Perspectives on Regulating Systemic Risk

by Steven L. Schwarcz

Whether the macroprudential regulation enacted to protect the stability of the financial system is sufficient to prevent another crisis is uncertain. Although much of that regulation represents good faith and, in many cases, highly thoughtful efforts to control systemic risk, its primary focus is on banks and other systemically important financial institutions (“SIFI”s). This entity-based approach may be too narrow because it largely ignores other critical elements of the system, such as financial markets.

Furthermore, influenced by political and media pressure to assign blame for the financial crisis, some of the entity-based regulation is itself imperfect. A major focus of that regulation, for example, is on controlling morally hazardous risk-taking by SIFIs that deem themselves “too big to fail” (“TBTF”). Capital requirements epitomize this approach, protecting SIFIs against losses by requiring them to hold minimum levels of capital. However, the ability of capital requirements to control systemic risk is unclear. The cost of capital requirements is also uncertain; some argue they impose no public costs, others argue to the contrary.

Although SIFIs did take excessive risks, there’s also no evidence that was caused by moral hazard. Other factors (such as a tragedy-of-the-commons market failure, later discussed) may better explain that risk-taking. In the United States, however, the Dodd-Frank Act strips the Federal Reserve Bank of much of its last-resort-lending powers in order to control moral hazard. That virtually assures a crisis if a SIFI fails and the law’s resolution mechanisms are inadequate.  

Even regulation going beyond the narrow entity-based approach is sometimes questionable. For example, politicians and the media have assumed that the high rate of mortgage-loan defaults that contributed to the financial crisis resulted from moral hazard caused by the originate-to-distribute model of making and then selling off loans in securitizations. In response, the Dodd-Frank Act requires lenders to retain a minimum unhedged portion of the risk on the loans they securitize. That response, however, ignores that it was always common practice for sponsors of securitizations to retain substantial risk on the underlying loans. They did this to signal the quality of the securities they were selling to investors. That signaling inadvertently may have created a novel information failure: not the typical asymmetric information but, instead, a mutual misinformation problem caused by complexity: neither the sponsor of the securitization, nor the investors, fully understood the risks—especially those associated with highly leveraged re-securitizations of the underlying loans.   

To more effectively protect financial stability, macroprudential regulation requires a more systematic framework. Constructing this framework should start by engaging the normative justification for financial regulation: to correct market failures. The justification for macroprudential regulation thus should be to correct market failures that could trigger and transmit systemic risk. To accomplish that, we need to identify and better understand those triggers and transmission mechanisms.

Although economists and finance scholars have identified three categories of shocks that can trigger the collapse of the financial system (bank runs, asset-price falls, and foreign exchange mismatches), they have not tried to identify the market failures that could cause those shocks. I have argued that at least five types of market failures could cause those shocks: complexity, conflicts, behavioral limitations, change, and a type of tragedy of the commons. Also, maturity transformation could cause a maturity gap, which in turn could lead to a default that triggers a systemic shock.

This concluding chapter to Systemic Risk in the Financial Sector: Ten Years After the Global Financial Crisis (Douglas Arner, Emilios Avgouleas, Danny Busch, & Steven L. Schwarcz, eds.; forthcoming 2019)  analyzes how to try to correct these market failures. For example, conflicts represent a market failure insofar as they can distort incentives. Scholars have long studied conflicts of interest between managers and owners of firms within the broader context of principal-agent problems and agency costs. Post-financial-crisis regulation attempts to fix this traditional type of conflict. Post-crisis regulation, however, overlooks the problem of secondary-management conflicts, which are an intra-firm principal-agent failure. The problem arises because secondary managers are almost always paid under short-term compensation schemes, misaligning their interests with the long-term interests of the firm. Complexity exacerbates this problem by increasing information asymmetry between technically sophisticated secondary managers and the senior managers to whom they report. Macroprudential regulation should be designed to correct, or at least mitigate, this market failure by requiring SIFIs to pay secondary managers under longer-term compensation schemes.

Behavioral limitations represent a market failure because they can undermine two perfect-market assumptions that underlie financial regulation—that parties have full information, and that they will act in their rational self-interest. I have separately examined how regulators could design macroprudential regulation to help control behavioral limitations. Notwithstanding our best efforts, however, that regulation will remain imperfect because we do not yet fully understand human behavior. As a result, future financial failures are inevitable. Macroprudential regulation should therefore be designed not only to try to deter financial failures resulting from behavioral limitations but also to mitigate their inevitable harm.

The tragedy of the commons represents a market failure insofar as it causes externalities. The shareholder-primacy model of corporate governance causes this failure by encouraging firms to engage in risk-taking that has a positive expected value to the firm and its shareholders, regardless of harm to third parties—unless, of course, that harm is prohibited by other law or internalized through tort law. This governance model is problematic for SIFIs because systemic harm is neither prohibited by other law nor internalized through tort law. SIFIs therefore are motivated to engage in “excessive” risk-taking—effectively risk-taking that has a positive expected value to the firm and its shareholders but a negative expected value to the public, who would suffer the externalized systemic harm if the firm fails. This externalization of harm evidences a market failure.

Correcting this market failure would require SIFIs to internalize systemic costs. In theory, resolution—which seeks to mitigate the systemic impact of a SIFI’s failure—could help to “internalize” those costs, by reducing them. In practice, however, most resolution approaches are effectively microprudential, focusing on protecting individual SIFIs. Correcting this market failure would require modifying the shareholder-primacy model of corporate governance, which encourages the excessive risk-taking. The most direct way of doing that would be to impose some type of a public governance duty that requires SIFI managers to also consider the public consequences of their firm’s actions. Proposing such a duty would engage the longstanding debate whether corporate governance law should require a duty to the public.            

My chapter also addresses how macroprudential regulation should adapt to the cross-border nature of finance. For example, the intra-firm problem of secondary-management conflicts faces a collective action problem because firms that offer their secondary managers longer-term compensation might be unable to hire as competitively as firms that offer more immediate compensation. Globally coordinated regulation may be needed to help solve this collective action problem not only within nations but also across nations, because good secondary managers can work in financial centers worldwide. Regulators nonetheless should be circumspect about globally correlating macroprudential rules, to avoid exacerbating systemic risk by decreasing the flexibility and resilience of the financial system.  

Steven L. Schwarcz is the Stanley A. Star Professor of Law & Business at Duke University and Senior Fellow at the Centre for International Governance Innovation (CIGI). He is a Founding Director of Duke’s interdisciplinary Global Capital Markets Center (now renamed the Global Financial Markets Center). His areas of research and scholarship include insolvency and bankruptcy law, international finance, capital markets, systemic risk, corporate governance, and commercial law. He holds a bachelor’s degree in aerospace engineering (summa cum laude) and a Juris Doctor from Columbia Law School. Prior to joining the Duke faculty, he was a partner at two of the world’s leading law firms and Visiting Lecturer at Yale Law School.

The above post is adapted from the final chapter of Systemic Risk in the Financial Sector: Ten Years After the Global Financial Crisis (Douglas Arner, Emilios Avgouleas, Danny Busch, & Steven L. Schwarcz, eds.; forthcoming 2019).


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