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Building a Financial System That Enables Abundance
To achieve peace and prosperity, the U.S. financial system must be effective, resilient and trustworthy
By Brian Knight
Markets can facilitate cooperation, break down barriers between people and encourage innovation, helping to make things better, or in the parlance of this series, more abundant. So, what does a financial services system that facilitates abundance look like? First, we need to define abundance, because different definitions require different attributes in a financial system.
One obvious definition is material wealth: the ability to accumulate the goods and services that people rely upon and enjoy. That may sound unimportant, even hedonistic, but as my colleague Veronique de Rugy points out, economic growth, the engine by which the accumulation of goods and services occurs, is linked to peace, health and liberty in addition to material prosperity.
Financial services are not abundance in themselves: You can’t eat efficient execution of stock sales, wear secure savings or prolong your life with rapid payments if you get a serious disease. But because financial services undergird everything else in society, in a modern economy they are an essential precursor to abundance.
A financial system that facilitates abundance must be effective, resilient and trustworthy. Effectiveness means that people can use the system to do what they want with as little hassle or expense as possible. Wealth eaten up in transaction costs cannot be put to buying food and medicine or investing in the future. While some transaction costs are inevitable, the more efficient the system, the more wealth can be deployed to its best use.
Resiliency means that the financial system will weather shocks, will function as intended and will not fail in ways that cause collateral damage. Note, it is the system that will not fail, but any given firm can and must be able to fail. The ability of individual firms to fail is essential for resiliency because it provides discipline and enables more effective firms to displace less effective ones.
Finally, trustworthiness means a system that is resistant to abuse. Such abuse may come from fraudsters and other bad actors within the system trying to rip people off. But another, possibly more dangerous risk is that politicians, regulators and constituencies that have power or influence over the system will seek to abuse that power to de facto regulate society in ways that they cannot do directly.
To increase the financial system’s effectiveness, it should become more open to both competition and innovation. The past decade has seen an explosion of innovation in the form of “fintechs,” broadly defined as nonbank, high-tech firms that seek to compete with traditional financial services firms.
In lending, for example, fintechs initially differentiated themselves from traditional banks in their use of alternative data, predictive algorithms and their funding, which came (at least directly) from institutional and individual investors rather than federally insured deposits. This allowed them to serve borrowers who had trouble getting loans from banks or offer at least some borrowers better terms. For example, there is evidence that fintechs’ use of alternative data points allowed them to extend credit to borrowers, especially those with limited credit histories, on better terms than would be available by traditional means.
Likewise, fintechs can help small businesses that would otherwise have trouble getting funding from banks, including businesses with less experienced founders and those in places with less access to traditional financial services. During the recent pandemic, fintechs were associated with providing Paycheck Protection Program loans to smaller and less well-connected businesses disproportionately more than banks did.
To be sure, fintechs aren’t perfect. For example, fintech borrowing can lead to higher bank loan defaults because borrowers become overleveraged. (Much of the data from that study was taken from the early period when underwriting standards were lax, though, and there is also evidence that losing access to fintech lending leads to an increase in bankruptcies.) Likewise, fintech firms have been linked to significantly higher rates of Paycheck Protection Program fraud than banks, though at least some of that is attributable to the fact that banks favored existing customers, reducing both the risk of fraud and the reach of the lending program. Regardless of fintechs’ imperfections, however, they provide innovation and competition in a market that too often lacks it and are able to give customers more, frequently better, options.
Unfortunately, regulation hampers fintech firms unnecessarily. Fintechs, especially those in the lending and payments spaces, are often at a regulatory disadvantage relative to their bank competitors. Federal and state laws facilitate banks offering services nationally whereas fintechs tend to be regulated on a state-by-state basis, impeding their ability to compete at a national scale. Further, banks enjoy access to valuable government-provided services, such as the Federal Reserve’s payments system, the Fed serving as a lender of last resort, federally backed deposit insurance that allows banks to pay less for deposits and shields them from runs, and bailouts and the expectation of bailouts that help shield bank investors, encouraging investment in banks at lower cost to the bank.
Fintechs don’t enjoy these benefits, which distort competition. Leveling the playing field by reducing or eliminating government-granted privilege, including enabling equal access to interstate markets and government-provided infrastructure, can help expand competition and innovation and allow people to get better financial services from banks and nonbanks alike.
Another way to support competition and innovation, and therefore abundance, would be for states to lower regulatory barriers to entry and experimentation. One way that has been gaining momentum globally and within the U.S. is the “regulatory sandbox.” A regulatory sandbox allows firms with innovative ideas in highly regulated industries, such as finance, to test them out under the watchful eye of a regulator, before they have to go through a full licensing process. At least 14 states have adopted sandboxes of various forms, with more expected to do so.
Regulatory sandboxes are not without risk. These risks, however, can be mitigated by proper design and management. For example, requiring firms to have both a plan to protect or restore customers and the financial means to execute that plan, along with competent enforcement, can protect customers from irreparable harm caused by product failure. Likewise, the risk that sandbox admission becomes a government-granted “golden ticket” that gives some firms a huge competitive advantage can be mitigated through proper design and transparency.
While regulatory sandboxes are not a panacea and will not magically transform every jurisdiction into another Silicon Valley or Wall Street, they can play a positive role in creating an innovation- and competition-friendly regulatory environment.
In addition to effectiveness, the financial system must be resilient if it is to support abundance. Financial crises can cause significant collateral damage across the economy. This is not to say that firms, including financial firms, should not be allowed to fail. To the contrary, they must be allowed to fail for markets to improve or have any semblance of moral legitimacy. Rather, firms must be able to fail in ways that do not imperil the broader economy, without being bailed out, explicitly or implicitly, by the government.
Unfortunately, as the recent failures of Silicon Valley Bank (SVB) and Signature Bank show, we are currently far from that world. These failures were not the result of some black swan event. Rather, they were caused by a failure to properly address interest rate and duration risk. (It is also alleged that in the case of Signature Bank, the New York regulator was motivated by an antipathy toward cryptocurrency, which the regulator denies.)
While the banks’ management clearly failed, the government also failed to prevent the failure of the banks, even though the risks were apparent well ahead of time and the regulators had all the power they needed to force a change. The assets that were most responsible for SVB’s problems—long-term, low-interest government and government-backed debt—were deemed by regulation to be safe and liquid. While this is true with regard to credit risk, it turned out not to be true in an environment where interest rates were kept too low for too long, inflation arose and the Fed raised rates aggressively. This change made the debt less valuable than newly issued debt that paid higher interest. As such, when SVB needed to sell debt to pay out depositors, it would have had to sell the debt at a loss. Once this was announced, SVB tried to raise capital and failed; a run soon followed.
The interest rate risk and failure to hedge against it were known to SVB’s regulators, and they alerted the bank, but somehow it never went beyond that. The regulators, especially the Federal Reserve, failed to use the tools already at their disposal to force SVB to correct failures that Federal Reserve Vice Chair for Supervision Michael Barr later called “a textbook case of mismanagement.” Why this happened is being investigated, but as the regulators themselves acknowledged during congressional testimony, they had the needed authority to intervene before the banks failed.
Faced with the failures of two moderate-sized banks, the government invoked the “systemic risk” exception, which removed most of the legal limits on what the government can do to protect the stability of the banking system. In short order it was announced that uninsured depositors would have their deposits backstopped by the government, protecting depositors from the risk they ran exceeding the deposit limit. The Federal Reserve also announced that it would allow banks to use certain debt assets as collateral valued at par, rather than at the impaired market price. In effect, the Fed was overvaluing these assets to make them better collateral.
The Treasury Department and the bank regulators justified these actions as necessary to stop significant deposit outflows from other smaller and regional banks, who were seeing deposit flight to large “too big to fail” banks. The effect was a significant diminishment, if not an outright elimination, of market discipline. Rather than allowing depositors to reward more prudent banks at the expense of less prudent ones, the government sought to prevent bank failures, including of banks whose mismanagement made them vulnerable. This rewarded not only the management of those banks but their shareholders as well since their investment would not be lost in a failure.
Of course, to the extent depositors would have sought safety in “too big to fail” banks, that would simply reflect the distortionary effects of other government policies. Our largest banks are believed to be unable to fail not because they are so much better managed than smaller banks, but because their failure would be too catastrophic for the government to allow. While legal reforms after the 2008 crisis were supposed to provide the tools necessary for regulators to allow banks to fail, the fact that regulators pushed the panic button over two banks that were far too small to be considered a source of systemic risk ex ante, there is no reason to believe we would be more disciplined if Citi or Bank of America were in danger of failing again.
Systemic resiliency is good, but there is a difference between systemic resiliency and preventing failure. The failure of individual firms is necessary to allow markets to function and improve the overall level of service. Further, failure is necessary for the banking market to have any moral legitimacy. Privatized gains are a powerful incentive for people to serve others. However, a system that privatizes gains while protecting certain people from the consequences of their own actions and socializing any resulting losses will not only encourage bad (or at least negligent) behavior, but also undercut the legitimacy of those privatized gains.
We need a new paradigm. Regulators must be humble enough to know that they likely can’t predict what the most pressing risk is or intervene in time. Instead, we need to encourage resiliency by aligning the incentives of banks, their investors and the public. One way to do that is to require banks to fund with what my colleague Steph Miller calls “simpler, higher equity capital.” Instead of trying to predict how risky an asset is by regulation or micromanage banks in the name of safety, regulators should require banks to fund with larger equity capital buffers.
Higher equity capital has several advantages. First, it is risk agnostic, which means that wherever the threat may come from, be it climate-related damage or bad monetary policy or an alien invasion, banks have more equity available to cover losses and either survive or at least fail in a nonchaotic way. This way we are not relying on ineffective and potentially politicized regulatory risk-weighting but instead on the willingness of investors to put their money at risk.
Those same investors then have a strong incentive to monitor the bank’s conduct. As Steph again points out, while SVB looked well capitalized under current regulatory definitions, the equity investors were pulling out well before the bank failed. If the bank had been required to maintain a higher equity capital buffer in the face of investor skepticism, either it would have had to change its policies, or the inability to maintain the buffer could have served as an early warning for regulators.
Finally, simpler, higher capital takes away one of the major areas vulnerable to regulatory abuse. In several high-profile cases regulators have, under the guise of safety and soundness, pressured banks to stop serving legal customers, such as refund anticipation loan providers and gun rights groups, because they were disfavored by the regulators themselves.
Not only does this dynamic not help resiliency, and in at least one case it has caused more damage to the bank’s reputation than the supposedly threatening business practice. It also undercuts trust in the system. If the tools of financial services and financial service regulation are used as tools of universal regulation, people will and should lose faith in market participants and regulators. This would not contribute to abundance.
For a financial system to support abundance it must be trustworthy, or else people won’t use it. Trustworthiness contains the obvious, such as an absence or at least minimization of fraud and negligence. A less obvious but no less important element to trustworthiness, however, is knowing that the system will not be abused to achieve improper ends, such as the de facto regulation of lawful but disfavored conduct. Given how vital access to financial markets is to modern life, such markets present a tempting target to allow government officials, and others, to try to impose their preferences on society indirectly when they can’t lawfully do so directly. Or, as Rep. Alexandria Ocasio-Cortez once said in reference to pressuring banks to cut ties with legal but disfavored industries as an alternative to legislation, “there is more than one way to skin a cat.”
Financial services firms are extremely sensitive to pressure from the government because they are so dependent on powers and protections granted by law, they are extremely highly regulated and those regulations tend to give significant and opaque discretion to regulators. Therefore, financial services firms will only rarely challenge their regulators’ efforts at pressuring them, even if the regulators are exceeding their legal authority.
Recent examples of this include the officials at the Federal Deposit Insurance Corporation using their power as regulators to pressure banks to stop offering refund anticipation loans and cut ties with payday lenders, as well as the New York Department of Financial Services targeting banks and insurance companies that did business with gun rights groups.
In many cases the regulators were not able to point to a specific legal requirement, so they instead relied on more nebulous concepts such as “reputational risk.” This allowed regulators to apply significant pressure on banks without taking a formal step, such as an enforcement action, that would have provided transparency and an opportunity for an independent court to intervene.
It isn’t just government officials acting with force of law who seek to use the uniquely powerful position of financial firms as a tool of de facto regulation, however. Various constituencies, including management, employees, investors, customers, elected officials using “soft power” and activists have all sought to use financial services as a tool of broader social change. While the cause may sometimes be worthy, there are real questions as to whether financial services are the proper venue for us to sort out our political fights.
Financial services are highly regulated, often with strong barriers to entry, exit and market discipline. They are also essential. Allowing them to be used—by the government or by private actors—to coerce or frustrate others’ lawful desires, without the challenges and limits imposed by the political process, harms everyone who uses financial services and is antithetical to abundance. While there are differences between being prevented from doing something by law and being prevented from doing something because you can’t access essential services, in either case you are still prevented from doing what you want to do, and in the latter case often with far fewer rights.
While market forces may present a means of relief if new entrants take up the slack, if a sufficient number of participants share the same desire or are subject to the same pressure, or if the targeted group is not profitable enough to justify unique entry, the market might not correct. Even if new entrants do come in, there is still the chance that the new market will be shallower and more expensive, still reducing conduct on the margin.
Of course, private coercion and the response thereto is more complex than government coercion because it forces competing legitimate values in tension. Preventing the government from abusing its power is morally simple, even if it is hard to do in practice. Forcing a private firm to do business with someone it doesn’t want to implicates associational and property rights not present with the government. This question is further complicated when the private firm receives significant government power granted to facilitate, not impede, lawful commerce, or if the conduct being impeded is the type that the legitimacy of our pollical system relies on (e.g. reasonable privacy, peaceful speech and organization).
Resolving those questions will prove challenging, but it is important we do so in a way that prevents the abuse of the financial system for illegitimate ends while preserving as much freedom, autonomy and competition as possible. If we fail, the financial system will sink further into the polarized morass of political warfare and become just another venue where partisans reward their friends and punish their enemies. This is no one’s idea of abundance.
You can’t eat financial services, but in the modern world it is hard to eat without them. Our financial markets have proven very effective at allowing people to pursue their needs and interests, and to build wealth for themselves and others. If we want a world of abundance, we will need a financial services system that can support it. To do that it must be innovative, competitive, resilient and resistant to abuse. If we can do this, many wonderful things will follow. If we can’t, abundance will wither on the vine.