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

Topic and Objectives

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:

Key Findings

As a point of departure of our project, we laid out the development of European financial architecture and explored how it can be related to the goal, first, to establish an internal market and, later, to deal with systemic risk as it has increasingly become apparent throughout the global financial crisis. Following up on this, we found a variety of adverse repercussions of contracts on financial stability at the example of different phenomena which were particularly relevant for the development of the Global Financial Crisis. Since we show the formative effects legal rules have on markets, these findings amount to a paradigm shift because they depart from the common assumptions about the correlation between finance and law. In more detail, we show how pari passu clauses and regulation may create barriers to restructuring and highlight adverse repercussions of contracts on financial stability at the example of asset-backed securities. Another case in point is the tension between market discipline and financial stability and the resulting balance to be struck that we illustrate at the example of the design of CoCos as loss-absorption mechanisms under the European Bank Recovery and Resolution Directive (BRRD). It raises the question whether contractual or regulatory enforcement is the more suitable way to implement such a bail-in tool. Along similar lines, we can demonstrate the interdependence between the Basel III regulation and the countercyclical buffers introduced on its basis on the one hand and competition and consolidation in the banking sector on the other. On the other hand, we also find that the evolution of Chinese trust law has helped to prevent market instability and to shape corporate governance of the trust industry as the major part of China’s shadow banking sector. Our research on infrastructure governance in the OTC derivatives market shows the problems of market power of central counterparties and argues in favor of stricter regulation and liability of the CCPs. Overall, each of the papers, which were all published in a special issue of the European Business Organization Law Review, sheds a light on the contribution of legal design to shape financial markets and reduce financial stability in the respective areas.

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