Structural corporate degradation due to too-big-to-fail finance.

• Author: Roe, Mark J.

Corporate governance incentives at too-big-to-fail financial firms deserve systematic examination. For industrial conglomerates that have grown too large to he efficient, internal and external corporate structural pressures push to resize the firm. External activists press the firm to restructure to raise its stock market value. Inside the firm, boards and managers see that the too-big firm can be more efficient and more profitable if restructured via spinoffs and sales. But a major corrective for industrial firm overexpansion fails to constrain large, too-big-to-fail financial firms when (1) the funding boost that the firm captures by being too-big-to-fail sufficiently lowers the firm's financing costs and (2) a resized firm or the spun-off entities would lose that funding benefit. Propositions (1) and (2) have both been true and, consequently, a major retardant to industrial firm overexpansion has gone missing for large financial firms. The effect resembles that of a corporate poison pill, but one that disrupts the actions of both outsiders and insiders.

INTRODUCTION I. THE LONDON WHALE AND JPMORGAN'S $6 BILLION TRADING LOSS A. The Events and the Corporate Governance Failure B. The Conventional Corporate Governance Wisdom 1. A Loss Well Within Shareholders' Equity 2. Shareholder- and Board-Based Governance as Remedy II. STRUCTURAL DEGRADATION DUE TO THE IMPACT OF TOO-BIG-TO-FAIL A. Too-Big-to-Fail as Poison Pill B. Too-Big-to-Fail as Breakup Protection C. Too-Big-to-Fail as Stymieing the Managerial Divisional Buyout D. The Required Takeover Premium III. THE FINANCIAL IMPACT OF TOO-BIG-TO-FAIL: DATA A. The Data: Concept B. The Data IV. THE EXTENDED SOCIAL COSTS A The Monopolist's Rectangle B. The Subsidy as Analogous to the Monopolist's Rectangle C. The Degradation as Another Channel to Financial Crisis V. Further Corporate Degradation A. The Subsidy as Debt Overhang B. Competitive Failure and Marketwide Degradation C. Too-Big-to-Jail D. How Remaining Corporate Governance Pressures Are Weak or Further Degrade the Too-Big-to-Fail Financial Firm VI. WHAT CAN BE DONE: COMMAND-AND-CONTROL VERSUS INCENTIVE-BASED POLICIES A. Severe Command-and-Control: Mimicking the Takeover and Breakup Market B. Mainstream Command-and-Control: More Equity, Restricted Activities C. Aligning Incentives: Taxing Financial Firms' Debt VII. THE STRUCTURAL OUTLOOK FOR BIG FINANCE WITHOUT A. TOO-BIG-TO-FAIL SUBSIDY A. Reducing the Systemic Cost of Shareholder-Oriented Governance B. The Instability of the Too-Big-to-Fail Subsidy C. The Dealmaking Impact of Successful Regulation CONCLUSION APPENDIX INTRODUCTION

Corporate governance controls help to keep firms competitive and efficient. They work imperfectly and at times do not work at all, but overall they push large firms to perform better. Persistently poor results induce a firm's board of directors to assess the firm's internal organization to see if it needs restructuring. Shareholders often agitate for change; corporate funding costs rise and constrain managers from continuing down an unprofitable path; and, at the limit, activist shareholders agitate for the firm to be broken up into separate, more tightly organized parts.

But these corporate controls deteriorate in too-big-to-fail financial firms. The most powerful corporate governance control in recent decades has been the corporate takeover and breakup of a too-large industrial firm into its constituent parts, which induced American industrial conglomerates to boldly restructure in the 1980s. If financial firms today were subject to such pressure, then firms that become too big would face shareholder breakup efforts, some of which would succeed. In this Article, I first analyze the interaction between financial corporate structure and the breakup takeover--the strongest corporate governance tool, despite its ongoing rarity--to explain why the strongest tool in the corporate governance toolbox cannot work for too-big-to-fail firms. More tellingly, most day-to-day corporate pressures and controls for boards to resize, spin off, and restructure also cannot work well, or at all, in the too-big-to-fail financial firm.

The explanation--that too-big-to-fail finance is restructuring-proof--is not yet integral to the analytics of the too-big-to-fail problem. Its core explanation is as follows: The likelihood that big finance will be bailed out in a crisis lowers the financial firms' cost of funding. These lower financing costs redound to the benefit of the firms' shareholders. This much is well known. But then the implicit too-big-to-fail subsidy operates as a shadow poison pill, resembling the governance defense that managers and boards have used successfully for the past quarter-century to ward off unwanted takeovers in the industrial sector. The traditional poison pill dilutes only the offeror's stock, thereby discouraging offers to buy the target company. Hence, the conventional pill impedes outsiders, but not insiders. In contrast, the too-big-to-fail "pill" also impedes insiders--a controlling shareholder where there is one, the board of directors, and the CEO--from restructuring the firm, even if such a restructuring would be operationally wise.

An operationally successful restructuring of such a too-big-to-fail financial firm will increase the firm's (or its spun-off divisions') overall value to the economy, but it will decrease the private value of the firm's stock to the extent the restructuring strengthens the constituent firms enough--or makes them sufficiently small that they are no longer too-big-to-fail. If the constituent parts would no longer be too big, then, as long as the expected value of the subsidy lost exceeds that of the restructuring gains, stockholders lack the incentive to restructure the firm and have reason to oppose even operationally efficient changes that would result in the loss of that subsidy. Corporate governance at the too-big-to-fail financial firm degrades. The benefited firm need not even be aware that the profitability of a line of business depends on the too-big-to-fail boost; it just finds that operational change in the subsidized environment is unprofitable.

This corporate degradation hurts the economy as a whole. Just as a monopolist will invest to protect its monopoly benefits up to the private profit the monopoly provides the firm, a too-big-to-fail firm will sacrifice its own efficiency--along with the efficiency of the economy's financial system--up to the cost of its subsidy advantage. The full size of the too-big-to-fail subsidy--estimated after the financial crisis to be in the tens of billions of dollars annually--can thereby be lost to the economy, allowing the too-big-to-fail firm to take on activities that could be handled more efficiently elsewhere in the economy.

In Part I, I describe the 2012-2013 controversy over JPMorgan Chase's London Whale and the bank's $6 billion trading loss, which embarrassed the firm, derailed previously successful executives' careers, and led to congressional investigations and negative media attention. The managerial lapse induced two contrasting classes of responses: One sought more regulation because even America's strongest big bank could make a major mistake. The other dismissed the problem as a huge loss for shareholders and managers, but one whose size was well within both JPMorgan Chase's $20 billion in annual earnings and its $200 billion of bank capital. Similarly, respected commentators argued that although big finance has become too large to be efficient, market forces will eventually induce the too-big financial firms to resize.

In Part II, I analyze the conceptual impact of the too-big-to-fail subsidy on financial firms' cost of funding, which operates as a powerful corporate poison pill. The subsidy destroys takeover value for a shareholder who would buy up the firm's stock and break up a far-too-big banking conglomerate. Less dramatically, but more importantly, the potential loss of the too-big-to-fail subsidy also reduces the value of day-to-day corporate restructuring strategies that managers and boards might otherwise pursue. Managers at an orphaned subsidiary might, for example, seek financing to buy those operations out from the financial conglomerate, believing they can run the spun-off operation better than the far-off senior managers at the bank's headquarters. But the buyout's funding would not garner the too-big-to-fail subsidy that the entire financial firm gets. Hence, the divisional managers and their financial backers face higher financing costs and cannot buy out a division even if the buyout would otherwise be profitable and operationally wise. The too-big-to-fail "pill" degrades both internal and external incentives to build better, stronger corporate structures. Importantly, the firm's senior managers need not seek the too-big-to-fail subsidy--and may even deny its existence--but the subsidy will still drive their fundamental structural decisions, as they weigh the costs and benefits of restructuring.

In Part III, I examine too-big-to-fail data, which measures what the too-big firm saves on its borrowings due to lowered funding costs. Reconfiguring the existing data as a percentage of shareholder profits shows estimates that the financial crisis led to the too-big-to-fail subsidy increasing financial firms' profits by about one-third beyond what they would otherwise have been. The overall picture is of a subsidy amounting then to the size of the takeover premium needed to motivate a takeover. If this level persists, operationally efficient internal restructurings to downsize or spin off will often not make economic sense to the firm, its managers, or its shareholders.

In Part IV, I examine related economic concepts emanating from antitrust analysis of the costs of monopoly. Applying that thinking to financial firms shows how the extended costs of too-big-to-fail can put a protective umbrella over degraded...