The Collapse of SVB: Thoughts on Moral Hazard, Market Fundamentalism, Fiduciary Duties, and the Scope of Government Regulation

ON THE EXISTENCE OF MORAL HAZARD IN BANKING (ONCE AGAIN)

The collapse of Silicon Valley Bank and Signature Bank in led to a March 12, 2023 joint statement from Secretary of the Treasury Janet L. Yellen, Federal Reserve Board Chair Jerome H. Powell, and FDIC Chairman Martin J. Gruenberg, in which they declared, with respect to each bank, “All depositors of this institution will be made whole.”

So again rose the “moral hazard” – what occurs when people, or corporations (including financial institutions) are insured against losses. Risk-taking is encouraged, as some form of protection is afforded to the risk-taker. In the case of the management of banks, the managers – whose compensation is often tied to profits – are thereby encouraged to take on risks. A “no-lose” game in essence arises: “Heads, I win” (when the risks assumed result in good returns), and “Tails, someone else loses” (when the risks result in losses, not borne by those who took on the risks).

To be fair, the Yellen/Powell/Gruenberg joint statement also pointed out that “no losses will be borne by the taxpayer” as a result of the government actions taken. Yet, the ramifications of these losses are already being felt throughout the economy. Within a short period of time, banks have become more conservative in their lending practices. Businesses are more reluctant to expand their business activities, given the possible (and some say probable) future adverse events that may arise. It appears likely that the consequences to the U.S. (and global) economy of these bank failures will be felt for years to come.

I submit that “losses” will indeed occur from the failure of these banks (and possible failures of other banks to come). Faith in our system of banking has, and will, suffer. Our economic growth will be challenged, at least to some degree. In the end, all Americans will suffer some form of economic loss, at least indirectly.

Countries where businesses, governments, and other institutions have engendered more trust experience stronger economic growth. Yet, with every bank failure, trust – so essential to the conduct of affairs in the marketplace – will be diminished. As stated by Maryna Brychko, Yuriy Bilan, Serhiy Lyeonov, and Grzegorz Mentel in a 2021 article, “Lack of trust in banks or financial markets may undermine the functioning of macroeconomic systems in general and financial markets in particular.”

It seems clear to me that either government regulation of banks (which even Adam Smith noted was required, in some respects), or the enforcement of regulation, was partly to blame. Not as a primary cause of the banks’ failures. But a failure to detect and deter, nevertheless.

Should we now turn to government intervention, by embracing new regulation, or by calling upon tougher enforcement?

ON THE MYTH OF MARKET FUNDAMENTALISM

In their recent book, The Big Myth: How American Business Taught Us to Loathe Government and Love the Free Market, historians Naomi Oreskes (Harvard University) and Erik Conway (California Institute of Technology) take aim at the 20th Century emergence of the cult of the “free market.” They document in detail how the quasi-religious belief emerged that the best way to address our needs — whether economic or otherwise — is to let markets do their thing. They uncovered the concerted action by corporate interests to advance the belief that government regulation of business is inherently evil and must be avoided at all costs.

And yet, as we saw in the Great Financial Crisis, and now more recently, many of the same voices that loudly advocated for government non-intervention were quick to justify the intervention of the government to rescue “the banks.”

I do not profess that I agree with all of the thoughts expressed in Oreskes’ and Conway’s most recent book. For I believe that we must resist government becoming large. I believe that self-interest (as so famously advanced by Adam Smith) can lead to positive effects, including entrepreneurship and resulting economic growth. And I believe that any extension of government regulation over business should be firmly justified through appropriate economic analysis demonstrating a high return on the regulation for any costs such regulation might impose.

However, in my view, some government regulation of the markets is warranted. With all of the evidence before us, it is not rational to believe that – as long as every individual were to seek the fulfillment of her/his own self interest – the material needs of the whole society will be met. From the outset of The Wealth of Nations, Adam Smith emphasized that the wealth created by the market “extends itself to the lowest ranks of people.” But does it?

We have seen the greater disparities in income and wealth that have arisen over the past half-century. And we now observe the difficulties of advancement via meritocracy; here, in the U.S., it taking on average five generations to rise from the poor to the mean level of income. We must ask if Adam Smith’s moral duty to apply “universal benevolence” should, as Smith propounded, be limited to only those within our own close social circles, and whether such “universal benevolence” is sufficient to meet the needs of our society.

We have also entered an age in which business, with the aid of technological innovations, increasingly replaces labor with capital investments. As a result, the rewards from business activity appear to be flowing more greatly to the providers of monetary capital. Many other economic forces are at play, including (but by no means limited to) a decline in working-age populations over the next several decades in many countries, an extension of life expectancies, shifts in immigration policies, and the onshoring of business operations due to concerns over the reliability of distant supply chains (in part due to concerns over heightened geopolitical risks).

In the face of our rapidly evolving markets, and the challenges that lie before us, it is right to ask, “How can we provide for a better society?” To what extent should we seek to impose higher standards of conduct, or other means of regulation, upon those who engage in marketplace transactions?

THE FIDUCIARY STANDARD AS A BENEFICIAL RESTRAINT ON MARKET CONDUCT

A “free market” approach is not purely taken with fiduciary standards, which at their core impose a constraint upon the fiduciary’s personal conduct when engaging in commerce with the entrustor (client). The fiduciary standard recognizes that, at least in some business activities, the “benevolence” of Adam Smith’s baker, brewer or butcher is not enough. For there exists situations in which the self-interest of one party, armed with much greater knowledge than the other party would typically be able to possess (i.e., where substantial asymmetry in information exists), can too easily utilize that knowledge to obtain outsized benefits. In other words, the fiduciary standard operates – in matters of great social importance or economic importance – as a constraint upon greed.

There are many benefits to the imposition of the fiduciary standard upon providers of investment and financial advice to individual investors. Armed with expert knowledge, and observing the strict duty of loyalty, the fiduciary steps into the shoes of the entrustor (client), and uses the expert’s greater knowledge to obtain a more favorable outcome for the client. The client – i.e., the investor – become more likely to participate in our capital markets system, and to reap the rewards the capital markets have to offer over the long term. In essence, the fiduciary standard solves a problem of “trusting” by consumers.

In turn, this leads to greater personal savings (as often results from the receipt of financial advice) and greater accumulations of wealth (via disintermediation, and a lowering of total fees and costs, although some reintermediation occurs). As greater capital is deployed by individuals to our capital markets, the cost of capital to corporations is somewhat lowered. And individuals, possessing greater personal financial security, are more able to meet their own needs, and are less likely to be burdens upon governments and charitable institutions.

ON THE SCOPE OF GOVERNMENT REGULATION OF FIDUCIARIES

When fiduciary standards are imposed, we must be careful. For the fiduciary standard is a principles-based standard. There is always pressure to transform such principles into a myriad of rules, often imposing undue costs upon fiduciary actors.

And there always exists pressure to interpret any laws or regulations imposing the fiduciary standard in a manner that does not apply the standard, or which serves to weaken it.

Additionally, there are questions of enforcement of fiduciary duties. Government may be good at detecting and penalizing certain breaches of the fiduciary standard – such as blatant failures to disclose certain conflicts of interest. Yet, government agents may not possess the requisite expert knowledge to detect and/or bring action against violations involving other fiduciary breaches, especially those involving the duty of care. Should we turn in such instances to private enforcement, via arbitration or the courts?

Similarly, perhaps professional societies should more formally assist government actors in matters of fiduciary duty interpretation and application. Guidance can and should be provided by the very experts – the professionals – who are most familiar with the subject matter, and who live and breath the application of fiduciary standards each and every day.

But a bevy of complex, and costly-to-adhere-to, specific rules that apply the fiduciary standard should be resisted. For such rules can diminish the fiduciary standard, or result in costs of compliance that are so high that drive the costs to businesses (and their clients) higher, and/or deter new entrants into the profession. (I submit that some existing regulations for fiduciaries (investment advisers) are justified, but many others are not.)

Enforcement of breaches of the fiduciary standard might occur through private actions brought by clients, or by professional societies’ actions against their members, and (when warranted) by government action (often leading to fines and disgorgement). We must always ask, “Which is the most efficient and effective means of enforcement?” And we must examine existing enforcement structures, with the eye toward eliminating portions that have proven to be ineffective, and with the goal of strengthening portions when warranted.

I, for one, submit that government agencies should concentrate more of their limited resources on detecting actual fraud (such as Ponzi schemes), given the profound adverse effects of such violations on participation by individual investors in the capital markets. And I submit that investment advisers should otherwise be treated as other professionals are treated, with far more limited inspections (both as to frequency and intensity) – except for purposes of asset verification (i.e., detection of actual frauds), which is an essential government function. Perhaps peer review requirements would be a more practical, and effective, means of fostering the high standards of conduct of investment advisers – and could lead to a decrease in the number and extent of government examinations of investment advisory firms.

IN CONCLUSION

The fiduciary standard, at least as applied to the provision of personalized financial and investment advice, is but a small part of the solution to the problem of moral hazard (at least in the sense wherein the fiduciary seeks to induce an action that would be costly and unobservable by the client). The fiduciary standard also operates as a constraint on some conduct that would otherwise arise in an unconstrained market; such a restraint upon greed is imposed – not lightly – but for the greater good.

Yet, in imposing the fiduciary standard, I posit that we must resist actions by those in government, and by those who seek to influence government, to do more than simply enact the principles-based standard, whether by enacting exceptions to its application, or by promulgating a host of rules (that far too often can be evaded by simplistic means). And we must always reflect upon existing regulatory and enforcement structures, asking, “Is there a better, more cost-effective way?”

Let us also continue to support our professional organizations, as they continue to seek to “move the ball forward” in their advocacy for principles-based, prudent regulation. For the benefit not only of our emerging profession and its practitioners. And also for the benefit of our fellow citizens, and for a vibrant future U.S. economy as well.