Network-Sensitive Financial Regulation

Shocks that hit part of the financial system, such as the subprime mortgage market in 2007, can propagate and amplify through the complex network of interconnections among financial and non-financial institutions to take on systemic proportions. The financial crisis of 2007-2009 showed that the consequences of such systemic risk materializing can be catastrophic, prompting economists and regulators to redevelop the academic and regulatory toolkit used to study and curtail such risk. Increasingly, and intuitively given the important role of interconnections, they have resorted to the use of network theory to study systemic risk. Legal scholars, however, have so far largely overlooked this perspective; most of the rules in financial regulation remain “atomistic”, in that they fail to account for the fact that each individual is part of, and plays a role in, a wider network.

We argue that systemic risk can be more effectively mitigated by introducing “network-sensitive regulations”. Such policies take account of the position and role of an individual institution in the financial network and become progressively stricter as the importance of that institution to the wider network increases.

This approach complements the shift in regulatory emphasis from preserving the stability of individual institutions (“microprudential” regulations or policies) to ensuring the stability of the system as a whole (“macroprudential” regulations or policies) in two ways. First, although there are some network-sensitive macroprudential policies, such as the risk-based capital surcharge for systemically important banks, we show that their implementation is incomplete and patchy. Second, as of yet there is no example of network-sensitive microprudential regulation. We argue that such policies are not only feasible but also helpful in mitigating systemic risk by applying network theory to a novel area: proposals that aim to enhance the corporate governance of systemically important financial institutions (SIFIs).

Specifically, we consider four policy prescriptions that aim to enhance the corporate governance of SIFIs (one on directors’ liability, two on executive compensation, and one on failing financial institutions’ shareholders appraisal rights) that are currently atomistic in orientation, and show how making them network-sensitive would both increase their effectiveness in taming systemic risk and better calibrate their impact on individual institutions. Our purpose is not to argue in favor of (or against) any specific proposal but rather to highlight the advantages of a shift of paradigm in the direction of network-sensitive regulation in the area of corporate governance.