Abstract
Excerpted From: Cary Martin Shelby, Racism as a Threat to Financial Stability, 118 Northwestern University Law Review 755 (2023) (263 Footnotes) (Full Document)
The term “systemic risk” automatically elicits images of corporate elites experiencing grave financial losses that rapidly spread to the masses like a virus. This term became popularized during the financial crisis of 2007-2009 (the Great Recession), when the failure of multiple financial institutions nearly toppled the global economy. Images of hundreds of employees departing the building that once housed Lehman Brothers while holding cardboard boxes containing their scant office belongings proliferated across the major news channels at the outset of the crisis. Reports subsequently emerged from numerous sources that corporate executives from New York City to London were shedding actual tears at the mere thought of such a prominent financial institution shuttering its doors. Their tears incited a level of collective fear amongst the broader populace, as this country had not experienced a failure of this magnitude since the Great Depression. Excessive leverage, or taking on debt levels that threaten macroeconomic stability, seemed to be the primary culprit of such a disastrous event. Once Lehman failed, several other financial institutions faced imminent collapse. This led to a credit freeze of epic proportions that paralyzed seemingly unrelated corners of the market. Companies from an array of industries struggled to meet ongoing business expenses given the difficulties in accessing short-term liquidity. Unemployment skyrocketed as millions of Americans were laid off. Stock markets experienced dire losses that affected the retirement plans of countless Americans.
Yet, as one digs deeper in exploring the origins of this crisis, a different picture emerges that is unmistakably connected with race and racism. Subprime mortgages with higher fees and interest rates were disproportionately sold to Black people and members of other underrepresented communities, which initially incentivized the speculative housing bubble that introduced excessive leverage into the financial system. Prior racist practices such as redlining, restrictive racial covenants, and other forms of housing discrimination made these communities an easy target for unscrupulous lenders looking to sell the American dream of home ownership on highly unfavorable terms. Even worse, mortgage lenders would frequently engage in predatory lending practices by selling subprime mortgages to Black people who were eligible for more favorable prime loan counterparts. Such homeowners faced higher default rates, and countless ended up foreclosing on their homes across the duration of the financial crisis. Even as the systemic risk associated with the crisis started to decline, Black communities suffered the most in terms of unemployment rates and poverty levels. Regulatory relief did little to rectify these disproportionate and long-term harms.
Climate change is yet another systemic disruption that initially seems unrelated to racism. One generally associates climate change with heartbreaking images of melting glaciers and shifting weather patterns that contribute to rising sea levels. The resulting damage that such disruptions cause to all forms of life is almost unfathomable. Entire species of animals have already purportedly been lost to the vortex of climate change. Certain regions of the world face increased levels of risk associated with global warming which could result in devastating losses to infrastructure, property, and human life. Any such losses will further lead to profound market disruptions given how they would affect industries on a global scale. Available evidence demonstrates that private enterprises have played a primary role in facilitating this magnitude of climate change given their massive contributions to the record levels of greenhouse gas emissions.
In addition to these global risks, many Americans have already lived in seemingly dystopian realities where they endure daily challenges in accessing clean drinking water and breathable air. Private enterprises have a sordid history of targeting vulnerable communities as dumping grounds for toxic waste of multiple forms. Studies have overwhelmingly shown that Black communities have been disproportionately exposed to climate change contributors, such as the pollution arising from fossil fuels, long before climate change was recognized as a systemic threat to the financial industry. As a result, Black people have disproportionately suffered from asthma, cancer, lead poisoning, and several additional health issues. This inequitable exposure has also contributed to the racial wealth gap since property values within such neighborhoods are likely to be lower due to these higher levels of toxins. Advocates within the robust environmental justice movement have gallantly fought for both the recognition and eradication of such disparate harms over the course of decades. While significant gains have flowed from this movement, lawmakers as well as private sector participants have failed to eliminate these harms.
This Article seeks to more clearly “connect the dots” between racism and financial stability by using the two categories of systemic disruptions briefly discussed above as analytical frameworks for predicting how racism might affect future systemic disruptions. In doing so, it draws from several theoretical lenses such as critical race theory (CRT), law and economics, and rule of law conceptions to argue that the Financial Stability Oversight Council (FSOC) should formally recognize racism as a threat to financial stability due to its interconnectedness with recent and projected systemic disruptions.
The primary means through which this Article makes these underlying claims is through a novel model created by the author. This “Systemic Disruption Model” provides a theoretical depiction of how racism drives every phase along the life-cycle continuum of a systemic disruption. This Model pinpoints four distinct phases of systemic disruptions: (1) the Introduction phase, (2) the Growth phase, (3) the Maturity phase, and (4) the Decline phase. This theoretical account of the relationship between racism and systemic risk appears in the Appendix. Scrutinizing the racism and systemic risk relationship in this manner reveals that racism is a virus that continues to threaten financial stability on a global scale in a vicious cycle that is seemingly repeated into perpetuity.
The continuum reflected in the Systemic Disruption Model begins with the Introduction phase, when negative externalities are first introduced into the financial system by the private sector. This Article explains how Black communities and other vulnerable areas serve as ideal dumping grounds for negative externalities produced by the private sector during this timeframe. This claim is supported by historical accounts of preexisting legal and economic vulnerabilities that invite exploitation of this magnitude and by data explaining the depth and scale of disparate impacts resulting from such underlying markets. It then dissects the limited legal protections in preventing such harms from occurring ex ante that may further incentivize the dumping of negative externalities of this nature. In thinking about climate change, for example, the private sector has a sordid history of dumping pollutants that contribute to climate change into communities where they perhaps face limited legal repercussions for doing so. Fossil fuel combustion remains a primary contributor to climate change as it accounts for the bulk of harmful emissions released into the atmosphere. Preexisting vulnerabilities invite environmental exploitation. Historically, racist practices such as redlining and restrictive racial covenants constrained Black people to segregated communities with lower quality schools, inferior infrastructure development, and limited public transportation options, all of which have led to progressively lower property values and dilapidated living conditions. These vulnerabilities increase the appeal of underrepresented communities as ideal sites for fossil fuel production facilities from an economic perspective.
Law and economics models have infiltrated the ways judges make decisions. Accordingly, if any inequitable harms are difficult to measure, particularly under the weight of the perceived economic benefits of allowing such harms to continue, then it can be challenging to justify legal interventions when utilizing these deeply entrenched lenses. Neoliberal ideologies, which emphasize the value of free trade in unencumbered markets, have further constrained the extent to which lawmakers have directed public resources towards eradicating preexisting vulnerabilities related to unaffordable housing, inadequate health care, inferior education, and derelict infrastructure.
The combined effect of these various strands of economic theory can lead to “zones of inaction” with respect to multiple layers of disparate harms experienced by vulnerable communities. Even when gains are acquired after long-fought battles, shifting political regimes can further complicate the extent to which these harms can be resolved on a long-term basis. Some have even attributed disparate harms to inherent or cultural deficiencies within underrepresented groups as opposed to systemic inequities.
Since the disparate harms created in the Introduction phase are frequently left unattended to or even further cemented by lawmakers, the systemic disruption then moves along its life-cycle continuum through its Growth phase. The “blind spots” resulting from racism cause market participants to magnify the economic benefits flowing from such negative externalities while underestimating their resulting costs. In supporting this fundamental claim, this portion of the Model documents the exponential growth of these markets despite the disparate harms revealed in the previous phase. It then exposes the ways in which this growth remains exclusive under the operation of the law. With respect to fossil fuels, ownership and control of these industries rely on shareholder primacy models as opposed to community-based paradigms, which would give more input to surrounding areas that have been historically denigrated under these preexisting frameworks. The disparate impacts suffered by vulnerable communities during the Introduction phase are therefore largely ignored and dismissed during this Growth phase.
The life cycle of a systemic disruption peaks at its Maturity phase, when the masses experience the negative externalities that were initially disproportionately borne by vulnerable communities. This component of the Model utilizes Professor Derrick Bell's interest-convergence theory as a prism for examining the ways in which this spillover effect is a necessary condition for meaningful regulatory intervention. As background, this framework for assessing Black liberation efforts effectively theorizes that “[t]he interest of blacks in achieving racial equality will be accommodated only when it converges with the interests of whites.” Professor Bell has further analyzed how interest-convergence drove movements undergirding the Emancipation Proclamation and the Civil War Amendments to the Constitution, as well as the seminal Brown v. Board of Education decision.
In thinking about climate change, the systemic disruption matures when the masses collectively experience the physical, psychological, emotional, and economic harms flowing from a climate-related disruption. It is precisely at this juncture where the markets, as well as lawmakers, officially recognize such harms as being systemic in nature. This Article recognizes the inherent injustices of this delayed recognition, which is the primary basis for the proposals discussed herein. Moreover, this convergence period is fleeting in nature, as this Model further analyzes the ways in which racism enables selective emergency relief in response to the short-term harms of any such systemic disruptions. Lawmakers institute such relief through institutional bailouts, enhanced regulatory protections, and several other forms of interventions. With respect to climate change, lawmakers have historically provided relief that is tilted in favor of elite groups in responding to climate-related calamities.
The continuum reflected in the Systemic Disruption Model officially ends with its Decline phase when the prior emergency interventions begin to root out the systemic risk from the financial system. This Model asserts that racism elongates this phase, since it distorts the long-term costs borne by vulnerable communities in bearing the brunt of systemic harms. Scholars within the realm of energy justice, for example, have extensively studied the ways in which initiatives to reverse climate change create additional harms by continuing to select vulnerable communities for siting locations for new technologies and by excluding such groups as economic beneficiaries, among other categories of harms. As a result, the failure to implement tailored interventions increases the vulnerabilities of underrepresented communities. This enhances their allure as fertile dumping grounds for negative externalities, thereby increasing the likelihood of future systemic disruptions. This insidious cycle can theoretically continue into perpetuity without significantly reconfiguring how we collectively process the relationship between racism and systemic risk.
This Article builds upon a rich body of scholarship that has increasingly sought to hold the private sector accountable for the harms generated by its systemically racist activities. In particular, this Article extends existing scholarship by arguing that such racism remains a perpetual threat to financial stability. It therefore urges FSOC to make an official recognition in this regard. As background, FSOC was created under the Dodd-Frank Act of 2010 as a “super regulator” comprised of the heads of major financial regulators that is charged with overseeing emerging threats in the financial system. More specifically, it is “charged ... with identifying risks to the financial stability of the United States; promoting market discipline; and responding to emerging threats to the stability of the U.S. financial system.” FSOC fulfills its statutory mandate by identifying threats to financial stability. For instance, it recently released a lengthy Report on Climate Change which detailed the various ways in which climate change could trigger financial crises of epic proportions. Specific recommendations for its member agencies include building expertise, gathering data, and enhancing transparency related to climate change to assist investors and other market participants in protecting themselves against such risks.
This Article uses the Report on Climate Change as a blueprint for identifying the ways in which FSOC can potentially disrupt the vicious cycles of systemic disruptions that are incentivized by racism. Several benefits could flow from a comparable designation of racism as a threat to financial stability. First, it would concede limitations of preexisting protections that arise under federal and state law, as well as privately ordered responses, which could incentivize more inclusive rulemaking processes going forward. Second, a comparable FSOC designation of racism as a threat to financial stability could provide a rubric for formalizing data collection mechanisms and coordination among regulators, while building expertise across every corner of the financial markets. Such a framework inherently recognizes that additional data collection and expertise is essential in ensuring that any proposed rules are closely tailored to the harms discussed herein. Finally, a comparable FSOC designation could provide investors, asset managers, stakeholders, and nongovernmental organizations (NGOs) with essential tools in advocating for meaningful reforms, while stimulating integral rulemaking from applicable administrative agencies. For example, an FSOC recognition of this scale could be a vital step in prompting the SEC to promulgate rules within the context of its ongoing commitment to streamline the environmental, social, and governance (ESG) metrics utilized by its registrants.
In summary, Part I begins by providing foundational definitions of racism and systemic risk and introducing the Systemic Disruption Model. Part II then applies the various components of this Model to the Great Recession, which is a paradigmatic case study in highlighting how racism threatens financial stability. Part III applies this same analytical framework to the systemic disruption by climate change, which is the second integral case study selected by this Article given its timeliness and scale. Part IV examines how FSOC recognizing racism as a threat to financial stability can begin the process of disrupting this vicious cycle. Such a designation would concede the limitations of existing protections at the federal and state level, as well as privately developed solutions. Officially recognizing racism as a threat to financial stability could likewise facilitate the necessary process of data collection and coordination across the vast spectrum of regulatory agencies. This Article concludes with a brief synopsis of additional categories of systemic disruptions that seem to be following comparable patterns, as a final call to action for the regulatory interventions discussed herein.
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Additional categories of systemic disruptions are potentially interconnected with racism in ways that warrant further attention. Pandemics, for example, are yet an additional category of systemic disruptions that have crippled global economies in recent years. COVID-19 wreaked havoc on the global financial system by decimating small business owners, drying up supply chains, and propelling inflation, among other harms. While the virus itself did not originate within the financial system, racist practices and policies certainly exacerbated and perhaps prolonged the disruption.
With respect to the Coronavirus Aid, Relief, and Economic Security Act, also known as the CARES Act, an embarrassingly low percentage of Black business owners were able to secure necessary relief. The CARES Act included the Paycheck Protection Program, which was a loan for small businesses to assist with paying their employees. However, “[j]ust 12% of black and Latino business owners who applied for PPP (Paycheck Protection Program) loans reported receiving what they asked for, according to a survey by Global Strategy Group, and nearly half of these individuals say they anticipate being forced to close permanently in the near future.” In contrast, just over 38% of all U.S. small businesses were able to secure PPP loans around this same time frame. Preexisting vulnerabilities arising from systemic and structural racism likely led to these harms as Black business owners faced disparities in terms of accessing the necessary credit relationships with financial intermediaries in order to secure such PPP relief.
Many also faced prior discrimination in securing favorable financing arrangements, making them far more susceptible to closure during the pandemic. In April 2020, “[t]he number of African-American business owners fell from 1.1 million in February to 640,000 ..., a 41% decline. By comparison, the overall number of small business owners dropped by 35%.” As new pandemics continue to unfold, it is essential for regulators to begin the arduous process of collecting data on how to best reduce the depth and duration of its resulting economic shocks that are often exacerbated by racism.
Scholars have also assessed how the lack of diversity in all aspects of the financial sector is a potential source of systemic risk, as homogeneous groups face inherent challenges in managing multiple layers of risk. Such groups face comparable challenges in optimizing complex decision-making processes due to the tendency of like-minded people to maintain the status quo in governing enterprises. In summary, “groupthink, herd behavior, and affinity bias challenge group decision-making [and] [s]imilarly, humans naturally fall prey to confirmation bias, overconfidence, and structural bias.”
Laws at the state and federal level have sought to increase diversity through mandates or nudges, but the lack of representation within every aspect of the financial sector remains deeply troubling. Increasing diversity, particularly within the upper echelons of corporate management, could perhaps prevent the scale and depth of systemic disruptions. Claims of this nature warrant additional analysis and study as the financial markets grow increasingly complex and interconnected on a global scale.
Assessing the ways in which private sector actors have broadly contributed to direct and systemic racism with respect to its employees, managers, suppliers, and consumers has led to macroeconomic costs that are difficult to fully quantify. In 2020, Citigroup published a study which estimated the full impact of these costs since 2000. It concluded that “[i]f racial gaps for Blacks had been closed 20 years ago, U.S. GDP could have estimated $16 trillion.” In particular, closing the racial wage gap would have potentially “provided an additional $2.7 trillion in income available for consumption and investment ... [and] improving access to housing credit might have added an additional 770,000 Black homeowners over the last 20 years.” Other categories of harms are exceedingly difficult to quantify such as the loss of life, health, and liberty that can result from racist laws and practices. This Article demonstrates that such macroeconomic costs have become a source of systemic risk in the financial sector in ways that have been unrecognized by financial regulators.
By and large, an FSOC recognition of racism as a threat to financial stability could enable data collection and expertise building within every corner of the financial sector. It could further assist in mitigating the harms emanating from these additional systemic disruptions described above. Increasing data collection and transparency throughout the regulatory sector on issues related to race and racism could undoubtedly assist in preventing the occurrence of future systemic disruptions that remain unforeseen. Without such efforts, the cycle documented in the attached Systemic Disruption Model will continue to propel into unmitigable heights. Haphazard efforts to repair the harms resulting from future systemic disruptions, without addressing the underlying contributor of racism, will extend this “cycle of cycles” into a never-ending dystopia of calamities. After all, continuing to deny the interconnectedness of any such harms against humanity is the ultimate form of self-destruction. Reversing this vicious path charted by racism is imperative for the vitality of future generations.
Cary Martin Shelby, Professor of Law, Ralph Brill Endowed Chair, Chicago-Kent College of Law.