It is so very lucky that Sarah Woo chose to write Regulatory Bankruptcy: How Bank Regulation Causes Firesales as one article, not the four it could have been. When she died this summer, the legal academy lost a truly original thinker and careful researcher who asked the right questions—and had the knowledge, insight, and judgment to answer them. It is a huge loss.
Regulatory Bankruptcy is the rare article that finds smart answers to interesting questions, which also happen to be good answers to very important questions. The project occupies the intersection of bankruptcy, financial regulation, risk management, and crisis response, and makes theoretical and empirical contributions to each of these fields. I especially appreciate the way in which it helps flesh out the under-studied relationship between law and macroeconomic policy.
The article’s core argument goes to bankruptcy theory: the assumption that creditors seek to maximize individual asset recovery values in bankruptcy cases. Over the years, bankruptcy theorists have argued bitterly over the prescriptive implications of the maximizing assumption—whether it is socially desirable—but barely over the description. More recently, scholars have chipped away at the edges of the description, for example, where securitization or credit derivatives alter creditor incentives.
Woo’s case study goes to the heart of the bankruptcy paradigm: mid-market banks making simple secured loans for commercial real estate development. Her theoretical model suggests that banks, which manage risk on a portfolio basis, may suffer higher losses from asset concentration than from deterioration of individual assets. In their push to reduce concentration (or the proportion of commercial real estate loans in their portfolio), banks will rush to liquidate collateral, such as half-built homes, which would fetch far more if completed. This effect is especially pronounced in an economic downturn, and exacerbated by bank regulation and supervision.
For banking scholars, such findings are only partly intuitive. When bank supervisors press their charges to boost capital adequacy ratios, banks can either raise capital in the numerator, or sell assets in the denominator. The choice between categories and within each category is influenced by regulation and market conditions. For example, if regulators define qualifying capital narrowly, and it is relatively expensive to issue, banks will try to shed assets—especially those that carry high regulatory capital charges, come with supervisory penalties, and can fetch more in the market. In this world, it is perfectly plausible that a bank would choose to sell a “good” asset that has a high regulatory cost.
In Woo’s findings, regulation amplifies the risk management effect. Banks already benefit from reducing portfolio concentration; they benefit even more by responding to supervisory pressure to diversify. A key new twist comes with an economic downturn or a policy change: either or both can create across-the-board pressure on banks to sell assets, leading to fire sales and further depressing prices (bankruptcy contagion). Woo’s addition to financial regulatory literature thus is a mirror image of her bankruptcy contribution: in bankruptcy, she shifts focus from the debtor to creditors as a group; in banking, she illuminates the effects of regulatory policy on debtors as a group, and on other creditors.
If the core argument of the article is innovative, Woo’s execution is especially impressive. She develops her basic model by simulating loss rates in hypothetical bank portfolios with different levels of concentration in real estate construction and development. She finds that under stressed conditions concentration risk could become even more important than individual loan quality in driving portfolio losses, owing to loss correlation. Put differently, a bank with a decent but concentrated real estate portfolio may well lose more in a recession than a bank that made lower-quality real estate loans, but diversified better across sectors. The article proceeds to document a regulatory policy shift beginning in 2006 which resulted in across-the-board pressure on U.S. financial institutions to diversify real estate risk.
The empirical heart of the project is Woo’s analysis of data from real estate developer bankruptcies, combined with FDIC/FFIEC data on portfolio concentration and capital adequacy of the developers’ bank creditors. The hypothesis is that banks with higher real estate concentration ratios are more likely to ask bankruptcy courts to lift the automatic stay, allowing the banks to sell the underlying collateral (unfinished developments). To this un-quant, the analysis suggests pretty persuasively that concentration ratio trumps many other factors in driving bankruptcy fire sales.
The article ends with specific and sensible policy recommendations for bankruptcy reform and systemic risk regulation. More importantly, it helps inform bank regulators of bankruptcy, and bankruptcy judges of bank (and regulator) incentives, with implications far beyond the immediate context of the real estate case study. Woo is remarkably in tune with the latest economics research on crises and macroprudential regulation, yet she goes further to show that legal scholarship–as in her rich account of bankruptcy and banking law in action–has much to teach economists in this area. Her careful tracing of the ways in which “micro prudence” on the part of individual institutions, risk managers, judges, and regulators can become “macro risk” for the economy is smart, interesting, right, and immensely valuable.
Sarah Woo only just began teaching at NYU last year. She leaves behind an amazing range of articles, from contracts and project finance to bankruptcy, rating agencies and systemic risk regulation, along with blog and Jotwell contributions. Few people could or would take on the challenges she chose.
I met Sarah once last January, when she presented a version of Regulatory Bankruptcy and commented on other panelists’ papers—except that her commentary came complete with original (“quick and dirty”) data and graphs, which left both beneficiaries and observers momentarily speechless. I have kept her PowerPoint on my desktop, to remind myself of the effort and generosity we owe our colleagues and our audiences.