A Theoretical Framework for Law and Macro Finance

Recently, several UK pension funds came close to collapsing because of margin calls on secured interest rate swaps trades. The crisis at UK pension funds provides yet another illustration of the problem of the procyclicality of leverage. Leverage is the amount of debt firms (or other economic actors) rely on to fund their investments. The ability to obtain that debt is often a function of the security that the debtor can provide. Under standard Law and Finance analysis, that security reduces agency costs and makes debt cheaper.

However, that analysis neglects the fluctuation over time of the value of the assets provided as security captured in John Geanakoplos’ theory of leverage cycles. When the value of those assets increases, as is typically the case in a boom, the ratio of debt to assets decreases, and it becomes easier to borrow. The opposite happens in a bust when the value of those assets decreases. Under those circumstances, it becomes more difficult to borrow and debtors will face margin calls, which is what happened to UK pension funds.

In my recent paper, ‘A Theoretical Framework for Law and Macro Finance’, I consider the effects of the law within the theory of leverage cycles and propose a theoretical framework, ‘Law and Macro-Finance’, comprising two main clams: (1) the strength of legal protections of creditors has an impact on the quantum of debt creditors are willing to underwrite, not just the price of that debt and (2) that quantum varies across the cycle.

In a boom, when asset prices are higher, leverage decreases, creating incentives for creditors to underwrite additional leverage secured on those assets without increasing the interest rate. The stronger the legal protections of creditors, the stronger the incentives to underwrite additional leverage based solely on the increasing value of the collateral. By creating such incentives, strong legal protections of creditors, will accelerate the boom and increase the vulnerability of the economy to shocks. When the shock arrives, strong legal protections incentivise creditors to enforce their claims exacerbating the bust phase of the cycle.

In the article, I also show how to implement a novel time-varying countercyclical design of legal protections of creditors aimed at addressing the problem of procyclicality of leverage. The design makes the availability of strongest legal protections, associated under the Law and Macro Finance framework with bankruptcy ‘safe harbours’ (such as those for derivatives) conditioned on the adequacy of the price paid in the transaction. The adequacy, in turn, is determined by courts in reference to the applicable schedule of collateral haircuts determined by the central bank. 

Konrad Borowicz is Assistant Professor, Tilburg Law School, Tilburg University.