Centros@20: Making Legal Capital Relevant. Some Comments on Eilis Ferran’s ‘Revisiting Legal Capital’

In her article ‘Revisting Legal Capital’, summerised in this blog post, Eilis Ferran posits that recent ‘reconceptualisation of the corporation’ proposals pave the ground for bold new regulatory ideas. At the same time, she emphasizes that any legal capital reform must take place within a broader agenda—the ultimate aim being to support business activities that are both economically worthwhile and sustainable.

In this context, the time is ripe for a review of capital maintenance requirements. There is nothing fundamentally wrong with the standard doctrine that legal capital must be maintained except in strictly controlled circumstances. In the real world, however, firms generally operate under capital protection procedures that reveal no inclination to treat it as ‘cast iron’. In addressing this (apparent) discrepancy, it is important for reformers to take into account three constraints: 1) One size does not fit all; 2) ‘real world’ data is to be taken into account; and 3) politics matter.

One size does not fit all. The current capital framework essentially reflects a crude distinction between larger (public) firms and smaller (private) firms. This firm size approach is fundamentally flawed in that it does not take externalities into account. 
To begin with, legal capital requirements generally do not take systemic risk into account. The banking sector remains an exception. While the effectiveness and efficiency of existing bank capital requirements is debatable, they address a real and significant issue: market confidence. Systemic risk, however, is not confined to the banking sector. For example, the technological or financial failure of a major IT provider may well result in firms across industries being unable to operate. Similarly, production or distribution deficiencies at firms in the food or pharma sectors may put citizen’s health at risk and generate panics that will not fall short of those a financial crisis may generate.

Moreover, the shortcomings of existing legal capital go beyond systemic risk. Firms within a specific industry may face other types of risks. In some sectors, lack of diversification may prove the core risk; in other sectors, the presence of significant barriers to entry may result in firms under-estimating insolvency risk. To be sure, legal capital requirements are not the only way to address these risks; they may even prove counter-productive in some industries or for some firms. The point here is that 1) the current approach is overly crude and 2) increasing capital requirements for some industries could have efficiency benefits.

Data-based approach. One needs more than theoretical assessments to decide about the adequacy of capital requirements. Whether some industries require tougher capital requirements, whether some firms within a given industry need more capital is an empirical issue. Yet, ongoing discussions―especially among lawyers―are generally data-light. The focus should now be on data collection and assessment, with regulatory proposals being put on the backburner in the meantime.

Data collection should not be limited to firm-specific issues. It is also critical to identify whether capital deficiencies mainly matter in the presence of extreme events (eg financial or economic crises) or are also crucial in ‘normal’ times. In other words, the question is whether one must deal with natural selection in addition to disruptive situations. 

From an analytical perspective, one could start examining where capital issues matter under the current regulatory regime and whether some creditors suffer more than others. That done, it would be useful to improve our understanding of the relationship between capital requirements and investment appetite and, possibly, economic development.

Political economy dimension. Politics are often a significant driver of financial reforms. To the extent capital requirements are deficient or discriminatory, one must investigate why lawmakers and politically influent operators seem to disregard this state of affairs.

One explanation could be that capital reforms would ‘rock the boat’ and thus be the source of uncertainty. This is an outcome neither entrepreneurs nor politicians have an interest in, as it makes legal capital a toxic issue. Another explanation could be that the accounting and legal professions would be the main immediate beneficiaries from capital reforms; for most entrepreneurs, the cost of doing business would go up in the short term—making capital reforms a political non-starter.

To sum up, given the political economy situation, a better and data-based understanding of capital requirement is a pre-requisite to any meaningful regulatory reform.

Gerard Hertig is Principal Investigator at Singapore-ETH Centre.