Steven L. Schwarcz (Duke University Law School) has a new article in draft up at SSRN, “Regulating Shadows: Financial Disintermediation and the Need for a Common Language.” Professor Schwarcz is a preeminent scholar in financial markets and regulation, and produces new and interesting articles at a daunting (daunting, at least if you are me and, full disclosure, his co-author on a book on financial regulation that has been long in the writing on my end) pace. Here is his SSRN page.
This new article, “Regulating Shadows” (on which I gave comments in draft), is one of the most interesting pieces I’ve read in a long time on the nature of financial markets, financial institutions and so-called “shadow banking.” It’s quietly provocative at a theoretical level – but the most interesting and provocative ideas are introduced gently, almost slid into a discussion that is ostensibly about ways in which scholars talk with each other about market failures in today’s disintermediated financial system. The article is framed as an examination of the language by which scholars studying the financial system and its regulation talk with each other, and then says that a big conceptual piece is missing. The language and tools of legal scholarship, in particular, addressing the financial system and regulation, are often focused on two market failures – “information failure” and “agency failure,” and, to a certain extent, the problem of “externalities.”
Professor Schwarcz points out, however, that disintermediation in the financial system increases the potential magnitude of “systemic risk,” and in turn that makes externalities a still more important category for analysis. The ordinary treatment of “externalities” in the scholarly literature, however, treats externalities themselves as a form of market failure – like information failure and agency failure. Whereas this way of considering externalities as a market failure confuses the discussion, because externalities are fundamentally consequences, not causes, of failures. The article urges that a better way to conceptualize, and talk about this failure, is to denote the cause of externalities as “responsibility failure” – defined in the article as a “firm’s ability to externalize all or a portion of the costs of taking an action.”
Although modestly presented as simply a way of removing confusion, there’s something very interesting at a deeper conceptual level in talking about externalities as consequences of a market failure all its own, which he calls “responsibility failure.” The article is not long and still in working draft form, and subsequent pieces will flesh out this basic idea. But this is an observation worthy of serious discussion, and that’s so whether one thinks, as I do, that it describes something important and not really acknowledged about externalities and market failure or not. I think it describes something hitherto not described, or at least not sufficiently acknowledged in the context of the financial system.
It’s hard to come up with exactly the right term to convey the essence of this market failure. “Responsibility failure” is pretty good, but I know that Professor Schwarcz has worried that any term using “responsibility” risks suggesting that it is a normative term that, in the context of financial markets, crisis, and regulation, is a way of saying, the “bad guys.” That’s not the intent; it is descriptively to separate cause and effect, and to locate the cause as a market failure along the same lines as information failure or agency failure. It’s also important to find ways to make clear how this responsibility failure concept differs from agency failure, which might be an instinctive reaction by some readers when thinking about certain forms of externalities. This is a terrific and provocative new piece, and I strongly recommend it to readers interested in the financial system and its regulation. Abstract below the fold.
Financial disintermediation, or the removal of the need for bank intermediation between markets and the users of funds, has so transformed the financial system that scholars are finding it increasingly difficult to communicate about financial regulation. This article argues that legal scholars could better communicate by speaking in terms of the fundamental market failures underlying the disintermediated financial system (sometimes called the “shadow banking” system). The traditional perspectives and tools of legal scholars primarily address two market failures: information failure and agency failure. To a limited extent, they also address a third market failure: externalities. By amplifying systemic risk, however, disintermediation increases the potential magnitude of — and thus makes it even more important for scholars to address — externalities. But discussing externalities as a type of market failure can be confusing and counterintuitive because externalities are fundamentally consequences, not causes, of failures. Scholars could better communicate about the disintermediated financial system, the article contends, by denoting the cause of externalities as “responsibility failure” — a firm’s ability to externalize all or a portion of the costs of taking an action. The article also shows how a rudimentary common language using the terms information failure, agency failure, and responsibility failure could help legal scholars, and thus policymakers and regulators informed by their research, to communicate about financial regulation.