Understanding
Financial Architecture: Legal and Political Frameworks and Economic
Efficiency
Research
Training Network
Research Highlights
Scientific Highlights
The objectives of the UFANET network were to improve our understanding of the interaction between legal frameworks and financial market activity, as well as the effects that these have on economic efficiency and growth. A second objective was to link research on law and finance with political economy.
Since the network was conceived, research in the area of political economy of law and finance has expanded significantly, and this network has played an active role in this development (for a recent survey of the field, see Pagano (Salerno) and Volpin). Many of the leading researchers in the field are members of the network or have participated in its activities. Equally important, many young European researchers have been attracted through the network to this dynamic area of research.
The overall research output is substantial with 16 papers written involving researchers from two or more nodes of the network. In addition, network researchers have produced 50 papers under the general theme of the project. Most nodes have contributed research under all three main areas identified in the original project proposal: corporate governance, bankruptcy, and market organization and efficiency.
Several studies have addressed issues of corporate governance and advanced knowledge in this important field considerably. Suarez (CEMFI) has uncovered novel interactions between stock-based compensation and the stock market reaction to the announcement of certain financing deals, and between severance pay and different degrees of managerial entrenchment. Burkart (SITE) has questioned some of the conventional wisdoms in the rapidly growing literature on investor protection and finance, by showing that excessive protection of minority investors may undermine monitoring incentives of controlling shareholders. In a novel general equilibrium model with two countries (or regions), Fabbri (Salerno, Young Researcher) has analysed the impact of investor protection on private investment and provided a first empirical study showing that there are macroeconomic effects of better investor protection. Giannetti (SITE, Young Researcher) has identified a new channel from legal protection of investors to financing costs through the degree of diversification. Researchers based at the Frankfurt node have investigated international comparative corporate governance, both theoretically (Schmidt) and empirically (Mann and others). Becht (ECARES) and Mayer (Oxford) have completed work on a major book on "The Control of Corporate Europe" that has been described as "the most in depth-study of nuances and structure of concentrated ownership and voting control in Europe’s large firms" (Mark Roe, Harvard Law School). Mayer (Oxford) and Franks (LBS/ CEPR) have started a project looking at the evolution fo the ownership and control of companies in the UK over the past century. Becht (ECARES), Bolton (Princeton) and Roell (Princeton) were invited to contribute a survey on corporate governance and control for the forthcoming "Handbook of the Economics of Finance". Finally, Alan Schwartz (Yale) and Ronald Gilson have done work on corporate governance, in particular analysing the question whether sales or elections are superior methods to achieve efficient changes of corporate control. Roberta Romano (Yale) has done work on proxy contests and other aspects of securities law; and Henry Hansmann (Yale) has done work on corporate governance and a comparative study on the relation between trust and corporate law.
In the area of bankruptcy, Biais and Recassens (Toulouse) have studied the political determinants and the financial consequences of bankruptcy laws. In particular, they demonstrate how income distribution may affect the design of bankruptcy law. In work presented at the Frankfurt conference, Berglof (SITE) and Howard Rosenthal (Princeton) showed that the divergence of bankruptcy law in the United States from its English origins is explained by the legislative process, rather than the courts, and that economic conditions as well as ideology and banking interests shaped the outcome. In on-going work with Franks (LBS/CEPR), Sussman (Oxford) studied similar issues for the U.K., with particular emphasis on the role of banks. Berglof (SITE) and von Thadden (Lausanne/CEPR) have continued developing a framework for understanding the interaction between key elements of bankruptcy law, in particular the ex-post adjustment of claims, the right to trigger bankruptcy, "automatic stays" and seniority. Krahnen (Frankfurt/CFS) has identified banking pools as an important contractual remedy to inefficient liquidations that are imminent when multiple banks finance firms. His work allows possible conclusions for the re-design of the German insolvency code. Finally, Schwartz, Welch (Yale) and Bris (Yale) are doing research on the appropriate allocation of bankruptcy costs, as well as the actual allocation of them in large bankruptcies.
Critical aspects of financial architecture are the prudential regulation of banks and regulation of market organization. Repullo and Suarez (both CEMFI) separately analyse several aspects of the prudential regulation of banks. Repullo focuses on how the principle of home country supervision (applicable in the EU) affects the cross-border takeover activities of banks. Suarez, in an analysis of the interactions between competition policy and prudential regulation in banking, shows that promoting the takeover of failed banks by solvent institutions can be an effective means to prevent banks from excessive risk-taking. In Oxford, Morrison has developed important new theoretical insights into the role of deposit insurance and capital adequacy in banking regulation, while Schoors has empirically examined the effects of banking regulation in transition economies.
The relationship between banks and their clients are influenced by and affect the financial architecture. Krahnen and Elsas (CFS) have collected a unique data set on these relationships in Germany. Using first-hand credit file data from major commercial banks, savings banks and cooperative banks, they analyse how credit risks are typically measured and managed in the German banking sector. The research programme comprises projects on internal rating systems, on the economics of the German housebank, on bank behaviour in corporate distress, and on several other aspects of the financial architecture of the German economy.
The link between politics and financial market architecture has been the centre of attention of work by Pagano (Salerno) and Volpin (London Business School). They have shown that entrepreneurs and workers can strike a political agreement by which low investor protection is exchanged for high employment protection. This "corporatist" agreement is feasible if the political system favors the formation of coalition governments. These predictions are shown to be consistent with OECD evidence. The importance of political economy to our understanding of financial architecture has probably never been more conspicuous than in the transition economies. Berglof (SITE) and Bolton (Princeton) have evaluated the experience of financial development in the countries of Eastern Europe and former Soviet Union demonstrating the strong link between fiscal responsibility at the macro level and contractual enforcement at the micro level. Schoors (Oxford) has also analysed financial architecture in transition.
The network’s first conference, "The Political Economy of Financial Architecture", which was held in Frankfurt, was a success, with presentations by several leading contributors to the literature and involvement of key policymakers and practitioners, including the President of the Frankfurt Stock Exchange. All the nodes of the network, including the US universities, were represented at the conference. The focus was on the interaction between the political process and the financial sector, and how this interaction shapes financial arrangements between firms and investors.
The second workshop of the Network was held in Madrid on 26/27 October 2001, and was organized by Marco Becht, Erik Berglöf, Colin Mayer, Howard Rosenthal, and Rafael Repullo. Corporate governance is a key aspect of financial architecture. It has been an important policy issue, in particular in Europe, for over a decade. This workshop invited contributions analysing the origins and consequences of individually-adopted corporate governance mechanisms and economy-wide corporate governance systems. PDF versions of the papers, programme (34k) and the list of participants (33k) are available.
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Research Highlights