Structural Corporate Degradation Due to Too-Big-To-Fail Finance by SSRN

Mark J. Roe

Harvard Law School

May 1, 2014

162 University of Pennsylvania Law Review 1419 (2014)

European Corporate Governance Institute (ECGI) – Law Working Paper No. 253/2014

Abstract:

Corporate governance incentives at too-big-to-fail financial firms deserve systematic examination. For industrial conglomerates that have grown too large to be 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 spin-offs 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.

Structural Corporate Degradation Due To Too-Big-To-Fail Finance – 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 198os. 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.

Too-Big-To-Fail Finance

Too-Big-To-Fail Finance

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