Externalities and systemic risk

As discussed above, market failures can take many forms. A possibly non-exhaustive list can include externalities, monopolies, and information problems. Intuitively speaking, an externality exists whenever the activities (or inactions) of an agent influence the utility function or production possibilities frontier of another agent (third party) who neither pays nor receives any compensation for that effect.⁷¹ Externalities are one of the main reasons that cause a divergence of private marginal costs/benefits from social marginal costs/benefits. It is mostly because individual economic agents engage in activities which maximize their own marginal benefits regardless of their social costs created by their activities.

This thesis adheres to the definition of externalities which is proposed by Baumol and Oates. In their view,

68 It is appropriate to note here at the outset that in this dissertation, following Morgan and Yeung, regulation will be viewed as a “broad and open-ended category” which includes any intellectual inquiry or activity relating to the

“purposive shaping of social behaviour”. In this approach regulation can include both intervention in the markets by state and interventions by non-state entities to correct market failures using any means which can influence the shape or design and the functioning of the markets (market enhancing mechanisms) and market participants.

Therefore, this approach to regulation includes legislation by legislatures (such as setting and enforcing property rights), regulation in its narrow sense by the executive, the decisions of the courts (judicial law-making) in resolving disputes between parties as well as private regulation such as regulation laid down and implemented by Self-regulatory Organizations (SROs). Needless to say, this can include even the constitutional provisions. It accordingly follows that this thesis will not restrict the scope of regulation to its narrow sense which traditionally was the realm of the executive branch of government. The regulation in that sense is a concept which is especially adopted in countries with civil law system, while in common law countries this distinction is mostly blurred and can include any public policy response to the anomalies in the markets or society. For more info about such an approach to regulation, see Bronwen Morgan and Karen Yeung, An Introduction to Law and Regulation: Texts and Materials (New York: Cambridge University Press, 2007), p. xiv.

69See Anthony Ogus, Regulation: Legal Form and Economic Theory (Oxford and Portland, Oregon: Hart Publishing, 2004b), pp. 15-46. See also Joseph E. Stiglitz, "Government Failure vs. Market Failure: Principles of Regulation," in Government and Markets: Toward a New Theory of Regulation, eds. Edward J. Balleisen and David A. Moss (New York: Cambridge University Press, 2010), 1-28.

70 Morgan and Yeung, An Introduction to Law and Regulation: Texts and Materials, p. 18.

71 Mankiw, Principles of Microeconomics, p. 196.

“An externality is present whenever some individual’s (say A’s) utility or production relationships include real (that is, nonmonetary) variables, whose values are chosen by others (persons, corporations, governments) without particular attention to the effects on A’s welfare.”⁷²

The above definition of externalities excludes pecuniary externalities⁷³ from the definition of externalities. Since many of the externalities flow through the price system, Viner’s distinction between pecuniary and technological externalities becomes critically important in financial markets. In Viner’s view, to the extent that an effect on the third party does not generate resource misallocation, that effect is not an externality. In his view, there are circumstances in which the activities of one agent affect the financial circumstances of another party; however, these activities do not produce misallocation of resources in a purely competitive market. The reason is that these externalities do not create a shift in the production possibilities frontier or the third parties’ utility function. In this thesis, whenever the word externality is used, it will correspond to the “Pareto-relevant externality”, i.e., technological/true externalities and not pecuniary externalities, unless otherwise noted.⁷⁴

72 William J. Baumol and Wallace E. Oates, The Theory of Environmental Policy, 2nd ed. (New York: Cambridge University Press, 1988), pp. 17-18.

Baumol and Oates offer a two-pronged definition of externality of which I adhere to one. The second condition offered to the externalities definition is as follows: “The decision maker, whose activity affects others’ utility levels or enters their production functions, does not receive (pay) in compensation for this activity an amount equal in value to the resulting benefits (or costs) to others.” However, as they themselves admit, it is better to define an externality to be present whenever condition 1 holds.

As in other segments of the real economy, externalities can emerge in the financial markets. An externality in the financial market is defined as an externality caused by a financial institution which imposes costs on or offers benefits to other financial institutions or other economic agents outside the financial system. See Wolf Wagner, "In the Quest of Systemic Externalities: A Review of the Literature," CESifo Economic Studies 56, no. 1 (2010), p. 97.

See also Garry J. Schinasi, "Private Finance and Public Policy," IMF Working Paper (2004), pp. 22-23.

73 Pecuniary externality is produced in and flows through price mechanism, i.e., it is a result of changes in the prices of inputs and outputs in a given economy and it takes the form of a movement along the production possibilities frontier instead of a shift in the frontier. See Baumol and Oates, The Theory of Environmental Policy, pp. 29-31 In other words, the pecuniary externalities create third-party effects by affecting the relative prices or asset prices.

This means that it does not lead to a misallocation of resources and hence resource allocation will remain optimal. It is worth emphasizing that the essence of the distinction between technological and pecuniary externalities “is not that a pecuniary externality affects only the values of monetary, rather than real, variables.” Put differently, “the introduction of a technological externality produces a shift in the functions relating quantities of resources as

independent variables and output quantities or utility levels of consumers as dependent variables.” See Ibid.

In this view, pecuniary externality does not create misallocation of resources and hence does not require regulation.

It is further argued that the existence of pecuniary externalities is necessary for the market efficiency and public policy response to pecuniary externalities often lead to misallocation of economic resources. See Randall G.

Holcombe and Russell S. Sobel, "Public Policy toward Pecuniary Externalities," Public Finance Review 29, no. 4 (2001), 304-325.

74 Externalities can also be divided into two major categories according to their depletability or non-depletability. An externality is depletable (private) if the consumption of an externality by one agent diminishes its consumption for

Systemic risk as a form of externality is another reason for financial regulation which came to the fore of the financial regulation literature particularly in the aftermath of the global financial crisis. Prior to the financial crisis, although there were efforts to study, analyze, and account for systemic risk and financial instability, it was not central to the finance literature. It was only after the global financial crisis that financial analysts could realize how interconnected the financial markets became within the last few decades. The interconnectedness and possibility of contagion of financial shocks pose serious challenges to risk management strategies and techniques. Today, at the heart of the ongoing debates about financial regulation are the mechanisms that can reduce systemic risk and ensure soundness and integrity of the financial system as a whole. Though historically speaking the main reason for financial regulation was the consumer or investor protection, it was the systemic concerns that created the most sweeping regulations of the financial markets. In most countries, episodes after the financial panic were the crux of financial regulation.

Systemic risk is said to be created by the systemic events. These events create risks which involve a substantial number of financial institutions and subsequently channels into the real economy through the inter-linkages of financial institutions.⁷⁵ It goes without saying that these events weaken and endanger the financial stability. Financial stability is the ability of financial system “to facilitate economic processes, manage risk, and absorb shocks.”⁷⁶ Whenever there is a

other agents. In other words, this externality can be called rivalrous externality. For instance, dumping waste on the neighbor’s property is a depletable externality, because the consumption of the waste on the neighbor’s property will eat up the waste and will prevent others from suffering the same problem. Whereas a non-depletable (public) externality is an externality the consumption of which by an agent does not diminish its consumption by other agents. Most externalities are non-depletable. This means that they are non-rivalrous, such as positive externalities of education and negative externalities of air pollution. In addition, there is a special case of “shiftable externality”

as a subset of non-depletable externality in which the victim of an externality can shift the externality to a third party. See Baumol and Oates, The Theory of Environmental Policy, pp. 25-26.

Shiftability of externalities deserves special attention in addressing the potential externalities in financial markets which opens door for market mechanisms in addressing such externalities based on the Coase theorem.

75 There are different definitions for systemic events or risks which will be studied in the second chapter.

76 Pacces and Dirk, Regulation of Banking and Financial Markets”, p. 2.

Financial stability is defined as “a situation in which the financial system is capable of satisfactorily performing its three key functions simultaneously. First, the financial system is efficiently and smoothly facilitating the intertemporal allocation of resources from savers to investors and the allocation of economic resources generally.

Second, forward-looking financial risks are being assessed and priced reasonably accurately and are being relatively well managed. Third, the financial system is in such condition that it can comfortably if not smoothly absorb financial and real economic surprises and shocks.” See Garry J. Schinasi, Safeguarding Financial Stability: Theory and Practice (Washington DC: International Monetary Fund, 2006), p. 82.

malfunctioning in any of these functions, the entire financial system and possibly the real economy may suffer from its malfunctioning.

The structure and organization of the financial markets are such that idiosyncratic and individual risks may easily spill over and endanger the entire financial system. Hence, failures in the operation of the financial sector not only have adverse consequences for individual investors but also stock market crashes, bank failures, and financial market distress may endanger the health of the entire economy.⁷⁷ The following sections will expand on problems of asymmetric information and imperfect competition and given the important of systemic externalities, the second chapter of this dissertation will discuss the potential systemic risk concerns arising from the hedge fund industry.