements imposed by the Exchange Act.In particular, EGC status under the JOBS Act lasts up to five years, as long as revenues, market capitalization, and debt issuances stay low,^{^[18]} and with that status come “scaled-back disclosures, certain exemptions to executive-compensation disclosures and attestation requirements for the auditors.”^{^[19]} These features make EGC SPACs comparatively more attractive to potential targets. A private company looking to go public on the cheap (i.e., at even less expense than the JOBS Act’s on-ramp promises) might well favor an EGC SPAC acquirer that promises lower disclosure burdens over a traditional public company acquirer—or, for that matter, a non-EGC SPAC—both of which would require the Exchange Act’s more in-depth disclosure. Time will tell whether EGC SPACs prove to be more successful acquirers than traditional acquirers and non-EGC SPACs.

In sum, despite reformers’ best intentions, many of the first companies to file as EGCs were not small operating companies rushing to access the capital markets as soon as regulatory barriers fell away. Instead, they were firms looking to acquire private firms down the road and take them public. Even so, the net effect may be what the JOBS Act’s drafters intended: if these new EGC SPACs have their way, they will acquire private firms, and thus bring more small firms to the public markets. Yet the SPAC EGCs will accomplish this goal in a roundabout way. More small firms will go public, as the JOBS Act envisioned, but by way of shell companies that allow the general public to participate in the uniquely public form of private equity that SPACs offer. While successful EGC SPACs will thus bring more firms public, they will at the same time allow their own investors to participate in a species of private equity investment, a kind of investment traditionally reserved for accredited investors. All of this supports a telling conclusion: both regulators and the market itself are exerting pressure on the line separating public and private investment, and these two separate forces can combine to produce unanticipated results.

Blurring the Line Between Public and Private

In conclusion, SPACs and the JOBS Act, both considered singly and taken together, signal the mounting pressure building over the divide between public and private investment. SPACs are mechanisms that let the public make private equity-like investments. The IPO on-ramp is an attempt to entice private companies to the public markets. Yet even more tellingly, these separate phenomena have recently interacted in an unexpected way, revealing how difficult it can be for reformers to revise the public-private boundary with any degree of certainty.

SPACs and the JOBS Act’s IPO on-ramp are but two examples of recent trends that suggest that the line separating the public and private investment spheres may be blurring. Another example, the CROWDFUND Act, applies pressure on the other side of the public-private line: rather than making it easier for more private companies to access the public markets, it allows unaccredited investors a chance to invest limited sums in private companies for the first time.^{^[20]}

Securities regulation ultimately involves a delicate balancing act, with investors’ need for protection and firms’ thirst for capital pulling in opposite directions. The traditional balance reserved robust investor protection for the public markets, and allowed wealthy investors exclusive access to more risky, and potentially more profitable, private firm investment.^{^[21]} But SPACs are a sign that the general public also desires to furnish capital to private firms in exchange for the chance to earn a higher rate of return. At the same time, the JOBS Act signals a desire on the part of regulators and firms alike to allow companies to enjoy the benefits of being public while reducing some of the burdens that have traditionally accompanied public status. Such examples thus, in different ways, indicate that the public-private boundary may be shifting dramatically.

Preferred citation: Usha Rodrigues, SPACs and the JOBS Act, 3 Harv. Bus. L. Rev. Online 17 (2012), https://journals.law.harvard.edu/hblr//?p=2488.

† Associate Professor of Law, University of Georgia School of Law. I thank Mike Stegemoller and the staff of the Harvard Business Law Review. Any errors are my own.

[1] See, 15 U.S.C.A. § 77d (West 2009 & Supp. 2012) amended by Jumpstart Our Business Startups Act, Pub. L. No. 112-106, 126 Stat. 306 (2012).

[2] Rule 501 of Regulation D describes several categories of accredited investors, including certain banks, charitable organizations, and certain high net worth individuals, who may invest in securities that are not registered. 17 C.F.R. § 230.501(a) (2012). Most notably, individuals with a net annual income of over $200,000 or a total net worth of over one million dollars may invest in securities that are not registered provided that those securities meet the general disclosure requirements of Rule 502. 17 C.F.R. § 230.502 (2012).

[3] For a few recent scholarly discussions of the public-private divide, see Donald C. Langevoort & Robert B. Thompson, “Publicness” in Contemporary Securities Regulation After the JOBS Act (Georgetown Law and Econ. Research Paper, No. 12-002, 2012) available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1984686; Adam C. Pritchard, Revisiting “Truth in Securities” Revisited: Abolishing IPOs and Harnessing Private Markets in the Public Good (Univ. of Mich. Law & Econ. Research Paper No. 12-010, 2012) available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2103246; Usha Rodrigues, Securities Law’s Dirty Little Secret, 81 Fordham L. Rev. (forthcoming 2013) (on file with the author).

[4] Usha Rodrigues & Mike Stegemoller, Exit, Voice, and Reputation: The Evolution of SPACs, 37 Del. J. Corp. L. (forthcoming 2012).

[5] Id.

[6] Id.

[7] Id.

[8] See Steven M. Davidoff, Black Market Capital, 2008 Colum. Bus. L. Rev. 172, 225 (2008) (“SPACs are a species of private equity: these are capital pools organized to acquire individual businesses. But because of the general requirement that the initial acquisition comprise eighty percent of its assets, SPACs typically only acquire a single privately-held business. Despite these important distinctions, SPACs otherwise attempt to mimic private equity returns by employing comparable structures and practices. For example, SPACs utilize similar leverage to increase the size and potential returns of their acquisitions. The managers of SPACs are also typically provided twenty percent of the initial share offering at nominal amounts; ownership they are required to maintain until and after consummation of an acquisition.”).

[9] Daniel S. Riemer, Special Purpose Acquisition Companies: Spac and Span, or Blank Check Redux?, 85 Wash. U.L. Rev. 931, 950–51 (2007) (describing typical SPAC registration disclosure).

[10] Rodrigues & Stegemoller, supra note 4.

[11] Some call SPACs back-door IPOs, but SPACs differ from the seedier reverse mergers that led to so many Chinese companies with questionable accounting practices going public. Id.

[12] Riemer, supra note 9, at 944–45.

[13] For example, emerging growth companies need to disclose only two years of audited financial information prior to going public. 15 U.S.C.A. 77g(a)(2)(A) (West 2009 & Supp. 2012) amended by Jumpstart Our Business Startups Act, Pub. L. No. 112-106, 126 Stat. 306 (2012). They are not subject to Sarbanes-Oxley’s dreaded internal controls provision. 15 U.S.C.A. § 7262(b) (West 2009& Supp. 2012) amended by Jumpstart Our Business Startups Act, Pub. L. No. 112-106, 126 Stat. 306 (2012).

[14] Emily Chasan, Meet the JOBS Act’s Jobs-Free Companies, Wall St. J., June 4, 2012, at B1.

[15] Chris Hitt, “I Am Shocked, Shocked”: Blank Check Companies and the “Scandal” of the JOBS Act, Blogmosaic (Aug. 16, 2012), http://blogmosaic.knowledgemosaic.com/2012/08/16/spacs-as-egcs/.

[16] Id.

[17] See, e.g., Acquicor Tech. Inc., Registration Statement (Form S-1) (Sept. 2, 2005).

[18] 15 U.S.C.A. 77b(a) (West 2009 & Supp. 2012) amended by Jumpstart Our Business Startups Act, Pub. L. No. 112-106, 126 Stat. 306 (2012).

[19] Chasan, supra note 14.

[20] Title III of the JOBS Act, the CROWDFUND Act, allows issuers to sell up to one million dollars of securities in a twelve-month period without Securities Act of 1933 registration. Any investor can invest in these companies—they are not reserved for accredited investors only. If an investor’s annual net worth or income is less than $100,000, she can invest no more than 5% of her net worth or annual income or $2,000, whichever is greater. Jumpstart Our Business Startups Act, Pub. L No. 112-106, sec. 302, § 4(a)(6)(B)(i), 126 Stat. 306, 315 (2012). If an investor’s annual net worth or annual income is equal to or more than $100,000, then she can invest no more than the greater of 10% of her net worth or annual income and $100,000. Id.

[21] Individuals qualify as accredited investors by having a net annual income of over $200,000 or a total net worth of over one million dollars. 17 C.F.R. § 230.215 (2012). SEC regulations and industry practice dictates that only this special class of individual investors can invest in hedge funds, private equity funds, and venture capital funds. Thus, historically at least, ordinary investors have been shut out of the private market, except via pension funds that in effect pool the resources of many investors into an accredited-investor fund. No private market mutual funds currently exist.

March 12, 2012 By wpengine

The 2012 HBLR Symposium

The 2012 HBLR Symposium, Complexity and Change in Financial Regulation, will be held on March 23–24. Visit our symposium page for more information and to register.

October 11, 2011 By wpengine

Dodd-Frank and the Future of Financial Regulation

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Edward F. Greene*

I. Introduction

Dodd-Frank^{^[1]} represents the most sweeping changes to the financial regulatory environment in the United States since the Great Depression. While its enactment was important, the Act is seriously flawed. It does not deal with regulatory fragmentation, sidesteps international coordination, and is overly optimistic in dealing with too-big-to-fail. Going first doesn’t mean you get it right.

To consider my criticisms, we must put Dodd-Frank in context. Major changes to financial institution regulation have been called for by the G-20 on a coordinated basis.^{^[2]} Given the reality that major financial institutions increasingly conduct significant portions of their business in many different countries, consistency and cooperation are essential, especially between the US and the EU.^{^[3]} Dodd-Frank is not a good example of the necessary paradigm. I will first review the international response and recommendations, the US response, and then highlight some key differences in other markets.

In the aftermath of the crisis, regulators from around the world convened to discuss solutions and outline a framework for reform on an international basis.^{^[4]}This development was, in part, a recognition of the global causes and the global scale of the problem. Since that time, however, as lawmakers and regulators have begun to implement reform in their own countries, we have witnessed some loss of the coordination and cooperation that is critical to creating the framework needed to regulate systemically significant financial institutions operating internationally.

II. Causes of the Crisis

Market participants, government officials, and academics have not reached a consensus as to the causes of the crisis. Despite this, there is general agreement that the regulatory framework in place prior to the crisis was inadequate.

1. Systemic Risk and Too-Big-To-Fail

The shortcomings of the pre-crisis regulatory framework were illustrated by its failure to detect systemic risk posed by “too-big-to-fail” institutions. Of course, the problem with too-big-to-fail firms is that if the market believes that the government will be compelled to bail them out with taxpayer money, it will not exert sufficient oversight or discipline to control or mitigate risky behavior.^{^[5]}

2. Resolution Authority

The pre-crisis regulatory regime was also insufficient with respect to managing the failure of large, interconnected, cross-border financial institutions. The system did not have an effective and expeditious resolution authority.

The experience with the Lehman Brothers’ bankruptcy convinced almost all observers that bankruptcy proceedings generally, and in the US in particular, are not suitable for complex financial institutions.^{^[6]}

3. Shadow Banking

A third conspicuous shortcoming of the pre-crisis regulatory framework was the large number of non-financial firms that fell outside its scope – the unregulated, shadow-banking sector.^{^[7]}Many market actors – including Special Investment Vehicles, so called SIVs, certain mortgage originators, hedge funds and private equity funds, and derivatives market participants – were subject to little or no regulation.

III. International Institutions: G-20 and FSB

1. Group of Twenty (G-20)

At the height of the crisis, there was general recognition of the global nature of the problem and the need for a global response. The G-20 emerged as a leading forum for addressing it. The G-20 strongly recommended that international guidelines and frameworks be developed and that the efforts of national regulators be coordinated.

In terms of strengthening the regulation of systemically important firms, the G-20 recommended: (i) heightened prudential requirements to reflect higher costs of failure; (ii) a requirement to develop firm-specific contingency plans (so-called living wills); (iii) establishment of crisis management groups for major cross-border firms to strengthen international cooperation on resolution; and (iv) strengthening the legal framework for crisis intervention and winding down firms.^{^[8]}

The G-20 leaders also called for an international framework of reform which should: (i) build high-quality capital requirements and mitigate pro-cyclicality; (ii) reform compensation and governance practices to support financial stability; (iii) improve transparency and mitigate systemic risk in the OTC derivatives markets; (iv) address cross-border resolution; and (v) adopt a single set of generally accepted and accounting standards.^{^[9]}

2. Financial Stability Board

Other international organizations – including the Basel Committee on Banking Supervision, the Financial Stability Board (“FSB”) and the International Monetary Fund (“IMF”) – have also been active participants in leading global financial regulatory reform efforts, in part at the request of the G-20.

Specifically, the Financial Stability Board has set forth a five-prong policy framework to address the risk associated with systemically important financial institutions: (i) improve resolution regimes to ensure the winding down of any financial institution without disrupting the financial system and without taxpayer support; (ii) require systemically important institutions to maintain loss absorption capacity beyond Basel III standards; (iii) enhance the supervisory oversight of systemically important institutions; (iv) strengthen standards for core financial infrastructure; and (v) engage in peer reviews of the effectiveness and consistency of national policy measures applicable to global systemically important institutions.^{^[10]}The Financial Stability Board is in the process of identifying which institutions are globally significant, which raises interesting issues of moral hazard.

IV. Comparing US and Non-US Implementation of Reform

Reform efforts in the United States, however, have made only a modest effort to assure coordination with the G-20 recommendations or the responses proposed or adopted by other regulators, in particular, the EU. Thus, there is the “danger of divergence”, also the title of a report of The Atlantic Council reading, which will have unfortunate consequences.^{^[11]}

1. New Systemic Risk Monitors

The G-20 leaders called for regulators to have better access to information about activities and counterparty exposures that pose systemic risk to the financial system.^{^[12]} They noted that, while in the past regulators had adequate information about the financial conditions of individual regulated entities, no single regulatory body was charged with overseeing and assessing the risks generally posed to the financial system by both the activities (i.e., derivatives) and interconnectedness of individual financial institutions.^{^[13]} There was as well a dearth of information about generally unregulated key players such as hedge funds and private equity funds.

To address this issue, Dodd-Frank created the Financial Stability Oversight Council. Its members include the heads of Treasury, the Federal Reserve Board, the SEC, and the CFTC, and the federal banking regulators, among others. One of its primary charges is to identify risks to financial stability.^{^[14]}

The Council is mandated to gather information to identify gaps in regulation or activities that should be subject to more-stringent regulation.^{^[15]} To this end, the Council may require reports from any non-bank financial company or bank holding company to assess whether that company, or any financial activity or market in which it participates, is systemically important.^{^[16]} The Council may also recommend heightened prudential and capital standards, which must be considered by the primary financial regulator.^{^[17]}

The EU has created a similar body, the European Systemic Risk Board.^{^[18]} Unlike the Council, it has no regulatory authority. While responsible for monitoring and assessing potential threats to financial stability, the ESRB can only issue warnings and make recommendations to national regulators, who are obligated to explain reasons for not acting upon ESRB proposals, and notify the European Commission if appropriate actions are not taken.^{^[19]}

There are many questions one could ask about these new councils. In the case of the United States, would it not have been more effective to consolidate the fragmented financial regulatory structure rather than to further fragment oversight of financial markets? Will the complicated structure and mandated decision-making process of the Council hamper crucial efforts to act promptly? What will the costs be to collect information in a standardized format? How will the US and EU councils work together to coordinate oversight and regulation? With respect to the EU, shouldn’t the Systemic Risk Board have the power to intervene directly and not have to rely entirely on national regulators?

2. Solutions for Too-Big-To-Fail

In addition to enhanced oversight of a wider range of systemically important financial institutions, Dodd-Frank mandates more rigorous capital, liquidity and leverage requirements, as well as restrictions on certain activities to help address the problem of too-big-to-fail. Most importantly, it does not restrict size by growth, only by acquisition.^{^[20]} This is a critical judgment since the five largest US financial institutions have grown 20% since the onset of the crisis and currently have over $6 trillion in assets.^{^[21]} The judgment was made that size is not necessarily the only concern; many small, sufficiently interlinked institutions engaging in the same activity could pose a systemic risk if that activity should prove riskier than appreciated.^{^[22]} But size can be critical, because of the contagion effect of failure.

a. Capital, Liquidity and Leverage Requirements

The Federal Reserve Board has been given the primary responsibility for supervising and regulating systemically important institutions. These institutions include all bank holding companies with more than $50 billion in assets and all Council-designated systemically important non-bank financial companies doing business in the US.^{^[23]} These entities will be subject to heightened capital, liquidity and other prudential standards, risk-management requirements, concentration limits for credit exposure to customers, and will have an obligation to prepare living wills as well as to undergo periodic stress tests.^{^[24]} And if an insurance company is so designated as a systemically significant non-bank financial company, it will have for the first time a federal regulator, the FRB.^{^[25]}

Regulators have additional tools as well to restrict the size, growth and activities of these systemically important companies, in particular those determined to pose a “grave threat” to financial stability. The regulators, for example, can prohibit these companies from acquiring or merging with other companies and compel the divestiture of assets, and must impose a strict 15:1 debt-to-equity leverage ratio on them.^{^[26]}

Dodd-Frank further restricts the ability of large bank holding companies and systemically important non-bank financial companies to grow by acquisition. No financial company will be permitted to merge with or otherwise acquire another if the total consolidated liabilities of the combined company would exceed 10 percent of the total financial consolidated liabilities of all financial companies, unless the institution proposed to be acquired is in default or in danger of default and the FRB approves the acquisition.^{^[27]} Of course, at times of crisis, the largest financial institutions are likely to be the only candidates to acquire smaller failing institutions.

b. The Volcker Rule

One of Dodd-Frank’s most controversial provisions has been the Volcker Rule. In brief, the Volcker Rule prohibits banking entities from engaging in some types of proprietary trading and imposes limits on sponsoring or investing in hedge funds or private equity funds.^{^[28]}

Both US banking institutions and internationally headquartered banking organizations with US banking operations will be subject to the rule. There is an exception for foreign banking institutions for trading that is solely outside the US. The imprecision in and generality of many of the terms and exceptions as to permitted activities used in the Volcker Rule will require clarification by the regulators. Because the regulators will have a great deal of discretion in how they are defined and applied, they will be under pressure to be expansive as to permitted activities, not restrictive.

Across the Atlantic, the EU and Switzerland have refused to consider banning this type of activity. Instead, they would use enhanced capital requirements to address risk. On the other hand, the Independent Commission on Banking appointed by the UK government has, in its preliminary issues paper, broadly included among its list of reform options limits on proprietary trading and investing by deposit-taking institutions.^{^[29]}

c. The Swiss Approach

The Swiss have taken an interesting approach. They have rejected size limitations for banks under any circumstances. Rather, they have proposed reforms to capital requirements and organizational form to control systemic risk. With respect to capital, the Swiss have developed a four-part approach: first, there must be a minimum amount of capital required for the maintenance of normal business activities; second, a capital buffer, allowing banks to absorb losses without falling short of the minimum capital requirement; third, a progressive component of capital, which rises with the degree of an institution’s systemic importance; and finally, convertible or contingent capital which would automatically convert into equity when an institution’s financial condition has materially deteriorated.^{^[30]} And indeed, Credit Suisse has recently issued a contingent capital security,^{^[31]} a so-called Co-Co, which was oversubscribed, has been keenly followed and which will influence regulators in other markets.

The Swiss proposal also requires banks to have an organizational structure that would allow them, if their capital ratio fell below a certain level, to execute an emergency plan to swiftly transfer their systemically important functions to an independent and new corporate entity, called a bridge bank.^{^[32]} Thus, the Swiss believe capital assessment and organizational simplicity are the solution, not activity restriction or size limitations.

3. New Resolution Authority Regime: OLA

To address the concerns about the inability of the existing resolution regimes to handle the failure of a systemically important financial company, Dodd-Frank created a new special insolvency regime, known as the Orderly Liquidation Authority (“OLA”).^{^[33]} OLA is intended to avoid the serious, adverse effects of the liquidation of a systemically important financial company that would result if it were resolved under the Bankruptcy Code.

The new OLA regime, however, does not replace existing insolvency regimes. Instead, all companies eligible for orderly liquidation under the new regime remain subject to otherwise applicable insolvency law (generally the Bankruptcy Code) unless federal regulators determine, at the time of the financial company’s impending failure, that the company should be liquidated under OLA. ^{^[34]}

Under OLA, a failing financial company will be placed into a receivership administered by the FDIC, the sole purpose of which is the liquidation of the financial company. Sick institutions cannot be rescued with interim aid – they must die. When appointed as receiver, the FDIC can borrow from the Treasury to finance a liquidation. If the proceeds from liquidation are insufficient to repay the Treasury borrowings, the FDIC will first recover from creditors any amounts received in excess of what they would have received in an ordinary liquidation. If there is any remaining shortfall, the FDIC can levy an assessment on all Council-designated systemically important non-bank financial companies and all other bank holding companies with $50 billion or more in consolidated assets.

In the US, the decision was made after extensive debate not to create a fund in advance to be available for future crises but rather to impose a post-crisis levy on remaining, viable institutions to fund unmet costs of liquidations.^{^[35]} By contrast, the IMF has proposed a “financial stability contribution” to be paid by the industry prior to any failure, and linked to an effective resolution regime, to pay for the cost of any future governmental support to the financial sector.^{^[36]} A number of European governments are also considering “bank taxes” that would impose an assessment on financial institutions to create a fund that could be used for future “bail outs”. For example, the European Commission has launched a consultation regarding taxes on financial transactions and financial activities, and it is also seeking input on the introduction of separate bank levy.^{^[37]} In addition, the German government has adopted a bank tax and will use those revenues for its Restructuring Fund, which will be used to address future financial crises.^{^[38]}

These flexible approaches should be contrasted to Dodd-Frank. OLA and Dodd-Frank restrict any funding that might allow weakened institutions to recover. The only choice is liquidation. Before Dodd-Frank, government aid often served to maintain a company’s operations and to restore its health – as was seen in the infusions of taxpayer funds into AIG, Citibank and Bank of America, among others, as well as guarantees of debt issuances by the FDIC. In the face of public anger about “the bail out of Wall Street”, government aid on an individual basis is no longer available, even though the government has received significant returns from its investments.^{^[39]} Some have argued that restricting pre-insolvency assistance, comparable to TARP, and requiring liquidation, will, in fact, exacerbate the consequences of any individual failure because of contagion; instead, they call for an industry tax to create a fund permitting assistance to failing institutions^{^[40]}. The new limitations on the FRB and the FDIC to assist individual failing companies and the resulting lack of flexibility under OLA are thought by some to be serious flaws of Dodd-Frank, especially since many believe Dodd-Frank has not adequately addressed too-big-to-fail.^{^[41]} I agree with their critiques.

Another difficulty with OLA is that it does not apply to the significant non-US subsidiaries of systemically significant financial companies. Even if OLA had been in place at the time of the Lehman Brothers’ insolvency, Lehman Brothers’ UK entity would still have been resolved under the UK regime. While that regime has been changed, it is not the same as ours.

In response to the G-20’s call, the IMF and the FSB are acting to develop a framework for a coordinated resolution regime. However, it is not clear how it will be implemented domestically.

Critical to coordination and cooperation concerning resolution of global systemically significant institutions is colleges of supervisors, who are expected to consult about coordinated resolution. In this regard, the development of living wills is essential for coordinated resolution in the absence of an international resolution authority. However, there are a number of open questions about how “living wills” will work for non-US financial institutions that have US operations and how US and non-US regulators will cooperate with respect to the companies in their respective jurisdictions over which they have supervisory authority.

Absent further coordination in cross-border insolvencies of systemically important financial institutions, we are left with the dilemma of an uneven treatment of creditors and shareholders and a tendency for the regulators of markets in which large institutions operate to require operations to be conducted through subsidiaries, to ring-fence assets in those domestic subsidiaries, to impose liquidity requirements to protect domestic creditors and to avoid the transfer of assets prior to insolvency. Dodd Frank is silent on this issue.

4. Other Significant US-EU Differences

There are a number of other areas of financial regulatory reform in which the approaches of the US and EU diverge significantly.

a. Derivatives Market Reforms

In particular, the US proposals to reform the derivatives market differ in important ways from the reforms under consideration in the EU, including which types or classes of swaps will be subject to mandatory clearing requirements and how to reduce financial institutions’ interconnectivity risk. Dodd-Frank also includes a controversial “push-out” provision, which prohibits certain forms of Federal assistance—including access to the FRB’s discount window and FDIC deposit insurance—from being provided to swap dealers and major swap participants.^{^[42]} The EU almost certainly will not adopt anything similar.^{^[43]} The US regime could also end up being more restrictive in areas such as the governance of central clearing counterparties.

In addition, the scope of the exemption from the clearing requirement in the US for “end users” of swaps that use them to hedge or mitigate commercial risk, whether US regulators will defer to EU margin requirements for non-cleared swaps, and how the US reporting requirements can be reconciled with EU privacy laws remain areas of uncertainty. Finally, Dodd-Frank authorizes the CFTC to impose position limits; there are no equivalent provisions in the EU.^{^[44]} In the absence of further international coordination, the EU proposes mutual recognition and cooperation arrangements with non-EU regulators if their regimes are deemed to be equivalent.^{^[45]} Unfortunately, however, Dodd-Frank does not have a similar provision for mutual recognition.

b. CRAs, Compensation, Hedge Funds & Accounting

Despite being criticized for their role in contributing to the crisis, the US has mandated little reform of credit rating agencies; by contrast, the EU has adopted rules that significantly affect the way credit rating agencies operate.^{^[46]} Similarly, the EU reforms to executive compensation and the regulation of hedge fund and private equity funds are much more prescriptive than those in the US. Finally, the different accounting standards between GAAP in the US and IFRS in the EU remain an ongoing point of divergence and contention.

V. Conclusion: Assessing Dodd-Frank’s Impact and the Perils of Divergent Regimes

Although there are many open questions surrounding the ongoing implementation of regulatory reform, we can begin to assess Dodd-Frank’s effectiveness in addressing the problems that led to the crisis as well as the US efforts to coordinate with the international community. Unfortunately, by either measure, Dodd-Frank does not, in my opinion, do well.

Critically, Dodd-Frank fails to reconfigure in any significant way the fragmented US regulatory structure. Rather than consolidating existing agencies into one or two regulators, each able to act quickly and efficiently, we now require regulators with a history of disagreement and difficulty in operating together to sit collegially around the Council’s table and make key decisions by a vote of a majority or two-thirds of its members, depending on the issue. A single federal regulator may not be the answer, but the number of federal regulators we now have is surely not the right result either. The notion of one bank regulator, one markets regulator and one consumer regulator for all products remains, unfortunately, wishful thinking in the US.

But, more importantly, Dodd-Frank does not address adequately the issue of moral hazard. Despite the many provisions to monitor and reduce systemic risk, it remains unlikely that the Government will allow an institution that is the size of one of the US’s five largest financial institutions to fail, especially in the absence of effective coordinated and consistent resolution mechanisms in key markets. The market will likely make that judgment as well, and those firms will continue to have financing advantages that only increase the likelihood of their failure.

There is also a serious question about whether Dodd-Frank will undermine the competitive position of major US financial institutions. Certain of its provisions, clearly, will not be followed in other key jurisdictions such as the EU – for example, the Volcker Rule. The universal bank model is now accepted globally as the way to do business, and the Volcker Rule is not consistent with that model and is not likely to be replicated elsewhere. Furthermore, the size limitation imposed with respect to growth by acquisition could disadvantage US institutions if the industry consolidates globally.

Regulatory arbitrage remains a real issue as nations enact their financial reforms. Funding resolution and bailout expenditures have been a point of international divergence. As noted earlier, the OLA is not pre-funded, given the desire to avoid the appearance of a bailout. Further, Dodd-Frank restricts regulators’ other tools for financial assistance, such as government guarantees. Meanwhile, the IMF and European governments seem to be moving in the direction of imposing bank taxes to create resolution funds. Thus, the US may face a challenge in coordinating to resolve failing, international institutions if its only choice is liquidation, but other countries have a fund available to provide financial assistance to stave off insolvency.

Dodd-Frank is not as responsive as it should have been to the call of the G-20 for global, harmonized standards. The Atlantic Council’s report on “The Danger of Divergence” surveys the proposed reform proposals in the US and the EU, noting the areas of convergence but also highlighting the many areas in which significant differences remain. The report also sets forth recommendations of how regulators in the US and EU can work together to harmonize reform efforts. In light of the continuing integration of the world’s capital markets, international cooperation in implementing financial regulatory reform is essential if it is to be effective, especially between these two markets.

Preferred citation: Edward F. Greene, Dodd-Frank and the Future of Financial Regulation, 2 Harv. Bus. L. Rev. Online 79 (2011), https://journals.law.harvard.edu/hblr//?p=1728.

* Edward F. Greene is a partner at Cleary Gottlieb based in the New York office and was formerly the General Counsel of the SEC. A version of this article was delivered as a keynote at the Harvard Business Law Review’s inaugural symposium on April 1, 2011.

[1] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010) [hereinafter Dodd-Frank Act].

[2] See, e.g., Enhancing Sound Regulation and Strengthening Transparency (Report of G20 Working Group 1, 2009), available at http://www.g20.org/Documents/g20_wg1_010409.pdf.

[3] See Allen N. Berger et al., To What Extent Will The Banking Industry be Globalized? A Study of Bank Nationality and Reach in 20 European Nations, (Bd. of Governors of Fed. Reserve Sys., Int’l Fin. Discussion Paper No. 725, 2002), available at, http://www.federalreserve.gov/pubs/ifdp/2002/725/ifdp725.pdf.

[4] Press Release, SEC, Chairman Cox Statement on Meeting of IOSCO Technical Committee (Nov. 24, 2008), available at http://www.sec.gov/news/press/2008/2008-279.htm.

[5] E.g. James Bullard, Christopher J. Neely, and David C. Wheelock, Systemic Risk and the Financial Crisis: A Primer, 91 Fed. Reserve Bank St. Louis Rev. 403, 403 (2009); Ben S. Bernanke, Chairman, Federal Reserve Board of Governors, Address to Council of Foreign Relations: Financial Reform to Address Systemic Risk (Mar. 10, 2009), available at http://www.federalreserve.gov/newsevents/speech/bernanke20090310a.htm.

[6] See Sheila C. Bair, Chairman, FDIC, Lecture at the Harvard university John F. Kennedy Jr. Forum: Ending Too Big To Fail: The FDIC and Financial Reform (Oct. 20, 2010), available at http://www.fdic.gov/news/news/speeches/chairman/spoct2110.html.

[7] For an overview of shadow banking and the risks it poses, see Morgan P. Ricks, Regulating Money Creation After the Crisis, 1 Harv. Bus. L. Rev. 75 (2011).

[8] G-20 Finance Ministers and Central Bank Governors, Declaration on Further Steps to Strengthen the Financial System (Sept. 5, 2009), available at http://www.g20.org/Documents/FM__CBG_Declaration_-_Final.pdf.

[9] G-20 Finance Ministers and Central Bank Governors, Leaders’ Statement: The Pittsburgh Summit (Sept. 25, 2009), available at http://www.g20.org/documents/pittsburgh_summit_leaders_statement_250909.pdf.

[10] Letter from Mario Draghi, Chairman, Financial Stability Board, to G20 Leaders, Progress of Financial Regulatory Reform (Nov. 9, 2010), available at http://www.financialstabilityboard.org/publications/r_101109.pdf.

[11] Atlantic Council, The Danger of Divergence: Transatlantic Cooperation on Financial Reform (2010) [hereinafter Danger of Divergence], available at http://www.acus.org/files/publication_pdfs/403/ACUS_TR_Danger_Divergence_Report.pdf.

[12] Id.

[13] Id.

[14] Dodd-Frank Act §§ 111-112, 12 U.S.C. §§ 5321-5322.

[15] Danger of Divergence, supra note 11.

[16] Id.

[17] Id.

[18] Id.

[19] Id.

[20] Id. at 24.

[21] Thomas M. Hoenig, Too Big to Succeed, NY Times, Dec. 1, 2010, http://www.nytimes.com/2010/12/02/opinion/02hoenig.html.

[22] Danger of Divergence, supra note 11, at 22.

[23] Authority to Designate Financial Market Utilities as Systematically Important, 76 Fed. Reg. 44,763, 44,763 (July 27, 2011).

[24] Id. at 44,767.

[25] See id. at 44,773.

[26] Dodd-Frank Act § 165(j). See also Steven L. Schwarcz, Identifying and Managing Systemic Risk: An Assessment of Our Progress, 1 Harv. Bus. L. Rev. Online 94, 98 (2011), https://journals.law.harvard.edu/hblr//?p=1412.

[27] Danger of Divergence, supra note 11, at 24.

[28] For an overview of the Volcker Rule, see Charles K. Whitehead, The Volcker Rule and Emerging Financial Markets, 1 Harv. Bus. L. Rev. 39 (2011).

[29] Independent Commission on Banking, Issues Paper: Call for Evidence (Sept. 2010), available at http://bankingcommission.independent.gov.uk/bankingcommission/wp-content/uploads/sites/87/2010/07/Issues-Paper-24-September-2010.pdf.

[30] Commission of Experts (appointed by the Swiss Federal Council), Final Report of the Commission of Experts for Limiting the Economic Risks Posed by Large Companies (Sept. 30, 2010), available at http://www.sif.admin.ch/dokumentation/00514/00519/00592/index.html?lang=en.

[31] Jane Merriman, Swiss Give Fresh Momentum to Contingent Bonds, Reuters, Oct. 4, 2010, http://blogs.reuters.com/financial-regulatory-forum/2010/10/04/snap-analysis-swiss-give-fresh-momentum-to-contingent-bonds.

[32] Press Release, Swiss Commission of Experts, Commission of Experts submits package of measures to limit “too big to fail” risks, Oct. 4, 2010, available at http://ow.ly/6ha7L.

[33] Dodd-Frank Act §§ 201–217.

[34] See Harvey Miller & Maurice Horwitz, One Way That Dodd-Frank’s Liquidation Authority Could Achieve Parity With The Bankruptcy Code, 1 Harv. Bus. L. Rev. Online 1 (2010), https://journals.law.harvard.edu/hblr//?p=350.

[35] Jackie Calmes, Taxing Banks for the Bailouts, NY Times, Jan. 14, 2010, http://www.nytimes.com/2010/01/15/us/15tax.html.

[36] International Monetary Fund, A Fair and Substantial Contribution by the Financial Sector: Final Report for the G-20 (June 2010), available at www.imf.org/external/np/g20/pdf/062710b.pdf.

[37] European Commission, Consultation Paper on Financial Sector Taxation (Feb. 22, 2011), available at http://ec.europa.eu/taxation_customs/resources/documents/common/consultations/tax/financial_sector/consultation_document_en.pdf.

[38] See Germany, National Reform Programme 2011 15, (Apr. 6, 2011), available at http://ec.europa.eu/europe2020/pdf/nrp/nrp_germany_en.pdf.

[39] Yalman Onaran and Alexis Leondis, Bank Bailout Returns 8.2% Beating Treasury Yields, Bloomberg, Oct. 20, 2010, http://ow.ly/6hb3G.

[40] See, e.g., Steven L. Schwarcz, Identifying and Managing Systemic Risk: An Assessment of Our Progress, 1 Harv. Bus. L. Rev. Online 94, 103 (2011), https://journals.law.harvard.edu/hblr//?p=1412.

[41] E.g. Victoria McGrane and Deborah Solomon, Debating Dodd-Frank: Is ‘Too Big to Fail’ Gone?, Wall St. J., July 21, 2011, http://online.wsj.com/article/SB10001424053111904233404576458381947014162.html.

[42] See Dodd-Frank Act §716.

[43] See Proposal for a Regulation of the European Parliament and of the Council on OTC Derivatives, Central Counterparties, and Trade Repositories, COM (2010) 484 final (Sept. 15, 2010), available at http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=COM:2010:0484:FIN:EN:PDF (containing no such provision); Kian Abouhossein et al., Regulatory Arbitrage Series: OW European over US IBs, JP Morgan Cazenove 3 (2011) (“. . . all major European banks (except from HSBC) will be unaffected whilst US banks would have to set up a new swap entity to comply with Section 716.”), available at https://mm.jpmorgan.com/stp/t/c.do?i=5930E-12&u=a_p*d_558208.pdf*h_-2igf3ms.

[44] Statement Before the H. Comm. on Agri. Subcomm. On General Farm Commodities and Risk Mgm’t (May 25, 2011) (statement of CFTC Comm. Jill E. Sommers), available at http://www.cftc.gov/pressroom/speechestestimony/sommersstatement052511.html.

[45] See European Commission: Banking, http://ec.europa.eu/internal_market/bank/index_en.htm (last visited Aug. 30, 2011).

[46] Andrew Willis, EU Outlines New Credit Rating Agency Plan, Bloomberg Businessweek, June 4, 2010, http://www.businessweek.com/globalbiz/content/jun2010/gb2010064_765856.htm.

July 7, 2011 By wpengine

Identifying and Managing Systemic Risk: An Assessment of Our Progress

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Steven L. Schwarcz*

Although a chain of bank failures remains an important symbol of systemic risk, the ongoing trend towards disintermediation—or enabling companies to directly access the ultimate source of funds, the capital (i.e., financial) markets, without going through banks or other financial intermediaries—is making these failures less critical than in the past. While banks and other financial institutions remain important sources of capital, companies today are able to obtain most of their financing through financial markets without the use of intermediaries.[1] As a result, financial markets themselves are increasingly central to any examination of systemic risk.

THE FINANCIAL CRISIS

The relationship between financial markets and systemic risk has been dramatically illustrated by the recent financial crisis. Although the bankruptcy of Lehman Brothers filled the initial headlines, the trigger of the crisis was the collapse of the market for mortgage-backed securities. A significant number of these securities were backed by risky subprime home mortgages, which were expected to be refinanced through home appreciation. When home prices stopped appreciating, the borrowers could not refinance. In many cases, they defaulted. These defaults in turn caused substantial amounts of investment-grade rated securities backed by these mortgages to be downgraded and, in some cases, to default. Investors began losing confidence in these and other rated securities, and their market prices started falling.

Lehman Brothers, which held large amounts of mortgage-backed securities, was particularly exposed. Firms that had been doing business with Lehman—its ‘counterparties’—began demanding additional safeguards, which Lehman could not provide. As a result, absent a government bailout, Lehman could not continue doing business. The refusal of the Government to save Lehman Brothers, and Lehman’s resulting bankruptcy, added to this cascade. Securities markets became so panicked that even the short-term commercial paper market virtually shut down, and the market prices of mortgage-backed securities collapsed substantially below the intrinsic value of the mortgage assets underlying those securities.[2]

The collapse became a death spiral as banks and other financial institutions holding mortgage-backed securities had to write down their value under “mark-to-market” accounting rules. This caused these firms to appear more financially risky, in turn triggering widespread concern over counterparty risk. The high leverage of many of these firms effectively required fire-sales of assets, exacerbating the fall in prices.

Although the Dodd-Frank Act prescribes many steps to attempt to prevent another financial crisis, most of these steps focus on banks and other financial institutions, not on financial markets. Such a limited focus worked well when banks and financial institutions were the primary source of corporate financing. But the financial crisis reveals that this focus is insufficient now that companies obtain much of their financing directly through financial markets—such as through securitization financing.[3] Both financial institutions and financial markets can (if they fail) be triggers, and also transmitters, of systemic risk.

REGULATORY APPROACHES TO SYSTEMIC RISK

So how should we regulate systemic risk? The primary (if not sole) justification for regulating financial risk is the maximization of economic efficiency. Because systemic risk is a form of financial risk, efficiency should be a central goal in its regulation. But systemic risk creates an added regulatory dimension: without regulation, the externalities—harm to third parties—would not be prevented or internalized because systemic risk is a risk to the financial system itself. Market participants are motivated to protect themselves, but they are not as directly motivated to protect the system as a whole.

As a result, there is a type of “tragedy of the commons,” a collective action problem in which the benefits of exploiting finite capital resources accrue to individual market participants, each of whom is motivated to maximize use of the resources, whereas the costs of exploitation, which affect the real economy, are distributed among an even wider class of persons.[4] Any regulation of systemic risk thus should focus not only on traditional efficiency but also on the stability of the financial system.

In examining regulatory approaches to systemic risk, one should also take into account the costs of regulation. There are direct costs, such as hiring government employees to monitor and enforce the regulations. But more importantly there can be indirect costs, such as overregulation that stifles innovation and competitiveness. Subject to that caveat, a range of possible regulatory approaches, aimed at making the financial system more efficient and stable, should be considered when assessing Dodd-Frank.

Averting Panics. The ideal regulatory approach would focus on eliminating the risk of systemic collapse from the outset. This goal could be substantially achieved by preventing financial panics, since they are often the triggers that commence a chain of failures.[5] The recent financial crisis itself, for example, was initially triggered by financial market panic. But any regulation aimed at preventing panics that trigger systemic risk would almost certainly fail to anticipate all the causes of the panics. Furthermore, even when identified, panics cannot always be averted easily because investors are not always rational.[6]

Requiring Increased Disclosure. Another potential regulatory approach is to improve disclosure. Disclosing risks traditionally has been viewed, at least under U.S. securities law, as the primary market-regulatory mechanism.[7] Dodd-Frank puts great stock in the idea of improving disclosure.[8] Disclosure works by reducing, if not eliminating, asymmetric information among market players, making the risks transparent to all. In the context of systemic risk, however, individual market participants who fully understand that risk will be motivated to protect themselves but not necessarily the system as a whole. As a result of the aforesaid tragedy-of-the-commons, a market participant may well decide to engage in a profitable transaction even though doing so could increase systemic risk, since much of the harm from a possible systemic collapse would be externalized.

Furthermore, the efficacy of disclosure is limited by the increasing complexity of transactions and markets.[9] In the financial crisis, for example, there is little question that most, if not all, of the risks regarding the complex mortgage-backed securities were disclosed.[10] Yet many institutional investors bought these securities based primarily on their ratings, without fully understanding them. There are at least four reasons why disclosure failed:

(i) Investors overrelied on heuristics such as rating-agency ratings. Dodd-Frank attempts to fix this problem by focusing on ratings, not on investors.^{^[11]} However, the actions of S&P and Moody’s arguably met the Act’s requirements, had those requirements applied during the financial crisis. The real problem is not rating agency failure but investor complacency. Because human nature cannot be easily changed, it is unclear—and Dodd-Frank does not address—how investor complacency can be remedied.

(ii) Investors followed the herd in their investment choices. Again, this is an implacable problem of investor complacency.

(iii) Conflicts of interest were created by short-term management compensation schemes, especially for technically sophisticated secondary managers.[12] For example, as the VaR, or value-at-risk, model for measuring investment-portfolio risk became more accepted, financial firms began compensating secondary managers not only for generating profits but also for generating profits with low risks, as measured by VaR.[13] Thus, secondary managers turned to investment products with low VaR risk profile, like credit-defaults swaps that generate small gains but only rarely have losses. The managers knew, but did not always explain to their superiors, that any losses that might eventually occur would be huge. This is an intra-firm conflict, quite unlike the traditional focus of scholars and politicians on conflicts between senior executives and shareholders. Dodd-Frank attempts to fix the traditional type of conflict but completely ignores the problem of secondary-management conflicts.[14]

(iv) The retention by underwriters of residual risk portions may have fostered false confidence in buyers, in effect creating a mutual misunderstanding. Ironically, this could be exacerbated in the future by Dodd-Frank’s requirement that sellers of securitization products retain a minimum unhedged position in each class of products they sell.[15]

Imposing Financial-Exposure Limits. The failure of one or more large and interconnected institutions could create defaults large enough to de-stabilize other highly-leveraged investors, increasing the likelihood of a systemic market meltdown. This suggests another possible approach to regulation: placing limits on an institution’s financial exposure. The following financial-exposure limits may be considered:

(i) First, the limitation of an institution’s leverage could reduce the risk of failure of that institution in the first place. It could also reduce the likelihood of financial contagion between institutions. However, limiting leverage can create significant costs because some leverage is good, and there is no optimal across-the-board amount of leverage that is right for every institution. The Dodd-Frank Act, however, directs the Federal Reserve to set “prudential” capital standards for certain large financial institutions,[16] including a maximum debt-to-equity ratio of 15:1.[17]

(ii) Second, the limitation of an institution’s right to make risky investments could reduce that institution’s downside risk. It is, however, a highly paternalistic approach, substituting a blanket regulatory prescription for a firm’s own business judgment. One should be highly skeptical of any rule that attempts to protect a sophisticated financial institution from itself. Dodd-Frank’s implementation of the Volker Rule, however, attempts to do precisely that by limiting the ability of banks and certain other financial institutions to engage in “proprietary trading”—essentially investing in securities for their own account.[18]

(iii) Third, the limitation of amounts of inter-institution financial exposure would facilitate stability by diversifying risk, in effect by reducing the losses of any given contractual counterparty and thus the likelihood that such losses would cause the counterparty to fail. Limits might also reduce the urgency, and hence the panic, that contractual counterparties feel about closing out their positions. This approach already applies to banks through lending limits, which restrict the amount of bank exposure to any given customer’s risk. Its application beyond banks to other financial institutions is potentially appealing given the increasing blurring of lines between banks and non-bank financial institutions and the high volumes of financial assets circulating among non-bank financial entities.

It is questionable, though, whether the government should impose financial exposure limits on large financial institutions. These institutions have already tried to protect themselves through risk management and risk mitigation. The financial crisis has raised questions, however, whether conflicts of interest among managers and other failures can undermine institutional risk management. Dodd-Frank addresses this problem by requiring many large public financial firms to establish risk committees, including at least one risk-management expert, responsible for enterprise-wide risk management oversight.[19]

Limiting Financial Institution Size. This is related to financial exposure limits, but this approach also addresses potential moral-hazard from institutions who believe they are “too big to fail.” There is, however, no clear evidence of such risky behavior, and financial institutional losses in the recent financial crisis can be explained by other reasons.

Financial institution size should not be artificially limited. Size should be governed by the economies of scale and scope needed for institutions to successfully compete, domestically and abroad—so long as that size is manageable. We should watch out, however, for institutions that increase their size, especially by acquisition of other institutions, primarily to satisfy senior management egos. Dodd-Frank indirectly addresses this concern (at least weakly) by linking senior executive compensation to long-term results—for example, requiring stock exchanges to adopt standards whereby listed companies implement policies to recoup senior executive compensation in the event of an accounting restatement.^{^[20]}

Ensuring Liquidity. Ensuring liquidity could facilitate stability in two ways: by providing liquidity to financial institutions in order to prevent them from defaulting, and by providing liquidity to financial markets as necessary to keep them functioning.

The Federal Reserve Bank has had the role (under §13(3) of the Federal Reserve Act) of lender of last resort by providing liquidity to banks and other financial institutions in order to prevent them from defaulting.^{^[21]} However, acting as a lender of last resort to institutions can be costly. By providing a lifeline, a lender of last resort can at least theoretically foster moral hazard by encouraging financial institutions—especially those that believe they are “too big to fail”—to be fiscally reckless. It can also shift costs to taxpayers since loans made to institutions will not be repaid if the institutions eventually fail.

For these reasons, the Dodd-Frank Act sharply limits the power of the Federal Reserve to make emergency loans to individual or insolvent financial institutions.^{^[22]} That categorical limitation appears somewhat excessive, though; a lender of last resort can be an important safeguard if it acts judiciously.

One way that Dodd-Frank attempts to avoid the need to make emergency loans is by requiring banks and—to the extent designated as “systemically important”—other financial firms to be subject to a range of capital, leverage, and liquidity requirements[23] and periodic “stress testing.” ^{^[24]} It also requires these entities to submit a resolution plan (a “living will”) that sets forth how, in the case of failure, the firm would wind down in a way that minimizes systemic impact.^{^[25]} The intention behind these provisions is to prevent failure and, if failure occurs, to mitigate the need for emergency loans by allowing the firm to fail in an orderly manner. The ultimate question, though, will be whether the ex ante plan matches the ex post reality.

Regardless of how one views a lender of last resort to financial institutions, the financial crisis has shown that, in an era of disintermediation, more attention needs to be focused on providing liquidity to financial markets as necessary to keep them functioning. This approach should also be less costly than lending to institutions. A market liquidity provider of last resort, especially if it acts at the outset of a market panic, can profitably invest in securities at a deep discount from the market price and still provide a “floor” to how low the market will drop.[26] Buying at a deep discount will mitigate moral hazard and also make it likely that the market liquidity provider will be repaid.

Reducing Complexity. An obvious way to address complexity would be to require investments and other financial products to be more standardized, so market participants do not need to engage in as much due diligence. One of the goals of Dodd-Frank is to standardize more derivatives transactions. To this end, the Act requires many derivatives to be cleared through clearinghouses,[27] which generally require a high degree of standardization[28] in the derivatives they clear.[29] The overall economic impact of standardization is unclear, though, because standardization can interfere with the ability of parties to achieve the efficiencies that arise when firms craft derivatives tailored to particular needs of investors.

RECOMMENDATIONS

Three regulatory initiatives that go beyond Dodd-Frank could address the aforementioned concerns: (1) requiring that managers, including secondary managers, of financial institutions be compensated based more on long-term firm performance; (2) establishing a market liquidity provider of last resort; (3) requiring financial institutions of systemic significance to contribute to a fund that would be used to mitigate systemic externalities.

A market liquidity provider of last resort would have the best chance of minimizing a systemic collapse under any number of circumstances. Chaos theory supports the concept of a market liquidity provider of last resort. In complex engineering systems, as in complex financial markets, failures are inevitable. Therefore modularity is needed to break the transmission of these failures and limit their systemic consequences. Such a mechanism usually exists (or should exist) for banks, in the form of a liquidity provider of last resort; we also need this type of mechanism for complex financial markets.[30]

Recent experience in the financial crisis supports establishment of a market liquidity provider of last resort. In response to the collapse of the commercial paper market, the Federal Reserve created the Commercial Paper Funding Facility (“CPFF”) to act as a lender of last resort for that market, with the goal of addressing “temporary liquidity distortions” by purchasing commercial paper from highly rated issuers that could not otherwise sell their paper.[31] The CPFF apparently helped to stabilize the commercial paper market.[32]

This same approach can be applied more generally to respond to panic in securities market. Say, for example, that the intrinsic value—effectively the present value of the expected value of the underlying cash flows—of a type of mortgage-backed security is estimated to be in the range of 80 cents on the dollar. If the market price of those securities had fallen significantly below that number, say, to 20 cents on the dollar, the market liquidity provider could purchase these securities at, say, 60 cents on the dollar, thereby stabilizing the market and still making a profit. To induce a holder of the mortgage-backed securities to sell at that price, the market liquidity provider could, for example, agree to pay a higher “deferred purchase price” if the securities turn out to be worth more than expected.[33] This is just one (simplified) example of the flexible pricing approaches used in structured financing transactions to buy financial assets of uncertain value which could be adapted to a market liquidity provider’s purchases.[34]

One might ask why, if a market liquidity provider of last resort can invest at a deep discount to stabilize markets and still make money, private investors would not also do so, thereby eliminating the need for some sort of governmental market liquidity provider. One answer is that individuals at investing firms will not want to jeopardize their reputations (and jobs) by causing their firms to invest at a time when other investors have abandoned the market. Another answer is that private investors usually want to buy and sell securities, without having to wait for their maturities; whereas a market liquidity provider of last resort should be able to wait until maturity, if necessary.

The third recommendation—to require financial institutions of systemic significance to contribute to a systemic risk fund—responds to the tragedy-of-the-commons problem by helping to mitigate systemic externalities. This type of approach was originally provided by the Dodd-Frank Act, but it was taken out before enactment because of opposition by politicians who believed (perhaps wrongly) that it would increase moral hazard by institutionalizing bailouts.[35]

A privately-funded systemic risk fund not only can mitigate systemic externalities but also can help minimize the potential for risky behavior caused by institutions that believe they are too big to fail. The too-big-to-fail problem is effectively an externality imposed on government (and ultimately taxpayers) by an institution engaging in such risky behavior. A privately-funded systemic risk fund would help to internalize that externality. Furthermore, the ability of government to require additional contributions to this type of fund should motivate contributors to the fund to monitor each other in order to reduce the potential for such risky behavior.

Recently, the European Commission has been toying with the idea of a systemic risk fund in connection with its proposal to tax the financial sector.[36] Although the ultimate use of the tax revenues is currently unresolved, news reports indicate that an originally contemplated use was a systemic risk fund.[37] The IMF also appears to be using the European Commission tax proposal as a platform to announce that “new taxes on banks [are] needed to provide an insurance fund for future financial meltdowns and to curb excessive risktaking.”[38]

The European Commission recognizes that in order to avoid making the EU financial sector uncompetitive, any tax on the financial sector should be applied in all financial centres. This illustrates a broader principle: because financial markets and institutions increasingly cross sovereign borders, any regulatory approaches must be designed to work in an international context. The Dodd-Frank Act does not, however, fully come to grips with how the U.S. financial regulatory framework should operate, or even fit, as part of a global financial regulatory framework.

CONCLUSION

We have made some, but not nearly enough, progress in identifying and managing systemic risk. Being a political response, Dodd-Frank consists largely of politically targeted responses to the recent financial crisis, at times looking for villains (whether or not they exist) who caused the crisis. To be most effective, however, financial regulation must be situated within an analytical framework that realistically explains how systemic risk is transmitted and why free-market factors do not limit that transmission.[39] The tragedy of the commons, for example, is certainly part of that explanation.[40]

The Dodd-Frank Act nonetheless has the potential to ultimately reach beyond politically targeted responses. The Act delegates much of the regulatory details to administrative rulemaking, in many cases after the relevant government agencies engage in further study. Perhaps even more significantly, the Act creates a Financial Stability Oversight Council, part of whose mission is to monitor and identify potential systemic threats in order to find regulatory gaps.^{^[41]} The Council will be aided in this task by a newly-created and, hopefully, nonpartisan Office of Financial Research.^{^[42]}In these ways, regulators have the ability to look beyond the Act’s confines. This article has attempted to provide ideas they might pursue.

* Stanley A. Star Professor of Law & Business, Duke University School of Law; Founding/Co-Academic Director, Duke Global Capital Markets Center. E-mail: schwarcz@law.duke.edu. I thank Kenneth Anderson and participants in the George Mason University AGEP Advanced Policy Institute for valuable comments. This article was referenced in Professor Schwarcz’s testimony before the Subcommittee on Securities, Insurance, and Investment of the U.S. Senate Committee on Banking, Housing, and Urban Affair on May 18, 2011. The article is itself based on his keynote address at the March 2011 George Mason University AGEP Advanced Policy Institute on Financial Services Regulation.

[1] Steven L. Schwarcz, Systemic Risk, 97 Geo. L.J. 193, 200 (2008).

[2] For example, in July 2008 I was an expert in the Orion Finance SIV case in the English High Court of Justice. Orion’s mortgage-backed securities had a market value of around 22 cents on the dollar, whereas the present value of its reasonably-expected cash flows was around 88 cents on the dollar because most of the mortgages were prime.

[3] Securitization generally involves the issuance by special-purpose entities of securities backed by a wide range of financial assets, such as mortgage loans, and the process of creating and issuing those securities. Steven L. Schwarcz, Regulating Complexity in Financial Markets, 87 Wash. U. L. Rev. 211, 221 (2009).

[4] See Schwarcz, supra note 3 (explaining this concept).

[5] See id. at 214 (providing examples of regulatory means to avert financial panics).

[6] For an analysis of how regulation can help to mitigate the impact of panic in financial securities markets see infra notes 30-34 and accompanying text.

[7] See, e.g., Cynthia A. Williams, The Securities and Exchange Commission and Corporate Social Transparency, 112 Harv. L. Rev. 1197 (1999) (discussing the general purpose of disclosure in the Exchange Act and the Securities Act).

[8] E.g. Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 1103, 124 Stat. 1376, 2118 (2010) (requiring additional disclosure from the Federal Reserve).

[9] This increasing complexitiy may very well be the greatest challenge for the twenty-first century financial system.

[10] See Steven L. Schwarcz, Disclosure’s Failure in the Subprime Mortgage Crisis, 2008 Utah L. Rev. 1109, 1110 (2008).

[11] Dodd-Frank Act §§ 931-939H.

[12] See Steven L. Schwarcz, Conflicts and Financial Collapse: The Problem of Secondary-Management Agency Costs, 26 Yale J. on Reg. 457 (2009).

[13] See, e.g., Philippe Jorion, Value at Risk: The New Benchmark for Managing Financial Risk 568 (3d ed. 2006).

[14] Dodd-Frank’s attempt to fix the traditional conflict might actually backfire; recent research suggests that shareholders, even more than senior executives, want the company to take risks. See Iman Anabtawi, Who’s the Boss? Re-writing the Rules of Corporate Governance, Chapman Law Review 2011 Symposium Panel (Jan. 28, 2011), available at http://ibc.chapman.edu/Mediasite/Viewer/?peid=1976265402884963a7346be7bc42763b.

[15] See Dodd-Frank Act sec. 941, § 15G (directing the SEC to require sponsors of asset-backed securities to retain at least five percent of the credit risk of the underlying assets).

[16] Banks are already subject to the Basel capital requirements.

[17] Dodd-Frank Act § 165(j).

[18] Id. sec. 619, § 13.

[19] Id. § 165(h).

[20] Id. § 954.

[21] Federal Reserve Act of 1913 § 13(3), 12 U.S.C. § 343 (2010).

[22] Dodd-Frank Act § 1101.

[23] Id. § 115(b)

[24] Id. § 165(i).

[25] Id. § 165(d).

[26] This is very different from quantitative easing, in which a central bank purchases securities as a form of monetary policy. For example, the U.S. Federal Reserve recently concluded a $600 billion quantitative easing program of purchasing U.S. Treasury securities in order to hold down long-term interest rates. See, e.g., Burton Frierson, Richard Leong, & Chris Reese, Federal Reserve Announces It Will Conclude Quantitative Easing, Huffington Post, June 10, 2011, available at http://www.huffingtonpost.com/2011/06/10/federal-reserve-plans-to-_n_875044.html. In contrast, the task of a market liquidity provider of last resort (as contemplated by this article) would be much more targeted: to prevent market collapses due to panic. See infra notes 32-36 and accompanying text (explaining how a market liquidity provider of last resort would act).

[27] Id. sec. 723(a), § 2.

[28] See Martin N. Baily et al., Credit Default Swaps, Clearinghouses, and Exchanges 4 (Squam Lake Working Group on Financial Regulation, Working Paper, July 2009), available at http://www.cfr.org/content/publications/attachments/Squam_Lake_Working_Paper5.pdf.

[29] This can become a little circular, though, because Dodd-Frank includes an exception for derivatives that a clearinghouse will not accept for clearing. Dodd-Frank Act sec. 723(a), § 2(h)(3). Further, the clearinghouse requirement might inadvertently concentrate systemic risk in the clearinghouses themselves.

[30] See Schwarcz, supra note 5.

[31] See Tobias Adrian, Karin Kimbrough, & Dina Marchioni, The Federal Reserve’s Commercial Paper Funding Facility, Fed. Reserve Bank of N.Y. Staff Report No. 423 (April 1, 2010).

[32] Id. at 11 (concluding that “[t]he CPFF indeed had a stabilizing effect on the commercial paper market”).

[33] See Steven L. Schwarcz, Too Big To Fail?: Recasting the Financial Safety Net, in The Panic of 2008 (Lawrence E. Mitchell & Arthur E. Wilmarth, Jr. eds., Edward Elgar 2010), available at http://ssrn.com/abstract=1352563 (where this example was taken from).

[34] Alternatively, the market liquidity provider of last resort could attempt to stabilize the market by entering into derivatives contracts to strip out risks that the market has the greatest difficulty hedging—in effect, the market’s irrationality element—thereby stimulating private investment. By hedging—and not actually purchasing securities directly—the market liquidity provider would appear to be taking less investment risk, and thus its function may be seen as more politically acceptable. Id.

[35] S. Amdt. 3827, 111th Cong. (2010) (eliminating the proposed $50 billion dollar fund, financed by a tax on banks, that would help wind down failed financial companies).

[36] European Commission, Taxation of the Financial Sector, a Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee and the Committee of the Regions: (Brussels COM (2010) 549/5; SEC (2010) 1166).

[37] Commission Proposes a Bank Tax to Cover the Costs of Winding Down Banks that Go Bust (May 26, 2010), available at http://ec.europa.eu/news/economy/100526_en.htm (last visited Mar. 1, 2011).

[38] Larry Elliott & Jill Treanor, IMF: Supervise and Tax Banks or Risk Crisis, The Guardian, Oct. 8, 2010, at 25 (London-final ed.) (paraphrasing an announcement by the IMF’s then-Managing Director Dominique Strauss-Kahn).

[39] See, e.g., Iman Anabtawi & Steven L. Schwarcz, Regulating Systemic Risk: Towards an Analytical Framework, 86 Notre Dame L. Rev., issue no. 4 (forthcoming Spring 2011).

[40] See Steven L. Schwarcz, Understanding the Subprime Financial Crisis, 60 S.C. L. Rev. 549 (2009) (arguing that the failures giving rise to the recent financial crisis can be attributed conceptually to at least four market imperfections: conflicts of interest, complacency of investors and other market participants, complexity of financial markets and of the securities traded therein, and the tragedy of the commons).

[41] Dodd-Frank Act § 112.

[42] Id.

Preferred citation: Steven L. Schwarcz, Identifying and Managing Systemic Risk: An Assessment of Our Progress, 1 Harv. Bus. L. Rev. Online 94 (2011), https://journals.law.harvard.edu/hblr//?p=1412.

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