Grey matters

Read our article in the Cayman Financial Review Magazine, eversion 

Vincent Dilorenzo 

Barriers to Market Discipline: A Comparative Study of Mortgage Market Reforms
Available at  


This paper explores mortgage market reforms in the US and UK in response to the recent mortgage market crisis. Two issues are examined. First, the paper explores the extent to which regulatory bodies have recognised behavioural barriers to market discipline on the part of not only consumers but also industry actors. Second the paper examines the varied response in the US and UK to both market limitations and behavioural limitations to self-protection and self-discipline that led to unsafe lending practices in the period 2003 through 2007.

The greater emphasis on rules-based regulation in the US after 2008 is compared with the continued reliance primarily on principles-based regulation in the UK. This difference, however, is not what will determine future outcomes. Rather, the main finding is that future compliance with safety and soundness requirements will depend on a regulatory policy and enforcement record that will alter the industry’s past conclusion that evasion, or even noncompliance, with legal requirements is a reasonable business decision based on cost-benefit evaluations. In light of that finding, the UK’s new enforcement policy and record is far more likely to lead to compliance than the light-touch enforcement policy and record that has continued in the US.

CFR comment: 

An excellent comparative guide to responses to the mortgage market problems in the US and the UK, highlighting some of the more serious issues with policy “reforms” in the US. Well worth reading for anyone involved in mortgage-backed securities or real estate investing more generally.


George M Cohen 

The Financial Crisis and the Forgotten Law of Contracts, Virginia Law and Economics Research Paper No 2011-09
Available at 


At the bottom of the financial crisis lie failed contracts. Failed contracts are the stuff of contract law. Yet most discussions to date of possible responses to the financial crisis ignore contract law. To the extent contract law makes an appearance, the assumption is usually that the contracts at issue should and will be strictly enforced, so there is not much more to say. Contract law, however, is not dead. Nor is it impotent; it has just been forgotten.

This article explores how courts could use a number of contract doctrines to address perhaps the biggest current problem resulting from the financial crisis: the huge number of foreclosures of residential mortgages that have occurred are occurring and are expected to continue for some time. Many of these foreclosures might be avoided if the mortgage contracts were sufficiently modified, especially by reducing principal. Yet despite the fact that such modifications are often in the interests of both homeowner borrowers and investors in bonds derived from those mortgages, they are in many cases not occurring. The political will for bold legislative action on this problem seems to be lacking. Many solutions to this problem have been proposed, but only a few have been attempted, and these have not worked well.

A cramped view of contract doctrine may well be contributing to this lack of political will. Recognising the flexibility of contract law may foster a greater willingness to consider creative legislative solutions. After reviewing the conventional contract law approach to the mortgage contract and examining how financial wizardry changed the relevant risks, the article considers how courts might interpret the contract law doctrines of assignment, modification, restraint of trade, unconscionability, mistake, impracticability, damages and the objective theory of intent to address the current foreclosure mess.


CFR comment: 

Wading through academic papers, CFR often feels like Diogenes of Sinope, who wandered ancient Athens with a lantern searching for an honest man – although we’re looking instead for something worthwhile to recommend. Unlike Diogenes, we occasionally find one! If you read no other American law review article this year – and probably you shouldn’t be reading too many – read this one. A thoughtful, clear, and interesting analysis of the contract law problems involved in the financial crisis.



Barbara Jeanne Attinger 

Crisis Management and Bank Resolution: Quo Vadis, Europe?, ECB Legal Working Paper No. 13
Available at 


Crisis management in the financial sector is currently at the top of the reform agenda at national, European and international level. Well-designed bank resolution regimes are essential not only to meet the acute need of a credit institution in crisis but also to ensure that proper incentive structures operate in the market prior to any crisis. Existing regimes are inadequate and incentive structures have proven to be fundamentally destructive.

The lack of workable crisis resolution tools has had an adverse effect on crisis prevention and imposed enormous costs on the taxpayer. This paper summarises the main legal challenges for crisis management of ailing credit institutions and identifies the key features of an effective bank resolution regime. Effective crisis management demands the ability to manage. In the aftermath of the financial crisis, two leading EU Member States (the United Kingdom and Germany) adopted special resolution regimes, providing for tools and powers to manage the resolution of banks. The paper assesses and compares these two approaches. In addition, the paper analyses the emerging response at European and international level, focusing in particular on bail-ins, the suspension of netting and other rights, treatment of groups and systemically important financial institutions.

At the international level, the Financial Stability Board’s recently published ‘Key Attributes of Effective Resolution Regimes for Financial Institutions’ constitute a breakthrough in the development of a global resolution regime. At the EU level, the European Commission’s proposal for an EU crisis management regime is expected to be an even more ambitious step. The European financial sector reforms have the potential to achieve a quantum leap in the efficient cross-border management of key issues, in particular in the field of bank resolution and insolvency law. This may evolve into a whole new dimension of efficient cooperation and economic and political convergence. In the field of crisis management, the fact cannot be ignored that we need more Europe, not less.

CFR comment: 

Do you ever wonder what the ECB is thinking? CFR often does. This won’t settle that question definitively, but this paper from the ECB does shed some light on where the financial crisis might lead the bank.



Aaditya Mattoo & Arvind Subramanian 

China and the World Trading System, World Bank Policy Research Working Paper No 5897
Available at 


The World Trade Organization has been until recently an effective framework for cooperation because it has continually adapted to changing economic realities. The current Doha Agenda is an aberration because it does not reflect one of the largest shifts in the international economic and trading system: the rise of China. Although China will have a stake in maintaining trade openness, an initiative that builds on, but redefines, the Doha Agenda, would anchor China more fully in the multilateral trading system. Such an initiative would have two pillars. The first is a new negotiating agenda that would include the major issues of interest to China and its trading partners, and thus unleash the powerful reciprocal liberalisation mechanism that has driven the World Trade Organization process to previous successes. The second is new restraints on bilateralism and regionalism that would help preserve incentives for maintaining the current broadly non-discriminatory trading order.

CFR comment: 

Remember before European public debt crises didn’t dominate the daily news, when big picture trade issues were hot topics? This commentary, by analysts from the World Bank and IMF, puts the current set of trade negotiations in perspective. It raises some serious issues about how well the WTO framework is adapting (or not) to the implications of China’s growth. Someday Europe will sort itself out and this will be important again. Read this now to be ready for that. Besides, you’re tired of reading about Greece aren’t you?



Lorenzo Forni, C Emre Alper & Marc Gerard 

Pricing of Sovereign Credit Risk: Evidence from Advanced Economies During the Financial Crisis, IMF Working Paper No 12/24
Available at 


This paper investigates the pricing of sovereign credit risk over the period 2008-2010 for selected advanced economies by examining two widely-used indicators: sovereign credit default swap (CDS) and relative asset swap (RAS) spreads. Cointegration analysis suggests the existence of an imperfect market arbitrage relationship between the cash (RAS) and the derivatives (CDS) markets, with price discovery taking place in the latter. Likewise, panel regressions aimed at uncovering the fundamental drivers of the two indicators show that the CDS market, although less liquid, has provided a better signal for sovereign credit risk during the period of the recent financial crisis.

CFR comment: 

More data! A useful look at what predicts sovereign credit risk (besides being a European government).



Deniz Anginer & Asli Demirgüç-Kunt 

Has the Global Banking System Become More Fragile Over Time?, World Bank Policy Research Working Paper No 5849
Available at 


This paper examines time-series and cross-country variations in default risk co-dependence in the global banking system. The authors construct a default risk measure for all publicly traded banks using the Merton contingent claim model and examine the evolution of the correlation structure of default risk for more than 1,800 banks in more than 60 countries. They find that there has been a significant increase in default risk co-dependence over the three-year period leading to the financial crisis.

They also find that countries that are more integrated, and that have liberalised financial systems and weak banking supervision, have higher co-dependence in their banking sector. The results support an increase in scope for intra-national supervisory cooperation, as well as capital charges for “too-connected-to-fail” institutions that can impose significant externalities.

CFR comment: 

We admit to a weakness for empirical papers. Data are useful and smart people can get good information out of data. This is an interesting examination of changes in the global banking system. It raises important issues about the banking sector that might drive some regulatory changes.



Francisco F Vázquez & Pablo Mariano  

Bank Funding Structures and Risk: Evidence from the Global Financial Crisis, IMF Working Paper No 12/29
Available at 


This paper analyses the evolution of bank funding structures in the run
up to the global financial crisis and studies the implications for
financial stability, exploiting a bank-level dataset that covers about
11,000 banks in the US and Europe during 2001–09. The results show that
banks with weaker structural liquidity and higher leverage in the
pre-crisis period were more likely to fail afterward. The likelihood of
bank failure also increases with bank risk-taking.

In the cross-section,
the smaller domestically-oriented banks were relatively more vulnerable
to liquidity risk, while the large cross-border banks were more
susceptible to solvency risk due to excessive leverage. The results
support the proposed Basel III regulations on structural liquidity and
leverage, but suggest that emphasis should be placed on the latter,
particularly for the systemically-important institutions. Macroeconomic
and monetary conditions are also shown to be related with the likelihood
of bank failure, providing a case for the introduction of a
macro-prudential approach to banking regulation.

CFR comment: 

Yet more data on banks! Interesting results on who failed and who did not during the financial crisis.



Annamaria Kokenyne & Chikako Baba 

Effectiveness of Capital Controls in Selected Emerging Markets in the 2000s, IMF Working Paper No 11/281
Available at 


This paper estimates the effectiveness of capital controls in response
to inflow surges in Brazil, Colombia, Korea and Thailand in the 2000s.
Controls are generally associated with a decrease in inflows and a
lengthening of maturities, but the relationship is not statistically
significant in all cases, and the effects are temporary. Controls are
more successful in providing room for monetary policy than dampening
currency appreciation pressures.

We argue that the macroeconomic impact
of capital controls depends on the extensiveness of the policy, the
level of capital market development, the support provided by other
policies and the persistence of capital flows.

CFR comment: 

Capital controls are back in fashion in many circles. This IMF working paper asks whether they actually do what they are supposed to do. The answer, not surprisingly, is that “it depends”. But it depends on interesting things and so this is worth reading.



S M Ali Abbas, Alexander Klemm, Junhyung Park, Sukhmani Bedi 

A Partial Race to the Bottom: Corporate Tax Developments in Emerging and Developing Economies, IMF Working Paper No 12/28
Available at 


This paper assembles a new dataset on corporate income tax regimes in 50 emerging and developing economies over 1996-2007 and analyses their impact on corporate tax revenues and domestic and foreign investment. It computes effective tax rates to take account of complicated special regimes, such as partial tax holidays, temporarily reduced rates and increased investment allowances. There is evidence of a partial race to the bottom: countries have been under pressure to lower tax rates in order to lure and boost investment.

In the case of standard tax systems (ie tax rules applying under normal circumstances), the effective tax rate reductions have not been larger than those witnessed in advanced economies, and revenues have held up well over the sample period. However, a race to the bottom is evident among special regimes, most notably in the case of Africa, creating effectively a parallel tax system where rates have fallen to almost zero. Regression analysis reveals higher tax rates adversely affect domestic investment and FDI, but do raise revenues in the short-run.

CFR comment: 

Tax competition? It works. We like it, but the IMF is not so sure. A careful look at what happens as tax regimes evolve under competitive pressures in developing economies. 


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Andrew P. Morriss

Andrew P. Morriss, Chairman, is the D. Paul Jones, Jr. & Charlene Angelich Jones – Compass Bank Endowed Chair of Law at the University of Alabama School of Law. He was formerly the H. Ross & Helen Workman Professor of Law and Business at the University of Illinois,Urbana-Champaign. He received his A.B. from Princeton University, his J.D. and M.Pub.Aff. from the University of Texas at Austin, and his Ph.D. (Economics) from the Massachusetts Institute of Technology. He is a Research Fellow of the N.Y.U. Center for Labor and Employment Law,and a Senior Fellow of the Institute for Energy Research, Washington,D.C., as well as a regular visiting faculty memberat the Universidad Francisco Marroquín,Guatemala. He is the author or coauthor of more than 50 scholarly articles, books, and bookchapters, including Regulation by Litigation (Yale Univ. Press 2008) (with Bruce Yandle and Andrew Dorchak), and is the editor of Offshore Financial Centers and Regulatory Competition (American Enterprise Institute Press 2010).

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