Lawyers in the Shadows: The Transactional Lawyer in a World of Shadow Banking

This article examines how the role of transactional lawyers should change in the new world of shadow banking. Although transactional lawyers should consider the potential systemic consequences of their client's actions, their actions should be tempered by their primary duties to the client and by their responsibilities to the legal system more broadly.I. SHADOW BANKING AND DISINTERMEDIATIONThe financial world has been rapidly changing, and disintermediation is a key feature of that change. "Disintermediation" refers to bypassing the need for bank intermediation between the sources of funds, essentially the capital and other financial markets, and firms that use those funds to operate in the real economy.1 By bypassing banks, firms avoid the profit markup that banks charge on loans.The disintermediated financial system is often referred to more colloquially as "shadow banking."2 Shadow banking's funding already rivals that of bank-intermediated credit for households and businesses.3 The size of the worldwide shadow banking system was estimated to be $67 trillion in 2011.4By reducing the dominance of banks as financial intermediaries, shadow banking has so transformed the financial system that transactional lawyers-especially those accustomed to dealing with banks and bank lending-are facing an array of novel issues.5 This article focuses on one of those issues: to what extent should transactional lawyers address the potential systemic consequences of a client's actions?II. SYSTEMIC CONSEQUENCESAlthough client actions could, theoretically, always have some potential systemic consequences to the financial system, disintermediation greatly increases that potential. By increasing complexity, disintermediation makes financial transactions and products more difficult to disclose and understand.6 It also increases decentralization, which makes it more difficult for market participants to effectively process information.7 These information failures make panics more likely; they allow risks to accumulate undetected and unrestrained, causing market participants to panic when hidden risks suddenly materialize.8 Panics, in turn, often serve as a trigger for a chain of systemic failures.9Disintermediation can also exacerbate information failure by shifting financing in two ways: from firms to markets and from more formal markets to less formal markets.10 These shifts not only further increase the likelihood of panics, as explained above,11 they also exacerbate the potential for systemic risk transmission by "increas[ing] the system-wide correlation among financial firms and markets."12Disintermediation also increases the potential for agency failure, especially intra-firm conflicts between middle managers and the senior managers to whom they report.13 Middle managers will likely know more than senior managers about the complex and highly technical financial products that disintermediation makes available, creating difficulty for senior managers in monitoring middle managers14-especially when senior managers rely on simplifying heuristics, such as value-at-risk (VaR) models, to assess risk on those products.15 This increased potential for agency failure can increase systemic risk.16Even beyond those failures, disintermediation poses systemic risk to the financial system because it makes it much more likely that financial firms will engage in profitable, but risky, transactions. Doing so, however, could externalize harm onto third parties.17 Conceptually, this is the fundamental source of systemic risk:"No firm . . . has an incentive to limit its risk taking in order to reduce the [systemic] danger . . . for other firms." . . . As a result, there is a type of tragedy of the commons . . . . For these reasons, regulation of systemic risk appears not only appropriate, but necessary.18To be sure, bank-intermediated financing also can create externalities, which cause systemic failure. …