The Big Drop

After numerous months of uncertainty and growing fears related to financial contagion, the euro zone is teetering . . . and no one knows exactly what to expect next. Experts from Columbia Law School’s new Ira M. Millstein Center for Global Markets and Corporate Ownership examine how we got into this mess and what additional euro zone problems might portend for the global financial system.

By Peter Coy

Winter 2012

When asked about the continuing euro zone problems, Professor Katharina Pistor notes that, most of the time, she thinks Europe will muddle through its financial crisis, and that spillover damage to the rest of the world will be minimal.

But, Pistor confides, she cannot seem to shake the fear that things could get very much worse. Troubles have moved from small, peripheral nations, like Greece and Ireland, to Spain, a core member of the 17-nation, single-currency euro zone. What economists refer to as a “doom loop” of interdependence has developed, in which Spain’s weak banks drag down the sovereign government, and losses on sovereign bonds, in turn, further weaken the banks.

It is hard not to wonder about an end point—even if the resulting images may not be pleasant.

“If Spain blows up, and then the pressure goes against Italy, or maybe even pushes France, then the idea that Germany could rescue the sinking boat becomes hard,” says Pistor, the Michael I. Sovern Professor of Law and the director of Columbia Law School’s Center on Global Legal Transformation. “Hell could break loose.”

As similarly dire worst-case scenario hypotheticals become more prevalent, Columbia Law School scholars continue to focus on the potential for financial contagion from Europe. Over the summer, Jeffrey N. Gordon, Columbia Law School’s Richard Paul Richman Professor of Law, and Professor Robert J. Jackson Jr. were named co-directors of the Law School’s new Ira M. Millstein Center for Global Markets and Corporate Ownership. Grappling with the crisis in Europe is one of the center’s first missions: “Interdependence in the Global Economy” is one of its two founding projects.

Gordon notes that U.S. banks such as JPMorgan Chase have attempted to reduce their exposure to Europe’s most troubled nations, as have U.S.-based money market mutual funds. But because exposures still are not fully understood, fears that big U.S. banks are vulnerable to losses at European counter-parties could cause a generalized pullback in interbank lending, with disastrous consequences, says Gordon. That is essentially what happened four years ago when Lehman Brothers collapsed and the Federal Reserve had to step in as the go-between for banks that were suddenly afraid to deal with one another directly. “The vectors of financial distress and contagion are clearer in the aftermath than in anticipation,” he says. “There’s a lot of reason for concern.”

This past autumn, Gordon and Professor Ronald J. Gilson were busy preparing for a December conference in Brussels on how to stabilize Europe by creating a banking union, with a single regulator and rules for how a bank that gets in trouble will be repaired by the entire euro zone, not just one country. The Europeans could learn something from the U.S., Gordon says: When Bank of America was weakened during the 2008 financial crisis, it was supported by federal authorities, not just regulators in its home state of North Carolina. “Europe’s balkanized system has created enormous instability,” he adds.

In mid-September, as fall classes began, it was looking like Europe had begun to get a handle on its troubles. The European Central Bank had just strengthened its promise to buy bonds of countries that stuck to their reform commitments, and the red-robed justices of the German Constitutional Court in Karlsruhe rejected a challenge to the euro zone’s permanent rescue fund, the European Stability Mechanism (ESM). But with Spain’s debt crisis festering, and Germany, Finland, and the Netherands arguing that the new ESM be used to clean up only future banking problems, not past messes, no one is resting easy. Least of all Ira M. Millstein ’49, a longtime supporter of Columbia Law School and senior partner at Weil, Gotshal & Manges in New York City.

Millstein, who will serve as chairman of the new Center for Global Markets and Corporate Ownership, made his name in the antitrust field, while developing advanced expertise in corporate structure and accountability issues. He eventually devoted his career to pro bono work in the field, becoming chairman of a business sector advisory group of the Organization for Economic Cooperation and Development and active in a World Bank Global Corporate Governance Forum. He traveled to Singapore, Malaysia, the Philippines, Japan, China, and Russia, among other countries, for the cause. “It’s my life,” he says, “and it’s what I like to do.” In the 1980s, he co-founded the Institutional Investor Project at Columbia Law School, which focused on enforcing shareholder rights, and upon whose work the new center’s mission is partly based.

Millstein views financial crises through the prism of governance, which is why he thinks the new Center for Global Markets and Corporate Ownership is well-placed to investigate financial contagion as applied to the euro zone situation.

“Is it important to us that the Europeans straighten out?” asks Millstein. “Absolutely. If you scratch every one of our big banks, you’re going to find major holdings all over Europe. If Spain goes down, is that going to have a wild impact on the United States? Of course it is.”


So how did we get into such a mess, anyway? During the boom times, global financial integration was mostly regarded as a good thing. Savers had more options for places to put their money, while companies and households had deeper pools of cash to draw on for investments in housing, factories, and business equipment. The tightest integration occurred between the nations of the single-currency euro zone. Interest rates converged. The Greek government could get 10-year loans almost as cheaply as Germany could, and Greece’s mostly successful management of the 2004 Summer Olympics was viewed as its debut into the society of stable, advanced economies. Quietly, though, the Greek economy was becoming uncompetitive because of government overspending and pay raises that outpaced productivity gains. Integration, in short, enabled Greece to get in over its head, says Jeffrey Gordon.

Now the downside has become apparent. Banks in Germany and France are trying to unload loans they made to the nations of the southern tier. Greece, Ireland, and Portugal lost access to the private credit markets, and Spain is in danger of losing access as well, meaning it would be able to borrow only from official sources like the European Central Bank, the European Union, and the International Monetary Fund. Depositors in Spanish banks are pulling their money out, in part because they fear their euros will be forcibly converted to less-valuable new pesetas, says Merritt B. Fox, the Michael E. Patterson Professor of Law and NASDAQ Professor for Law and Economics of Capital Markets. “The fear,” says Fox, “would be, even if you think there’s only a 5 percent chance that your country’s going to pull out of the euro, you’re going to take [your euros] out of the local bank and put them in a country that’s not going to pull out.”

By now, European regulators should have developed a clear understanding of the potential exposure of each major bank to losses at other banks. Apparently, though, that has not happened. This past summer, the European Central Bank’s Financial Stability Review resorted to a simulation to study the contagion problem. “Only minimal information on financial institutions’ interlinkages is in the public domain,” the bank wrote.

To Katharina Pistor, that reality is unacceptable. “I found this shocking,” Pistor wrote in a blog post on the Institute for New Economic Thinking website at the time. “Shouldn’t supervisors and regulators know more about the legal structure of these inter-bank relations? And how would an integrated European supervisor monitor euro zone banks without a clearer picture of their structure than a probability chart based on proxy data can possibly render?”

Perhaps even more disconcerting, the links from Europe to the rest of the world are not just through ordinary bank lending. There is a huge shadow financial system, as well. Banks raise money to finance their operations by issuing commercial paper, which is essentially short-term borrowing in the capital market. American money market mutual funds own a lot of that commercial paper—or did before the warning lights began to flash. Repo lending is another pathway. It is a form of securitized borrowing in which banks “sell” high-quality securities like government bonds and agree to buy them back in the future at a slightly higher price. The transaction is the equivalent of paying interest on a loan. Columbia Law School professors, including Gordon, are studying how there can be a “run” on the shadow banking system—say, when mutual funds refuse to roll over their maturing commercial paper, or lenders start questioning the value of collateral posted for repo loans and demand bigger discounts.

The invention of deposit insurance has largely done away with conventional bank runs by taking away the incentive for depositors to be the first ones to withdraw their money from a troubled bank. But there is no such reassurance for lenders in the shadow banking system.

For international authorities, the nightmare scenario is a cross-border repeat of the failure of Lehman Brothers in 2008. The fourth-biggest securities firm in the U.S. had its AAA credit rating reaffirmed by Standard & Poor’s on Friday, September 12, 2008. Invisibly to credit raters, though, Lehman was already experiencing a run. By the end of that weekend, its situation was so hopeless that it filed the biggest bankruptcy petition in U.S. history at 1:45 a.m. on Monday, September 15. That event, more than any other, was responsible for touching off the financial panic that resulted, in 2009, in the first worldwide decline in economic output since the Great Depression.


It could happen again, this time with Europe as the epicenter.

“Nobody really understands the interconnections in the world financial system,” says Jeffrey Gordon. “Nobody. So there’s a great deal of caution about the unknown unknowns. It’s not just the damage from Europe, it’s the uncertainty about the extent of the contagion that has made parties conservative. We don’t know what would happen to U.S. financial institutions if Greece were kicked out of the euro. Some have said it would be a Lehman event. No one is really eager to run the experiment.”

The Dodd-Frank Wall Street Reform and Consumer Protection Act represents an attempt, however imperfect, to prevent contagion within one country. What is sorely lacking is an equivalent for the world as a whole.

This past spring, the Richard Paul Richman Center for Business, Law, and Public Policy presented a daylong, invitation-only conference called “Financial Risk and Regulation: Unfinished Business,” which was co-organized by Ira Millstein and Charles Calomiris, who is the Henry Kaufman Professor of Financial Institutions at Columbia Business School. Harvey R. Miller ’59, the attorney and bankruptcy expert who is also a lecturer-in-law at Columbia Law School and a partner at Weil, Gotshal & Manges, served as one of the featured speakers at the event.

During his presentation, Miller worried that the global framework for saving or shutting down big financial institutions lacks an adequate dispute-resolution mechanism. In his prepared remarks, he noted that “there is no reason to think that the next ‘Lehman’—and the disputes that arise from it—will not be significantly larger and more complicated” than the original Lehman scenario. “If there is any ‘unfinished business’ in the current framework,” he added, “it is the development of a flexible, cross-border dispute resolution mechanism that will adequately contain the conflicts that are likely to arise during the next crisis.”

There is a well-known saying on Wall Street that you can borrow as much money as you want, just as long as you don’t need it. Financial crises tend to break out when organizations that counted on being able to borrow freely are suddenly cut off by the capital markets. For participants in the new “Interdependence in the Global Economy” project of the Ira M. Millstein Center for Global Markets and Corporate Ownership, the challenge is to help formulate robust institutions and regulations that are resistant to global contagion.

“There are many terrific things about creating a global economy with global opportunity, but there are risks that arise as well,” says Gordon. “We need to be thinking very hard about new institutions that can understand the risks and respond to them. Isolation is one way to avoid the spread of disease, but that’s highly costly. We really ought to be able to do better than that.”

Peter Coy is a business writer and the economics editor at Bloomberg Businessweek.