9 Regulation
9.1 Bailouts
Tooze on SVB Bailout
The crucial point is that an ecosystem of depositors was saved. And SVB’s depositors were in no regular sense, depositors. They are badly run and ill-advised businesses that for obscure reasons parked huge cash balances in a highly vulnerable bank. As Matt Klein remarks in his brilliant post at Overshoot the real problem at SVB was that its depositor was base was so “low quality” i.e. extremely prone to run with influence exerted by a small group of VC advisors. This was not so much classic large-scale bank in which mass psychology played its part on a grand scale, as a bitchy high-school playground in which the cool thing to do was to bank with SVB until it no longer was.
One could refer to the theory of financial dominance, which in the wake of 2008 argued that the Fed would ultimately face insuperable pressure from asset holders to step back from a high interest rate policy that inflicted losses on them.
But what happened over the weekend has a particular quality. On the face of it SVB is not a bank big enough to do systemic damage. That was the prima facie reason for exempting it from the oversight that extends to really big banks. Finance per se will not explain the emergency intervention.
But as should have been obvious all along SVB matters very much indeed, because its depositors are very powerful, very rich and very influential people who own a narrative that makes them indispensable to one vision of America’s future.
The bailout is how modern capitalism deals with investment cycles through the state’s intervention. And in doing so, the state assigns losses to someone. That’s where the politics lie! This dynamic is especially vicious in the United States. As I like to tell my European counterparts, “America does social policy through investment and industrial policy.” This means that the US has a very weak welfare state but is not a small state. The American government is very good at stimulating investment and cleaning up the consequences of bubbles. At its best, this makes the American economy extremely innovative and productive and creates many highly paid jobs and employer-provided benefits. However, at its worst, it leads to lost decades and massive inequality…. the tools we developed to do so were constructed in ad-hoc ways in response to lots of crises and learning by doing. Thus, what we don’t know how to do as well is to apply these mechanisms in a way that is pre-planned and explicit in how it distributes the downside. This is where my friend Saule Omarova steps in! In her work with Robert Hockett and others, she has noted that the state is vital to the smooth functioning of the private banking system and its support for investment. So, she asks, why not make it official? Instead of an ad hoc bailout of real assets through a private financial system, which tends to be very indirect in its effect, why not have some public entities which can do the work directly? This is most explicit in work Saule, and I did together on a “bailout manager” whose job is to buy out the tangible assets of critical sectors facing bubble dynamics. However, this theme of recognizing the state’s enablement of private investment and, thus, the need to have an explicit policy for managing the bailout and fallout of financial capitalism runs through all her work. And this recognition of capitalism’s natural and normal functioning and how to make it more efficient apparently makes someone some raging Marxist…
Tooze (2023) Venture dominance? The meaning of the SBV interventions.
9.2 Complexity Theory and Financial Regulation
- Battiston Abstract*
Traditional economic theory could not explain, much less predict, the near collapse of the financial system and its long-lasting effects on the global economy. Since the 2008 crisis, there has been increasing interest in using ideas from complexity theory to make sense of economic and financial markets. Concepts, such as tipping points, networks, contagion, feedback, and resilience have entered the financial and regulatory lexicon, but actual use of complexity models and results remains at an early stage. Recent insights and techniques offer potential for better monitoring and management of highly interconnected economic and financial systems and, thus, may help anticipate and manage future crises.
Battiston Memo
Recent research on contagion in financial networks has shown that network topology and positions of banks matter; the global financial network may collapse even when individual banks appear safe.
Information asymmetry within a net- work—e.g. where a bank does not know about troubled assets of other banks — can be problematic. The banking network typically displays a core-periphery structure, with a core consisting of a relatively small number of large, densely interconnected banks that are not very diverse in terms of business and risk models. This implies that core banks’ defaults tend to be highly correlated. That, in turn, can generate a collective moral hazard problem (i.e., players take on more risk, because others will bear the costs in case of default), as banks recognize that they are likely to be supported by the authorities in situations of distress, the likelihood amplifies their incentives to herd in the first place.
Publicly available bank information does not allow reliable estimation of systemic risk. The estimate would improve greatly if banks publicly reported the number of connections with other banks, even without disclosing their identity.
Too-central-to-fail may be even more important than too-big-to-fail.
Recent experiments studying behavior of a group of individuals in the laboratory show that economic systems may deviate significantly from rational efficient equilibrium at both individual and aggregate levels (14). This generic feature of positive feedback systems leads to persistent deviations of prices from equilibrium and emergence of speculation-driven bubbles and crashes, strongly amplified by coordination on trend-following and herding behavior. There is strong empirical evidence of monetary and fiscal policies and financial regulation designed to weaken positive feed- back are successful in stabilizing experimental macroeconomic systems when properly calibrated. Complexity theory provides mathematical understanding of these effects.
9.3 Institutionalizing ESG
Beslik
Suddenly, millions of influential, wealthy and beyond imagination privileged people in the financial and corporate sectors around the world realised that “Oh, this is no good anymore. We need to deploy ‘non-financial’ metrics to understand the value of companies we invest in and run, from financial point-of-view.”
Just like that? Well, maybe not. But I think one of the most relevant answers to how this has happened does not come from sudden and enormous pressure from clients (they usually don’t even know what they are buying on ESG since they lack information) or from a prophetic moment in the morning-mirror for millions of people in the financial and corporate sector asking themselves how they can save the world.
If you try to track down some of the key drivers you can see the traces going back to 2008 when people working in the financial sector and their decisions driven by the only God (money) shook the entire world – and billions of people around the world paid a price, some with their life.
Politicians reacted too late and too lame, and most of the losses were paid for collectively, i.e. tax money. For too long, self-regulation and voluntary, business driven responsibility was championed as most efficient symbiosis for the benefit of all, or very few.
After 2008, politicians might have learned the lesson that self-regulation and voluntary responsibility by the financial and corporate sectors means different things to different actors.
In the climate negotiations in Copenhagen and in Paris (two among the hundreds of conferences on climate change and consequences related to that, that I have participated in over last 20 years) the financial industry was largely absent. It was not there, or just there to observe. Despite its size and influence, despite its power, the financial sector does not have any climate targets discussed and agreed upon on a global level – neither from the COP negotiations, nor via any other transnational agreements.
That’s changing now. It’s the regulation in the EU and by now partly in the US that is the key driver behind ESG growth, both in terms of interest and in terms of assets.
Yes, those grey politicians in the different parts of the world are by all means changing the word of investments by posing rules, sometimes in the need of improvement, yet rules that institutionalise ESG. Not as an add-on, as self-regulated nice-to-have things you can market to clients. But as a law.
This, if anything, is monumental, and in the years to come regulation, nothing else, forced by reality, will completely reshape the social contract between the financial industry and societies at large.
It is both needed and necessary if ESG is meant to make real changes on the ground.