1 Introduction
Research on the causes of the global financial crisis and ensuing recession that began in 2007 has focused on institutional and societal factors that enabled some financial firms to privatize profit while socializing risk.Footnote 1 While diverse in argument and approach, the accepted wisdom from mainline scholarship is that market actors were able to exploit asymmetric information and moral hazard to profit at the expense of society in the years before the crisis; societies then faced political choices over the extent to which they should commit resources to these actors to escape the crisis.Footnote 2 Market actors’ capacity to lobby and obtain support through subsidies,Footnote 3 financial protectionism,Footnote 4 and the capacity to outrun existing regulatory frameworksFootnote 5 arose because of finance's prominent position within economic systems.Footnote 6
This special issue of Business and Politics on Property Rights, Financial Risk, and the Politics of a Networked Global Financial System examines the political economy of financial intermediation, and proposes a post-crisis research agenda, containing four dimensions. This introduction proceeds by, first, conceiving of financial products as ranging across a goods typology under different contexts; financial products are not just private goods, but also sometimes comprise club goods and club structures, common pools, and public goods.Footnote 7 Papers in this special issue explore how the complexity of property rights in finance opens new pathways for scholarship using an explicitly political conceptualization of financial risk at the firm, industry, national, and global levels. Second, this issue examines the unique nature of networks in global finance and banking by exploring how private, multilateral, governmental, and mixed-form actors view risk, construct strategy, implement policy, and interact with other actors through their boundedly-rational view of the financial risks they face.Footnote 8 Third, the articles offer unique insights into financial power, regulation, and governance. Governance of finance is complex and problematical; regulation is conducted by a mishmash of public and private agencies operating at multiple levels, and at each level the outcomes are conditioned by the power distribution and access to information.Footnote 9 Taken together this system—of market action, governance, political engagement, and regulatory rule-making and oversight—constitutes a dense political economy of finance, which sometimes falters and fails under pressure. These systemic failures increase the likelihood of radical forms of politics emerging, as they have in much of the world since the subprime crisis began in 2007. So fourth, the special issue considers forms of possible governance that have been neglected by comparative and international political economists. The Ostrom School emphasizes the possibility for effective polycentric governance of complex systems, but the conditions under which that could occur in global finance have not yet been fully explored; this special issue thus brings comparative and international political economy analyses of finance groupings into conversation with the Ostrom School of political economy (and vice versa).
2 Property rights in financial markets
The legal, social, and institutional contexts within which financial actors make their economic decisions have a profound impact on how financial markets function.Footnote 10 Despite high levels of political contestation regarding the activities of financial actors, nearly all scholarship in the fields of financial economics and public policy implicitly treat financial products as private goods that are bought, sold, and traded in frictionless (or near-frictionless) markets characterized by efficiency. In a public policy sense, “markets” are seen as the best settings in which to transact in private goods.Footnote 11 Non-private goods may be provided by other, non-market, means of social coordination.
Private goods are defined as excludable from other's usage once they are owned and thus taken out of the pool of goods that can be accessed and “rivalrously” consumed once the owner takes possession. This characterization certainly captures many aspects of financial markets, but finance also includes club goods and club good structures,Footnote 12 common pools—in which consumption depletes the supply of the good but exclusion of consumption is difficultFootnote 13 —and public goods, which are neither excludable nor rivalrous in consumption.Footnote 14 We consider financial markets as multidimensional markets with unique products and structures to share return and offset risk. In practice, boundaries between these categories are not only fuzzy, but financial products can span different categories as well.Footnote 15
For instance, Selmier's contribution to the special issue categorizes national currency (fiat currency) systems as a public good because exclusion from access and usage of fiat currencies is infeasible and consumption is not rivalrous: a government simply prints more or removes some from circulation.Footnote 16 But this raises the issue that the monetary system is also an institutional structure given the extensive institutional framework that manages and utilizes it, the required trust and reputation which projects its value across the United States and internationally (in the case of the dollar), and its other uses as a store of value, accounting measure, and investment vehicle.Footnote 17 As discussed below, fuzzy boundary conditions are not only legal and functional, but institutional and geographical as well, extending far beyond national borders.
Considerable institutional variation is driven by wide diversity and innovation in financial product design, as well as the broader institutional forms that bankers and financiers have created in order to take on risks and increase returns. Pan-industry governance structures, interfirm linkages, and financial products can create club goods whereby returns can be captured within the club structure while risk is moved outside of it.Footnote 18 Bankers and financiers engineer financial products, sometimes altering the property rights embedded in financial goods to improve returns, address segmented markets, and share or “push out” risks. These institutional arrangements and linkages condition the ways in which financial actors behave.
In this issue, Schwartz argues that the information economy—of which financial services is a key part, particularly in increasingly financialized advanced economies such as the United States—is built on the transformation of non-subtractable, non-excludable and thus public goods into non-subtractable but excludable club or franchise goods. This transformation permits public goods to be monetized as franchise goods, creating a potential stream of profits. This is an important part of financial engineering and finance itself.Footnote 19 Schwartz's special issue contribution focuses on industrial sectors where patents and other boundary-defining forms of intellectual property rights can be used to wall off access from others in that industry, creating monopoly profits. Many large “nonfinancial” corporations generate a larger percentage of profits from the financialization of corporate activity than ever before, in the United States and in other highly advanced capitalist economies.Footnote 20 The need to lower uncertainty—perhaps by transforming financial risk from a private good to a club good, common pool, or public “bad”—also drives financial engineering of new products. Patent portfolios in banking and finance are difficult to construct because products are easily reverse-engineered, resulting in a race to develop new products and structures through technology investment.Footnote 21
Like all markets, financial markets require credible enforcement mechanisms that guarantee property rights in order to properly function. Formal enforcement mechanisms often involve commonly-understood regulatory rules that (in principle) ensure a level playing field and a legal system capable of adjudicating contractual obligations. The character and detail of these rules—which curtail property rights as they demarcate what financial actors are, and are not, allowed to do with their capital—is political. Every regulatory rule, principle, or directive has distributional implications. In this special issue, for instance, Quaglia discusses the legal debates and lobbying competitions required to develop and implement rules on hedge funds and over-the-counter derivatives in a way that would satisfy regulators on both sides of the Atlantic, all of whom are facing pressures from the firms located in their jurisdictions.Footnote 22 In this issue, Young, Marple, and Heilman examine the “overlapping networks of financial regulation” that result from personal links between firms’ and governments’ personnel.Footnote 23 They show that the “social distance” between financial firms and the Securities and Exchange Commission (SEC) plays a significant role in lobbying activity, which in turn significantly influences how the financial system architecture is designed.
Central banks sit at the core of financial markets. Although some key functions of central banks vary across the globe and financial actors alter their behaviors accordingly,Footnote 24 in general, central banks may provide public goods in the form of macroeconomic stability and monetary liquidity (via issuance and maintenance of a stable currency), part of which might involve aspects of banking supervision and economic signaling. Yet there is an ongoing debate between those who view the need for a strong central bank as paramount, those who believe that it is a necessary evil that should be operationally constrained,Footnote 25 and those who argue that many of its common core functions should be removed.Footnote 26 For example, although many believe the emergency measures undertaken by central banks in response to the global financial crisis to have been necessary, John Taylor criticized the extent of Federal Reserve because it had “effectively replaced the entire interbank money market and large segments of other markets with itself—i.e., the Fed determines the interest rate by declaring what it will pay on bank deposits at the Fed without regard for the supply and demand for money.”Footnote 27 Salter and Tarko argue in this issue that free banking systems could be polycentrically governed using principles from the Ostrom School of political economy (discussed in more detail below) in a way that promotes financial stability even in the absence of centralized control.Footnote 28
Thus, re-conceptualizing property rights as more diverse than simple private goods being exchanged in frictionless financial markets forces us to think differently about how those markets perform. This has implications for the politics and economics of modern finance, as it implies that finance generates risk differently according to the actors’ positions within complex, interdependent, market structures. This also suggests that power in political economies of finance is at least partially distributed according to the structure of the network: Prominent actors are able to distribute risk throughout the system—reducing their individual exposure but increasing system exposure, thus converting financial risk from a private good to a common pool resource (perhaps inducing moral hazard in the process)—in ways that could impact overall system performance and stability. We explore these dynamics in the following sections.
3 The networked nature of finance and banking
Fundamentally, finance involves “the design, production, distribution, evaluation, acceptance (or rejection), enforcement, and modification of promises.”Footnote 29 The relational nature of finance results in the emergence of network structures tied together by promises, sometimes written and sometimes merely verbal. Financial systems can be conceptualized as networks by the nature of intermediation. Banks are intermediate nodes connecting savers and borrowers, financial institutions are counterparties with each other as well as nonfinancial companies, and equity markets link investors and corporations.Footnote 30 Through intermediation, insurance, and investment the whole of society in advanced economies becomes interconnected.
Financial networks take many different forms, among them material,Footnote 31 ideational,Footnote 32 informational,Footnote 33 and social.Footnote 34 The distribution of resources in financial networks is not equal. Rather, some “nodes”—which could be persons, banks, or nonbank financial firms—are far more prominent than others. Influence over these systems originates from, and reinforces, positions within the global and national network structures.Footnote 35 Yet, mainline models in financial economics frequently do not portray these systems as interconnected in a hierarchical way. Financial economists Allen and Babus criticize these common financial market models because they are based on maximum entropy, wherein “banks spread their lending as evenly as possible.”Footnote 36 Thus, the distribution of influence within financial networks is disproportionately concentrated within certain nodes, which enjoy a form of structural power (as discussed in the next section).
Financial firms and industry groupings exist within these network structures. These networks form to manage risk and distribute it away from the originators to the rest of the network. Many highly-advanced economies have become increasingly financialized, shifting profit share to the financial sector,Footnote 37 increasing governments’ reliance on finance for tax revenue, high-paying jobs, and subsidization of consumption in environments of low wage growth.Footnote 38 This development has reinforced the prominence of financial capital within broader economic networks, and has made the stability and profitability of the financial sector an important priority of public policy both domestically and internationally.Footnote 39
The papers in this special issue deal with the nascent political economy of finance literature that employs network concepts and methods, engaging with finance capitalism as an interdependent network through different lenses. Schwartz's contribution takes a broad view of economies, arguing the club goods structure of much of intellectual property generates positive network externalities that are captured by those in corporate clubs at the expense of those outside of it.Footnote 40 Fichtner, Heemskerk, and Garcia-Bernardo show that the “Big Three” investment firms (BlackRock, State Street, and Vanguard) are prominent within the network of corporate ownership to such a degree that corporate governance may be compromised as their political influence increases.Footnote 41 Quaglia shows how transnational financial networks were a crucial mechanism for overcoming transatlantic regulatory disputes in the post-subprime crisis period of regulatory revision.Footnote 42 Salter and Tarko compare and contrast network effects caused by national central banking versus local and regional bank clearing houses, arguing that the latter create incentives for better bank monitoring through a polycentric bank governance network.Footnote 43 Selmier counters that bank clearing houses cannot manage systemic risk on their own, but agrees with Salter and Tarko that central banks may create too much moral hazard, and seeks to selectively employ club governance in place of purely regulatory responses.Footnote 44 Winecoff extends “preferred habitat” theory in financial economics into a political economy context, arguing that the financial ecology is a complex network that can be modeled and examined using network methodologies.Footnote 45 And Young, Marple, and Heilman show that the “social distance” between financial firms and the Securities and Exchange Commission constitutes a social network that influences firms’ lobbying behavior.Footnote 46
The networked nature of finance catalyzes innovation and propagates it through the network as financial firms constantly engineer new financial products to remain competitive and constantly design corporate structures around these new products.Footnote 47 Competitive pressures transmitted through patterns of network connectivity increase network hierarchies. This view of financial markets suggests that no financial actors are truly discrete, and that they do not all face the same incentives from competition. In particular, the network approach suggests that competitive pressures should be strongest in the core (and aspirational core) of the network, while actors in less-connected parts of the network retain greater room to maneuver.Footnote 48 Information asymmetries may not only increase some firms’ profitability and political power, but also increase risk—or alter the distribution of risk—within financial networks. The resources employed in finance to acquire, amalgamate, employ and protect proprietary information increase the spread between those more or less endowed with informational resources.Footnote 49 Network positions alter the outlook that financial actors employ and the access to information that they possess, thus changing their perceptions of risk and uncertainty.
4 Risk, power, and governance
Risk and uncertainty are characteristics of financial contracting and of business itself. The specific uses of the terms “risk” and “uncertainty” began to acquire technical meanings centuries ago, meanings which Frank Knight categorized:
The practical difference between the two categories, risk and uncertainty, is that in the former the distribution of the outcome in a group of instances is known (either through calculation a priori or from statistics of past experience), while in the case of uncertainty this is not true, the reason being in general that it is impossible to form a group of instances, because the situation dealt with is in a high degree unique.Footnote 50
Knight's statement implicitly includes the idea that learning through “past experience” or through improved “calculation” techniques the expected probability of an outcome may pull a “group of instances” out of an actor's pool of uncertainty and place them into a her risk pool. So asymmetric information advantages, gained either through experience or access or both, should lower uncertainty for the one possessing the advantage. But broader, systemic financial risk manifests as a common pool or even a public good (or public “bad”).Footnote 51 Financial actors may employ this common pool nature of financial risk to improve their return-to-risk profile,Footnote 52 which sometimes generate excessive systemic risks sufficient to threaten the global economy.Footnote 53
Financial risk may be defined as
[e]stimated exposure to a situation of uncertain outcome… [E]stimation is in the eye of the beholder, and varies based on the risk-consumer's preferences and experiences. Financial risk consists of potential volatility or changes in returns which differ from actors’ expectations and estimation of these values.Footnote 54
Sources of risk that affect financial markets include macroeconomic and regulatory risk, business-operations risks, environmental risks, and broader government-linked risks (such as electoral change, war and corruption). Indeed, all risk is political in the sense that its creation and dissemination reflects, reinforces, and alters the distribution of power in the world economy between public and private actors. “Fat tails” in the distribution of even idiosyncratic market risk increases the chance of encountering “black swan” events, which contain a low outcome probability but have potentially-severe consequences if they do occur.Footnote 55
The “preferred habitat” approach extended by Winecoff in this volume begins from this empirically-grounded assumption that actors have different levels of risk-tolerance, different time horizons, and otherwise prefer to occupy heterogeneous positions within the market structure. So market actors (and the policymakers that regulate them) are required to assess the difference between risk and uncertainty, probabilistically model of what they assume to be “risk” while leaving out “known and unknown unknowns,” and then adjust these probabilities based on prior experience and their accessible information set. The culmination of actors’ behaviors generates a common pool of risk in which financial actors interact with political systems, choosing to locate themselves within specific niches of domestic and global political-financial “habitats” that resemble a networked ecology.Footnote 56
Traditional models of financial markets assume homogenous agents can be represented by a single actor, but this ignores the observation that market structures vary substantially across countries and time.Footnote 57 Under preferred habitat models, the distribution of financial risk depends upon the location within the market where risky activity takes place. This presents challenges for risk-assessment, because the full market structure is ex ante unknowable from the perspective of any single market actor: One's links and exposures to the rest of the network is information that is privately held by each agent or firm.
AIG's collapse in the recent financial crisis provides an example of increased risk. Each counterparty of AIG knew the strength of its own ties to the insurer pre-crisis, yet none of them could observe neither the breadth and weight of AIG's exposure to the American and British financial sectors nor AIG's corporate appetite for extreme risk. Counterparties may have guessed at the extent of AIG's risk exposure, but their respective investment preferences bounded their knowledge within their preferred habitats. Thus, this view of risk and uncertainty as a structural feature of interdependent systems is fundamentally different from the dominant approaches in the financial economics and political economy literatures based on independent actors with identical preferences. This research stream is consonant with the emerging literature of “risk topographies” that reflect the range of interconnected components that could impact volatility.Footnote 58
Volatility can be caused by political intervention, broad (or narrow) market instability, or even natural causes. A systems approach suggests that volatility is related to the organizational structure of, and patterns of interdependence within, financial markets. Salter and Tarko's contribution to this issue pushes this regional approach further by arguing that bottom-up institutional arrangements—through reestablishment of local and regional bank clearinghouses—may provide more robust polycentric bank governance systems by creating incentives to minimize risks and more closely monitor banks (and thus protect counterparties). That the wide range of interacting factors that could alter the viability of investments suggests that a dynamic equilibrium approach to risk—one that assumes complex interlinkages—is needed,Footnote 59 rather than treating all risk as independent and randomly-generated (in the statistical sense).
The control of information becomes highly salient to market actors because accurately assessing risk is dependent on information. Information may be protected through property rights; in the broader economy, Schwartz's article in this issue discusses how corporations employ intellectual property protection to create club goods that retain profits within firms while pushing business risk onto workers, and in particular onto contingent labor. In finance, Gary Gorton “argue[s] that banks should be opaque” because opacity protects banks and financial firms from loss of confidence.Footnote 60 But opacity also increases risks and enhances the informational asymmetry possessed by financial firms and investors, thereby increasing their political power.Footnote 61
Financial risk is highly political because of finance's position at the core of modern economic structures. Moreover, the politics of financial risk operates at multiple levels within the global system, and political systems have responded with multilevel governance efforts that are highly contentious. In this special issue, for instance, Quaglia discusses what Posner described as the “Euro-U.S. regulatory condominium characterized by close interactions among decision makers and mutual accommodation” between regulators and financial industry firms and their industry organizations.Footnote 62 In the three cases she analyzes, Quaglia finds that post-crisis regulatory reformers were preoccupied with locating risk within broad market systems and minimizing societal exposure, while those affected by these reforms in the financial industry sought to minimize impacts on trading, to resist regulatory efforts to internalize the risks they were taking, and to retain as much self-regulatory oversight as possible. This is in line with prior literature suggesting that self-regulatory dynamics sometimes “disproportionately advantage the powerful members of the ‘self-regulating’ group… [and] tend to create barriers to entry and thus affect stakeholders beyond those who have a voice in the rule-making process.”Footnote 63
Actors who occupy positions at the core of the structure may access an enhanced set of opportunities compared to those who exist in the periphery. Because core positions frequently confer influence on actors who occupy those positions, the distribution of power within political economies of finance is also related to structural prominence within these financial networks. In fact, national governments sometimes support financial firms’ strategies to gain market share by becoming more embedded within the global market.Footnote 64 This “structural power” could take many forms in finance specifically (and in economies more generally): the ability to influence the flow of resources or information,Footnote 65 the capacity to generate and distribute risk throughout the system while concentrating profits,Footnote 66 or a more latent ability that Susan Strange described as “the power to shape and determine the structures of the global political economy…the power to decide how things will be done, the power to shape frameworks within which states relate to each other.”Footnote 67
5 Alternative governance models and the Ostrom School: What is new and what is old in this research program?
As the first pains of the financial crisis faded, banking economist Paul Woolley argued, “Policy makers can only regulate the banking and finance sectors effectively if they have a reasonable idea of how markets work.”Footnote 68 This special issue has taken his argument to heart by expanding the narrower view of regulation into one of governance, analyzing governance complexity in financial markets, and by introducing or reintroducing new models and theories in risk management and market governance. These new models and theories include explicit and implicit links to the Ostrom School and may further open ideas of the Ostrom School to a broader community seeking new ideas in financial market governance.
This special issue focuses on governance rather than regulation because governance emphasizes the utility of employing more of the contextual knowledge and information embedded within markets—conceptualized as networked habitats, or ecologies—to improve outcomes. But simply spreading the responsibility for resilient, robust financial markets to more actors does not resolve the complexity of financial market governance. In the words of Peters, Pierre and Randma-Liiv, “divid[ing] the public sector into numerous single-purpose organizations…has tended to divide information and regulatory powers, and therefore limited the capacity of the public sector to understand and regulate [financial] risk.”Footnote 69
The articles in this special issue explore these complexities in detail, and in so doing they integrate the analysis of at least five governance challenges in the political economy of finance: 1) the condition of informational opacity and asymmetry; 2) the complexity of financial networks that engender risk and “structural” political power; 3) the possibility of conflicted regulators; 4) the club goods nature of many financial products; and 5) the importance of very well-connected (i.e., “systemically important”) players.
-
1. The existence of huge informational asymmetries and behavioral heterogeneity within markets makes governance difficult.Footnote 70 While the information resources of financial firms are enormous and their access to regulators and government decision-makers quite robust,Footnote 71 the complexity of modern financial intermediation has made some financial firms “too complex to depict” in risk management terms for both banks and for regulators.Footnote 72
-
2. The hierarchical nature of financial networks makes it nearly impossible for governments to govern alone. Network scientists have extensively studied the conditions under which networks are stable or unstable, and how “contagion” can spread from one unit to others based on their ties to each other. The articles in this special issue suggest that instead of viewing financial markets as solely made up of private goods or homogenous markets, a more accurate model may better match observational reality while situating financial markets within a realistic political context.Footnote 73
-
3. Regulators may be biased against disclosing financial institutions’ weak health due to political pressures,Footnote 74 more delimited in their market knowledge, and more susceptible to political pressures.Footnote 75 Bankers and financiers in fact use this, as noted by member of the German Council of Economic Experts Beatrice Weder di Mauro: “As soon as crisis strikes, the optimal choice for policymakers differs from the pre-announced policy…the authorities will usually offer support. The banks anticipate this behaviour and run even more risks as a result.” Political economists have examined pressures on regulators in a range of studies,Footnote 76 and this special issue provides a broader context for understanding how the complex organization of financial markets further complicates regulators’ difficult balancing act.
-
4. Governance of financial markets and financial products are complex in part because property rights often resemble club goods rather than private goods.Footnote 77 Financial market actors, especially financial intermediaries and very large investors, have been able to capture returns of these products while exteriorizing, or socializing, a portion of the risk.Footnote 78 Even in the highly networked global markets that we observe today, banks and bankers still attempt to mitigate risk and increase return through club formations.Footnote 79 These articles suggest that banks organize their capital structures of debt and equity in order to differentiate themselves for competitive purposes and to fit into the niche they prefer to inhabit.Footnote 80
-
5. “Too Big to Fail” (TBTF) was a coveted club to join, and aspiring banks paid significant acquisition premiumsFootnote 81 and saw their cost of funds drop once membership had been achieved.Footnote 82 The club-like benefits of American banks in the TBTF club include access to implicit insurance underwritten by the U.S. government which serves to lower these banks' costs of funding by a substantial amount.Footnote 83 TBTF presents the sharp edge of increasing political influence and capital-concentration in the industry.Footnote 84 Mishkin noted a more apropos title for these huge banks might be “too-politically-important-to-fail.”Footnote 85 Since the subprime crisis, however, the language used by many policymakers to refer to these has shifted from “too big to fail” to “systemically-important financial institutions” (SIFI). That is, as interdependencies in global finance have grown so have the risks of exposure to those connected to the core of the financial network. Global financial governance bodies have taken notice of the shift in importance from TBTF financial institutions to SIFI, the designates of which now also include non-bank financial institutions: “The work of the Basel Committee forms part of a forms part of a broader effort by the FSB to reduce the moral hazard of GSIFIs…and will also help level the playing field by reducing too-big-to-fail (TBTF) competitive advantages in funding markets.”Footnote 86 The articles in this issue provide new approaches for understanding how certain firms could become structurally important, and how the existence of SIFIs creates areas of political contestation and challenges for governance.
This issue initiates a dialogue with the Ostrom School of political economy regarding the possibility of addressing these challenges through three governance approaches: self-governance, monitoring, and polycentricity. Each of these has applications to the study of financial markets that are conceived of as a mixture of all four goods types wherein financial risk may be considered as common pools, leading to development of complex, hierarchical network structures with considerable informational asymmetry engineered into the networks.
Self-governance
Elinor Ostrom cautioned that self-governance efforts are more effective when they “roughly fit the ecological boundaries of the problems they are designed to address.”Footnote 87 Depending on market context, categorizing financial risk across goods types—private, club, common pool, public—can help us locate governance challenges, but that alone will not help create the policy mechanisms needed to address the problem. Rather, smaller incremental applications to specific problem areas might be more efficacious. That is, limited self-governance could be linked to specific services, products, or delimited sections of financial markets. Selmier suggests LIBOR pricing might be one area, using the participating banks to self-govern the pricing mechanism and punishing transgression by exposing it.Footnote 88 While this fits Winecoff's conception of preferred habitat,Footnote 89 it is not yet clear where the boundaries exist between LIBOR and the broader market, and how Selmier's example might utilize Ostrom's maxim that “[w]ell-understood and enforced rules operate so as to rule out some actions and to rule in others.”Footnote 90
The boundaries between self-governance and polycentric approaches are fuzzy, and for simplification we assume that polycentricity is a broader mechanism of governance while self-governance may be applied specifically, locally, and in more defined (and particularized) habitats. Young, Marple, and Heilman bridge these boundaries by utilizing a classic model from Ostrom, Tiebout, and Warren to note that there are “overlapping networks of financial regulation”:
Global finance has many regulatory bodies (public and private regulatory bodies) operating at different geographic scales (national, sub-national and international). Taken as a whole, the global financial system exhibits characteristics of polycentricity.Footnote 91
Bryce makes an extended, similar argument from a legal perspective about the structure of American financial governance.Footnote 92 In both cases, a challenge, which we discuss below, is to determine where the power resides and how a balance between powers is struck. The efforts of the transatlantic financial industry to engage in financial rule-setting as analyzed in Quaglia provide a partial lesson in self-governance, in that governments on both sides of the Atlantic interacted to a significant degree with individual financial firms, their legal counsel and their industry groups, to craft governance solutions.Footnote 93 While successful in some ways, these approaches were also ad hoc as they arose to deal with the tasks at hand. And importantly, government intervention was required to impose governance vehicles. In addition, the influence of private agents on public regulators opens the door for regulatory capture, various forms of rent-seeking, and other outcomes that are suboptimal from the perspective of social welfare.
Monitoring
If the approach taken by Young, Marple, and Heilman provides promise for polycentric governance approaches, then Fichtner, Heemskerk, and Garcia-Bernardo provide a cautionary tale wherein large financial institutions with the capacity and resources to monitor the strategies of their investments appear, thus far, to be abdicating their responsibility.Footnote 94 Delegated monitoring is theorized as a fundamental task of banks and financial institutions, and assumed to provide a considerable public good through better economic management, information disclosure, and disciplining through capital allocation or withholding.Footnote 95 The “Big Three” investment management complexes that Fichtner et al. analyze have significant structural prominence within the American corporate network—BlackRock, Vanguard, and State Street—are the largest shareholders of 40 percent of all corporations listed in the United States, including 88 percent of the S&P 500. Not surprisingly, the “Big Three” and corporate managers seem to find themselves in agreement quite often. In voting cast during annual shareholders’ meetings, rather than disciplining through monitoring, the Big Three vote with management frequently, particularly on environmental, social, and governance issues.
Salter and Tarko span all three governance approaches from the Ostrom School in their discussion of supplanting central banking with decentralized bank clearinghouses, but we focus on monitoring here.Footnote 96 A debate persists as to whether, in a central bank-stabilized economy, monitoring functions are dampened because of implicit insurance and access to funds provided by a central bank. Salter and Tarko argue that banks which are members of bank clearinghouses—which are private—deliver public goods more efficiently, which makes them optimal forms as argued by Ostrom, Tiebout, and Warren—that provision and governance of a targeted service or product should be tuned to its most efficient level.
Polycentricity
While not yet well-incorporated into international political economy scholarship, polycentricity is in many respects a natural fit: Pragmatic institutional approaches where “fair distribution of the benefits and costs of alternative financial system[s]”Footnote 97 are used to engineer comprehensive governance mechanisms have long been accepted as a normative goal in mainline international political economy. Yet while the Ostrom School emphasizes the possibility for effective polycentric governance of complex systems,Footnote 98 the conditions under which that could occur in global finance are just beginning to be explored, and this special issue is a step in that exploration.
Relatedly, Schwartz ponders how to structure effective macro-economic regulation in his analysis of the shift from mechanical technologies to information and financial technologies. Several papers in this special issueFootnote 99 discuss the ways in which micro-economic regulation often reflects narrow rather than broad interests. Polycentricity may provide both a platform and the applications needed to address this challenge. Polycentric governance is innovative and conceives of equilibria as dynamic, just as innovation is rapid in the broader information economy and equilibria are dynamic in financial technologies.Footnote 100 A challenge to the viability of polycentric governance, according to Schwartz, is the question of power, particularly structural power, which determines who decides the content of rules and the allocation of rights to resources: archetypal polycentricity means that “[n]o one office or decision structure has an ultimate monopoly over the legitimate use of force in a polycentric political system.”Footnote 101 But in economic governance generally and financial governance specifically, the government with jurisdiction will exercise legitimate force (or choose not to), and prominent firms will exert influence regarding this decision to the extent that they are able.
McGinnis argued that “polycentric orders have their own inherent properties, and cannot be seen as exact analogues of private markets.”Footnote 102 While polycentricity cannot be reduced to the market concept, the present policy suggestions in this special issue probe ideas that governance of markets could be governed through polycentric approaches. Winecoff notes that “representative agent models (the accepted paradigm in financial economics)…treat markets as equilibrium-seeking and stable absent unpredictable exogenous shocks; PH [the preferred habitat model] understands markets to be dynamic, evolving, and characterized by multiplexity.”Footnote 103 This descriptive reality is not only closer to how markets actually work, but dovetails with the view of the reality of governance, which the Ostrom School would consider to be polycentric.
Polycentric approaches, especially those that explicitly consider the common pool nature of financial risk and the vast population of club good-like products and institutions, might contain opportunities to improve financial market governance in theory. But could they work in reality? The Ostrom School is decidedly empirical,Footnote 104 and these claims and questions have yet fully to be clarified, tested and answered. Here are four questions that this special issue raises, but does not fully answer, which could guide future research:
-
1. How would application of a democracy-based concept to hierarchical structures of finance, whose main productive actors are command economies,Footnote 105 function? For self-governance, monitoring, and polycentricity to be effective, the institutional framework requires input and governance actions from a range of firms and others with informational stores. Each approach also requires risks to be pushed back onto the financial actors who originate risk.
-
2. Can some public goods, such as the provision of monetary liquidity by central banks, be curtailed while retaining the linked portfolio of other public goods supplied by a robust national government? This is a major challenge confronting reinstitution of bank clearinghouses, as central banking may “come with the package” of a central government providing a broad portfolio of public goods and enforcement mechanisms. Moreover, central banks have pursued a range of political goals that could be may not be efficiency-seeking but rather stability-seeking which may not be pursued if not tied to public goods provision by a national government.
-
3. Can a polycentric approach to the governance of financial markets yield an effective enforcement mechanism? Two challenges arise here. First can club governance actually work? Potoski and Prakash explain that free-riding and shirking are complex to address in club discipline, and require high standards of entry and effective monitoring and enforcement rules.Footnote 106 Yet in finance some clubs are of an ad hoc nature so standards are, at best, sketchy. Informational asymmetry complicates monitoring, while enforcement requires risks to a targeted firm's reputation and the capacity to impact that reputation. This leads to a second problem, will polycentricity be capable of dealing with local tyrants who may shift governance in their favor?Footnote 107 While Ostrom School foundations of this research program have been laid over the course of sixty years,Footnote 108 the distribution of power across the private and public sectors, nationally and transnationally, is not something the Ostrom School has emphasized. In the Ostrom School the strategic interaction is often more about coordination than competition, since the logic of competition can lead to mutual destruction. Financial markets involve a shifting mix of coordination and competition and so the distribution of power in markets is often contended.
-
4. Ostrom's distinction between the production of public goods and the provision of public goods is challenging for finance,Footnote 109 because financial goods are generally produced for profit. Indeed, this distinction is rarely found in practice except in pure public financial products, services, and institutions,Footnote 110 but they may be critical to effective financial market governance. If so, then rules of governance that come from the Ostrom School may have limited purchase in the governance of financial markets.
As such, this special issue offers a challenge to scholars working within the Ostrom School tradition, as well as those in comparative and international political economy, and financial and institutional economics. Each of the papers in this issue could sustain a deeper research agenda on their own, but we believe that the cross-pollination of the ideas contained in them will yield substantial profit for scholarship on the political economy of global finance.
