A week ago, I posted about a new draft article on SSRN by Steven L. Schwarcz (Duke University Law School) on ways in which scholars talk about the financial system and its regulation. (The working paper is on SSRN here – “Regulating Shadows: Financial Disintermediation and the Need for a Common Language.”) I noted in my post that the article makes an important and provocative point about the nature of externalities, market failures in the financial system, and a concept that Professor Schwarcz calls “responsibility failure.” This point generated some interest among readers, and so I invited Professor Schwarcz to give us a short guest post saying more about what he means by “responsibility failure” and its relationship to externalities in financial systems. My thanks to Professor Schwarcz for giving us this short comment:
My purpose in introducing the concept of responsibility failure—responsibility for a firm’s ability to externalize all or a portion of the costs of taking an action—is to bring more accurate and intuitive terminology into the financial regulation debate. Externalization of costs is the most important reason why shadow banking poses systemic risks to the financial system. Yet “externalities” themselves are not fundamental market failures. Externalities signal that a market failure has occurred; they are, in other words, consequences, not a cause, of the failure. Externalities also cannot be considered a truly distinct type of market failure because all types of market failures can result in externalities.
It therefore can be confusing to speak of externalities as a market failure. That focus would also shift the attention to consequences, potentially obscuring what caused the externalities. Consider a firm that takes an action because it can externalize all or a portion of the costs. Focusing on externalities, one may well conclude that the firm itself should be considered solely responsible for causing externalities that result in harm. Focusing on responsibility failure, in contrast, would help shift attention back to the fundamental cause of the externalities, as illustrated by the following example.
Because the managers of most firms have obligations under law solely to the firms’ shareholders, firms that engage in risky projects in order to increase profit opportunities may be acting responsibly as defined, indeed mandated, by law—even if the effect is to externalize costs. In those cases, the government could, and arguably should, be viewed as the party fundamentally responsible for causing the externalities, by failing to impose laws that limit the ability of firms to externalize those costs. This sharpened focus on causation is important because the traditional paradigm of market failure assumes away government action (or inaction) as a cause of failure.
Responsibility failure can also help inform a regulatory analysis of the limited liability of investors who manage firms in the shadow banking system. By facilitating decentralization, shadow banking makes it much more likely that a firm will externalize all or a portion of the costs of taking an action. This is because the relatively small firms that operate in the shadow banking system are often managed directly by their primary investors. Because those investor-managers typically divide up a significant share of the firm’s profits, they have strong incentives to take risks that could generate large profits. Yet if a risky action exposes their firm to significant liability for externalized harm, they would not be personally liable. This creates management incentives radically unlike those in large firms, such as traditional banks, in which the senior managers tend to share only indirectly in profits and are ordinarily more invested in maintaining their jobs—and thus are less motivated to take risky actions.
Responsibility failure squarely focuses the regulatory inquiry on who, or what, should be fundamentally responsible for causing the harm. To the extent investor-managers of those shadow banking firms comply with applicable law, the government itself could, and (again) arguably should, be viewed as the party fundamentally responsible for causing the externalities—by failing to modify limited liability to the extent needed to mitigate the investor-manager conflict and thus reduce externalities. [Note] As before, a sharpened focus on causation is important because, traditionally, market failure assumes away government action or inaction as a cause of failure. That focus also raises the normative question of what “responsibility” should mean in a society governed by law. In contrast, viewing externalities as the market failure could limit inquiry to merely whether individual investor-managers should be liable for the harm.
[Note: This investor-manager conflict is not an agency failure; agency failure goes to a principal-agent relationship, whereas conflicts resulting from investor-manager limited liability do not involve principals and their agents.]
(Steven L. Schwarcz is the Stanley A. Star Professor of Law and Business, Duke University Law School.)