GLawFin – Private Contracts and Systemic Risk

Project Start:01/2014
Researchers:Luca Amorello, Pedro Magalhães Batista, Biljana Biljanovska, Jacob Bonavita, Grygoriy Pustovit, Max Weber
Category: Law and Finance, Systemic Risk Lab
Funded by:LOEWE

All financial relations and financial markets are rule-bound. Private contracts are important sources of rule-bound finance. Their credibility and by implication their value, however, depend on the likelihood that state regulators and courts will vindicate them in light of existing rules. There are instance when the binding effect of contracts might threaten the survival of the financial system. The resulting tension between contract and systemic risk will be exemplified in different areas:

1. The credibility of public IOUs – sovereign debt -, and their value hinges on the expected likelihood that the state is both capable of and willing to make good on its promises. This becomes clear from the complications for restructurings that can result from the use of pari passu covenants in sovereign bonds and shall be analyzed in light of current questions these covenants raise (CACs, economic effects, institutional responses).

2. In order to avoid systemic risk when enforcing contracts to the letter of the law the European legislator included the bail-in in the Single Resolution Mechanism as a tool to enable authorities with the statutory power to impose losses on shareholders, bondholders and possibly other creditors. Open questions touch on failure of cross-border banks, the emergence of different risk appetite on investor side, who might review their risk and reward perception, and their funding strategy and funding mix, the legal uncertainty because of possibly resulting unforseeability for issuers and investors, and asset quality review.

3. In the investor-advisor relationship the new perspective of the role of contracts may not so much turn on the optimal amount of information, but rather on the protection of retail investors against macro-economic shocks. Since the trend towards consumerization in the EU retail investor protection regime has been looked at very frequently in the light of behavioral finance, the analysis in light of systemic risk may lead to new regulatory tools in the field of retail investor protection.

4. An example of how the contractual design of financial instruments is used to allocate the costs of future uncertainty and liquidity volatility are OTC derivatives. In collaboration with researchers from the Chicago Fed we plan to look at legal arrangements of cross-border resolution and liquidity in OTC derivative markets a little more closely in order to crossfertilize perspectives among academics, policymakers, and practitioners.

In June 2014 Pistor and Haar participated in a workshop at the Chicago Fed which laid the foundation for an interdisciplinary exchange with practitioners. At the LEMF Summer School on central banking in 2014, this exchange was continued in order to identify liquidity as one of the major issues to focus on in the future work of this project. This was also the topic of a workshop held in June 2015 in Oxford. Liquidity will also be a major topic at the concluding conference on ‘Finance between Liquidity and Insolvency’ to be held in Frankfurt in December 2015, which will explore the relation between liquidity and insolvency both at the conceptual and institutional level.


Related Published Papers

Author/sTitleYearProgram AreaKeywords
Brigitte HaarFreedom of Contract and Financial Stability
European Business Organization Law Review
2016 Law and Finance, Systemic Risk Lab

Related Working Papers

No.Author/sTitleYearProgram AreaKeywords
141Brigitte HaarFreedom of Contract and Financial Stability Through the Lens of the Legal Theory of Finance2016 Law and Finance, Systemic Risk Lab law and finance, financial stability, financial contracts, structured finance, asset-backed securities, pari passu clauses, collective action clauses, otc derivatives markets, central counter parties, Basel III, Coco bonds, trust law, China