Too Small to Fail: State Bailouts and Capture by Market Underdogs

Author:Sharon Yadin
Position:Assistant Professor of Law and Business, Peres Academic Center, Israel. Email: sharon@yadin.com. This Article was written as part of my Lady Davis postdoctoral fellowship at The Hebrew University of Jerusalem and with the generous support of The Peres Academic Center. I would like to thank Judge David Mintz and Prof. Ruth Plato-Shinar for...
Pages:889-932
SUMMARY

Bailouts have become a pervasive phenomenon, particularly around the 2008 global financial crisis and states’ rescue of major financial institutions considered Too Big to Fail (TBTF). The TBTF approach intends to prevent catastrophic market domino effects due to the collapse of interconnected firms, through state subsidies. Critics who object to state bailouts of financially troubled firms point... (see full summary)

 
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TOO SMALL TO FAIL: STATE BAILOUTS AND CAPTURE
BY MARKET UNDERDOGS
SHARON YADIN *
ABSTRACT
Bailouts have become a pervasive phenomenon, particularly around
the 2008 global financial crisis, as states came to the rescue of financial
institutions considered Too Big to Fail (TBTF) faced with imminent
bankruptcy. While TBTF bailouts are officially designed to prevent
catastrophic domino effects in markets, critics view these bailouts as a
result of industry manipulations of regulators and state officials, leading to
regulatory capture. Scholars describe regulatory capture as a situation
where regulators favor the private interests of regulated firms over public
interests, in exchange for legally-dubious gains such as political capital,
monetary support, or lucrative future employment opportunities. While the
phenomenon of regulatory capture by large and resourceful firms is well
researched by economists, jurists, and political scientists, a new
unexplained phenomenon, yet to be addressed in academic literature, is
emerging in modern economies: the bailout of small firms. Due to the
relatively insignificant size and influence of those firms, they cannot be
considered economically too big to fail and are usually unable to provide
regulators with sufficient incentives to secure bailouts through classic
capture. Aiming to explain this phenomenon, this paper develops a Too
Small to Fail (TSTF) approach, asserting that small firms adopt an
underdog rhetoric designed to facilitate regulatory capture. TSTF firms
capture regulatory decision-making for lucrative bailouts by blaming
regulation, regulators, global and local catastrophes, or by pleading for
special consideration due to social importance. The case studies examined
in this paper include U.S.-owned firms in both health and media sectors
operating in Israel under Israeli regulation. This is an extremely useful
Copyright © 2015, Sharon Yadin.
* Assistant Professor of Law and Business, Peres Academic Center, Israel.
Email: sharon@yadin.com. This Article was written as part of my Lad y Davis
postdoctoral fellowship at The Hebre w University of Jerusalem and with the
generous support of The Peres Academic Center. I would like to thank Judge
David Mintz and Prof. Ruth Plato-Shinar for illuminating i nsights, professors
Barak Medina, Ro y Kreitner and Tal Zars ky for helpful advice a nd guidance, a nd
Jessica Paulik, Brian Finch and the ed itorial team at Capital University Law
Review for their diligence.
890 CAPITAL UNIVERSITY LAW REVIEW [43:889
arena for examining the underdog rhetoric of small firms because of its
unique geopolitical characteristics and disposition to capture, stemming
from an absence of comprehensive regulation policies. The paper
concludes with normative suggestions for overcoming TSTF capture by
imposing new legal duties on the regulatory decision-making process of
administrative agencies.
I. INTRODUCTION
Bailouts have become a pervasive phenomenon, particularly around
the 2008 global financial crisis and states rescue of major financial
institutions considered Too Big to Fail (TBTF).
1
The TBTF approach
intends to prevent catastrophic market domino effects due to the collapse
of interconnected firms, through state subsidies. Critics who object to state
bailouts of financially troubled firms point at manipulations that regulated
institutions perform on regulators and state officials, who become captured
by industries interested in state aid via the exchange of legally-dubious
favors.
2
While the phenomenon of regulatory capture by large and resourceful
firms is well researched by economists, jurists, and political scientists,
3
a
new unexplained phenomenon, yet to be addressed in academic literature,
is emerging in modern economies: the bailout of small firms. Due to the
relatively insignificant size and resources of those firms, the economic
logic of TBTF and regulatory capture does not account for their bailout.
Attempting to explain this phenomenon, this Article proposes a Too Small
to Fail (TSTF) bailout theory in which small firms capture regulatory
decision-making to obtain lucrative bailouts by employing an underdog
rhetoric: blaming regulation, regulators, global and local catastrophes, or
by pleading for special consideration due to social importance.
4
The case
studies examined in this Article include U.S.-owned firms in both health
1
For a general explanation of the idea of Too Big to Fail see infra part III.A. For the
emergence and development of the term and policy in U.S. financial history, see Jonathan
R. Macey & James P. Holdcroft, Jr., Failur e is an Option: An Ersa tz-Antitrust Approach to
Financia l Regulation, 120 YALE L.J. 1368, 137678 (2011).
2
For the general idea of capture see, e.g., DANIEL CARPENTER & DAVID A. MOSS,
Introduction, in PREVENTING REGULATORY CAPTURE: SPECIAL INTER EST INFLUENCE AND
HOW TO LIM IT IT 1, 13 (Daniel Carpenter & David A. Moss eds., 2013) [hereinafter
PREVENTING CAPTURE]; George Stigler, The Theory of Economic Regulation, 2 BELL J.
ECON. & MGMT. SCI. 3, 4 (1971).
3
See infra Part III.A.
4
See infra Part III.B.
2015] TOO SMALL TO FAIL 891
and media sectors operating in Israel under Israeli regulation.
5
This is an
extremely useful arena for examining the underdog rhetoric of small firms
because of its unique geopolitical characteristics and disposition to
capture,
6
stemming from an absence of comprehensive regulation policies.
While Israeli government administration relies heavily on regulating
private sectors, it has only recently started developing general regulation
guidelines and procedures, following Israel’s acceptance to the
Organization for Economic Cooperation and Development (OECD) in
2010. Israeli market regulatory and administrative procedure flaws are
especially evident, making it a good backdrop for legal analysis of
regulatory capture.
In 2008, one of history’s biggest financial crises erupted in the United
States and then spread worldwide. Similar to other countries, the U.S.
financial crisis was eventually resolved through government subsidies
state bailouts of major commercial and investment banks that were
considered too big to fail, such as JPMorgan Chase, Citigroup, Bank of
America, Bear Stearns, and large insurance companies like AIG.
However, this bailout practice, seemingly serving the public’s interest in
financial stability, was not immune to regulatory capture, as critics have
since pointed out.
Regulatory capture refers to regulatory agencies that prioritize the
interests of private regulated firms at the expense of the public interest they
are supposed to uphold.
7
Private regulated firms steer regulators away
from their public duties, encouraging regulators to act in those firms’ favor
when promoting legislation or taking regulatory action. These TBTF firms
use their vast resources to secure future posts for retired regulators,
influence political outcomes to favor regulators who seek reelection, or
refrain from media campaigns against regulators that might harm
regulatory reputation.
8
For example, a bank regulator may be considered
captured when he refrains from imposing strict regulation on the bank he
expects to chair after his retirement or extends regulatory favors when the
regulated bank has the power to publicly shame him or help his political
campaign.
5
See infra Part II.
6
See, e.g., Manuel Puppis, Media Regulation in Small States, 71 INTERNATIONAL
COMMUNICATION GAZETTE 7, 9 (2009).
7
See supra notes 14851 and accompanying text.
8
PREVENTING CAPTURE, supra note 2.

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