# Financial regulation is just debt covenants

Financial regulation is to public lending precisely what loan covenants are in the private sector. They are similar mechanisms intended to serve the same function: to prevent shareholders from exercising their customary control rights in ways that, in expectation, would transfer wealth from debt investors to equity holders rather than or in addition to increasing the aggregate value of the enterprise.

A leveraged firm is, from the perspective of shareholders, a call option on the assets of the firm. Equity holders maximize their wealth by taking large risks. If those risks work out, shareholders get to appropriate the increase in the value of the firm. If the firm crashes and burns, well, sure shareholders lose their stake, but their stake is only a fraction of the resources they had used to build their lottery ticket. Lenders eat most of the loss.

When shareholders swing for the fences, they enjoy all the fruits of victory, but creditors bear the cost of striking out. In expectation, creditors lose money on big risks. Creditors' upside is restricted to the interest payments they've contracted for, so their interests are maximized when the firm chooses the least risky path that would just cover those interest payments and repayment of the debt. Ambitions any risker than that increase the probability of nonpayment without doing creditors any good. However, riskier ambitions increase potential earnings beyond debt service, earnings that equityholders get to keep if the risks pay off. So risk-taking amounts to transfer from creditors to shareholders. As risk increases, the expected value of creditors' investment declines (because the probability of default rises), while the expected value of shareholders position rises (because the possibility of a big payoff increases).

Creditors "sign up" to a certain degree of risk-taking by equity holders when they agree to lend to a firm. The firm presents its business plan. Firms must take some degree of risk to generate the operating profits from which interest will be paid.

But once the contracts are signed and the money is lent, what is to prevent shareholders from changing their business plan and adopting a much riskier strategy that effectively loots their creditors?

Well, when the lenders are private, they insist upon "debt covenants" in the lending contracts. These give creditors leverage to usurp shareholders' control rights as soon as it seems like shareholder risktaking may be putting repayment in jeopardy. What kind of "leverage"? Usually, they allow the creditors to demand full and immediate repayment, which the firm — which has borrowed to spend and invest — is unlikely to be able to provide. So, when covenants are violated, shareholders and lenders enter into negotiation, and shareholders ultimately have to do whatever creditors say to avoid being sued into bankruptcy.

In a better world, public lenders could do the same thing. They could protect their interests via debt covenants. Unfortunately, most public lending is opaque and covert: it takes the form of public guarantees of private debt, rather than public lending directly. In this case, the notional lenders (bank depositors, for example), have no reason to negotiate debt covenants and monitor adherence to them, because the notional lenders could care less. They are not on the hook for the loss. The actual bearer of risk, the public guarantor, is not directly a party to the contracts, and so cannot negotiate covenants either.

Thus financial regulation.

There are lots of different kinds of financial regulation, for lots of different purposes, sure. But the main thrust of financial regulation is simply to do for public guarantors exactly what covenants do for private debt contracts. Just as private covenants are negotiated so that creditors can usurp control from shareholders early on in the dangerous-risk-taking process, financial regulation aspires to prompt corrective action, under which regulators exert control before shareholders can put too big a hole in balance sheets that the state guarantees. Private creditors take control by threatening to accelerate repayment of their loans. Public regulators use a variety of tools, from compelling management to perform specific actions in order to reduce risk, to taking the indebted firm into receivership and operating it themselves.

Fundamentally, private debt covenants and public financial regulation are the same thing. They are means by which creditors of leveraged firms try to ensure shareholders can't loot them by building tripwires that allow creditors to usurp control from shareholders when shareholder risktaking threatens creditor interests. They look different, they take different forms, because private creditors can regulate within debt contracts that they sign, while the public sector offers finance primarily via guarantees, and so must impose its regulation outside of the contracts that borrowing firms and their notional creditors devise.

← Banks are not private
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Banks should fail much more often →

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