Brian Knight is the Director of Innovation and Governance at the Mercatus Center at George Mason University. Brian’s research focuses on numerous aspects of financial regulation, including the creation of pro-innovation regulatory environments, the role of federalism in fintech regulation, the use of digital assets for financial transactions, the role of regulation for credit markets and consumer protection, and the provision of capital to businesses. Brian joins David on Macro Musings to discuss the politicization of finance and its implications for policy. Specifically, Brian and David discuss the concept of reputational risk and its relevance for financial regulation, the extent and limits of ESG concerns in financial regulation, whether financial regulators are too political or not political enough, the present state as well as the future of ‘woke capitalism’, and much more.
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Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].
David Beckworth: Brian, welcome to the show.
Brian Knight: Thank you so much for having me.
Beckworth: It's great to have you on. We're going to get into a very interesting conversation today about the politicization of finance. You've written widely on that and you have some important things to say. But before we do that though, Brian, tell us a little bit about yourself, your program, what you do at Mercatus.
Knight: Sure. So, I am the Director of Innovation and Governance, which means I have the honor of overseeing several of our projects. But as a scholar, I was recruited to do financial regulation and I'm the lead scholar on our financial regulatory project. And hearing that bio, which clearly needs to be updated, it's clearly from a much more innocent time, right? Where it's all innovation and getting people money. And that stuff's all still really important. But for the past few years, I've been finding myself doing more and more on politicization of financial services and financial service regulation. And I guess I just can't quite bring myself to update the bio to acknowledge that's where we're at.
Beckworth: Well, we're going to do that today. We're going to update the conversation with you. We're going to bring it to the front here, talk about this hot topic. And really, it's a pressing issue and it has a bearing. And I want to begin on that by just recalling things that I have noticed, Brian, at least to me. Again, this is your wheelhouse. But to me, things that have been really striking over the past few years that I've observed. For example, the FDIC had that shake up of the board, very politicized. The SCC just recently issued its proposals for climate change, which has also been very controversial.
Beckworth: There's been a number of ESG proposals. The Fed has gotten more into progressive issues and that's led to some of the nominees that President Biden has brought before the Senate to have had challenges. Sarah Bloom Raskin, case in point. The OCC under President Trump tried to push through new bank regulations to offset what they perceived as politicization of the banking laws. So there's a lot going on and that's just kind of the tip of the iceberg there. But is my impression correct, that it seems like there's more and more politicization of the financial regulatory space?
Knight: I believe so. Obviously, financial regulation is at some level always political, right? It's derived from law, it's derived from regulation. There's a political component to everything. I think what we have seen in the relatively recent past, however, is this effort to use financial regulation among other types of regulation as a way to achieve something that people who want to see achieved haven't been able to do through the legislative process or through the traditional political process. So it's not an anti-money laundering law where it's like, we're going to use banks as a tool of law enforcement. But undergirding this are all these criminal laws that we did pass and survive constitutional challenge. It's well, we can't pass this law. We can't get it through the Senate or whatever. But we can use financial regulation as a tool to achieve a similar end.
What we have seen in the relatively recent past, however, is this effort to use financial regulation among other types of regulation as a way to achieve something that people who want to see achieved haven't been able to do through the legislative process or through the traditional political process.
Beckworth: So, the big concern then is we're bypassing the democratic process. There's less legitimacy to this and it could lead to further political problems down the road if people perceive that a bunch of technocrats are making decisions that aren't elected and have the proper delegated authority.
Knight: So that's one big problem that we can definitely talk more about. But there are other potential risks to this, right? Because for example, if your financial regulators suddenly become your climate regulators or your whatever regulators, one, they're not particularly well equipped to be that other type of regulator. So you might get bad climate regulation or whatever other sort of regulation. Two, every bit of resources that's devoted to the climate regulation, I'm using climate because it's a salient example, it's not the only one to be very clear, you risk not doing the core job of that regulator, right? You end up with sort of poor and democratically illegitimate regulation on one front and poor regulation on the other front that the regulator was actually stood up to address.
Beckworth: Okay. So there's multiple problems that emerged from this increasing tendency to politicize financial regulation. And again, as you said, there's always been some politics involved. It just seems like it's growing at a faster rate. And to be fair, Brian, I mean our society as a whole seems to be more politicized, right? Everything's becoming more political. It's kind of hard to get away. So maybe we should be surprised that it's taken this long for financial regulatory space to become politicized.
Knight: Yeah. And I mean, I should note that I'm sure you can absolutely look back in time and find examples. And I alluded to sort of the anti-money laundering, Bank Secrecy Act example, because that was the case of the politicians saying, hey, you know what? Banks are this really useful tool that we can use to further other political goals. But that was pursuant to a law that was passed and I'm not trying to defend the anti-money laundering Bank Secrecy Act, those bylaws, because they have problems. But you can at least say that undergirding it is a series of fairly specific laws. What I do think we're seeing now is, because we were going through this phase of high polarization, high gridlock that there's this effort to say, well, okay. Look. The argument you would hear from a proponent would be something like, Congress won't do its job. But the SCC can or the FDIC can or the Fed can or the banks themselves can or whatever.
Knight: But the part of that argument I quip with is, Congress's job isn't to give any given person what they want. Congress's job is to represent the interests and perspectives of the people who vote for them across the country, pass legislation consistent with the constitution and the legislative process as dictated by the constitution, et cetera. And so, I guess what we are seeing is an effort to utilize existing laws. Because all of these agencies have enabling statutes that give them some amount of power in sort of creative ways to use those as tools of leverage to get to something else.
Beckworth: Okay. Well, let's jump right into your work. And you have an article that was published in The Hill and is titled, “How financial regulatory tools are used against law-abiding Americans – and how to fix it.” I want to read the first paragraph that you introduce this discussion. And it's interesting because you invoke a recent situation in Canada that we're all familiar with. So here it goes. “Canadian officials have told banks to unfreeze the accounts of people involved in the recent COVID-19 protest. Cutting off access to financial infrastructure may be justified in certain serious situations, but not in the case of citizens where standard law enforcement tools will suffice.
Beckworth: Canada's excessive use of power accomplished its immediate goal and is a wake-up call about how powerful and how prone to abuse the tools of financial regulation can be. And even though we in the United States have greater constitutional protections, financial regulation is regularly turned against Americans. The bell cannot be unrung. It must be broken. To do so, we must take affirmative steps to prevent financial abuse in the future.” Great opening there, Brian, I must say. Very dramatic. So talk us through this piece and you bring up quite a bit this idea of reputational risk. What is reputational risk and how is it a key part of this conversation?
Reputational Risk in Financial Regulation
Knight: Sure. So reputational risk is this concept that kind of originated in the '70s, early '80s where the bank regulators who are responsible for policing the safety and soundness of the banking system and who have adopted a mindset that generally speaking a bank failure is bad. And certainly a big bank failure is really bad. And so their sort of regulatory perspective shifted to, we need to be risk based in our regulation and in our supervision of banks. So we need to make certain that the banks we supervise are mindful of potential risks to their safety and soundness and that they're properly addressing them. And one of the risks that they came up with is reputational risk. The idea that you, the bank will do something that will make people not want to do business with you.
Knight: It's not the same thing as, for example, legal or compliance risk. Because of course, if you break the law, yes, people may not want to do business with you because you broke the law. But also, the law is going to be after you because you broke the law. So, to the extent that reputational risk has an independent salience, it's that you've done something legal but people might not like it. And then, well who are the people and what might it be? And it's expanded into this concept of basically if your potential customers don't like it, if your counterparties don't like it, if your employees don't like it, if the regulators themselves don't like it, well that could be a reputational risk issue. And it is expanded from you, the bank have done something to, well, are you doing business with somebody who other people might not like you doing business with?
Reputational risk is this concept that...the bank will do something that will make people not want to do business with you. It's not the same thing as, for example, legal or compliance risk. Because of course, if you break the law, yes, people may not want to do business with you because you broke the law. But also, the law is going to be after you because you broke the law. So, to the extent that reputational risk has an independent salience, it's that you've done something legal but people might not like it.
Knight: And we saw this used as a justification a few times with the FDIC going after banks that were partnering with legal though controversial businesses. And the big two would be payday lenders and tax refund anticipation loan companies, both of which are legal but which are controversial and are particularly controversial or were shown to be particularly controversial among some folks at the FDIC. And so they looked at this and like, well, we can't regulate the payday lenders directly, right? But they have to work with banks. We regulate banks and we can use reputational risk and moral suasion as a tool to encourage, wink, wink, banks to not do business with these industries. And the FDIC also published an article in their Supervision Insights magazine, listing a bunch of other industries that people should be watchful of because they were high risk.
Knight: And some of the things were legit, like Ponzi schemes, which okay. But some of them were things like firearms and ammunition manufacturers, fireworks. Some were bad but legal like racist t-shirts or I think that was one of them. And because a lot of the banks curtailed their doing business with customers on this list because the concern was if we don't curtail doing business, the regulators in their supervision of us will make our lives harder, they will potentially bring enforcement actions. But even if they don't bring some sort of enforcement action, they can make our lives pretty hard through the supervisory process. They can make it painful and expensive. And to be honest, most bank accounts just aren't worth the pain. Right? So it's easier, it's profit maximizing potentially to just cut ties with the offending, albeit legal customer then to risk drawing the ire of the regulator.
Knight: And the way that was justified by the FDIC is, well, we do have the authority to police safety and soundness. And we do have this broad grant of authority from Congress. And so we think this will pose a risk to reputation. And there's no real obligation on the FDIC's part to articulate or to prove this up. There's no empirical requirement. It's kind of in the eye of the beholder. And so that was the justification that was leveraged. And so got to expand on that, right? So you have a situation where you can be a law-abiding business and the regulator, if they disapprove of you can through a host of relatively opaque, relatively informal means change the incentive structure of your bank so that it's no longer worth them banking you. And that can have a significant cost. And so that's what I was referencing there in that piece.
Beckworth: So the concern here is that even though there might be some businesses that everyone agrees that is not ideal, maybe immoral, whatever it may be, the danger is though that the FDIC kind of determines what's appropriate and what's not and that can be driven by the winds of political change. I mean, so right now it might be firearms, might be climate related, it might be a number of different areas, but it could change depending on who's in power what happens. Is that one of the concerns?
Knight: Well, so I would say in a scenario where everyone agrees that something's not ideal, it's questionable whether or not that customer is actually economically viable, right?
Knight: If you're selling something that nobody wants to buy, banks probably shouldn't lend to you because you're a bad credit risk. Rather, what we're talking about are businesses that are economically viable and sufficiently popular among some body but are unpopular with the regulators or are unpopular with someone who has leverage over the regulators, members of Congress who cannot get legislation passed but who could make the leadership of the agency's life difficult. And because there's no requirement on the part of the regulator to sort of prove up that hey, you doing business with this firm is creating a risk to safety. It's very much sort of impressionistic. The risk is that it allows for personal preferences on the part of someone at the agency or someone who has leverage over the agency to then take on regulatory weight.
Beckworth: So one specific application or question maybe related to this. So a lot of these marijuana businesses, they've had a hard time getting access to bank accounts. Is it because of this or some other regulation?
Knight: Well, so I don't know for certain. But I should note that marijuana is still illegal at the federal level.
Beckworth: Okay, so that's the reason.
Knight: Yeah. Or at least that's part of the reason. And that puts sort of the marijuana in a somewhat different category than some of this other stuff is there is a legality – I don't know if I would say it's necessarily a question because it is explicitly illegal. Right? Well, okay. Let me walk that back. Some types of business are explicitly illegal, some are not. But there is that enhanced legal risk that doesn't necessarily exist for some of these other things.
Beckworth: Okay. So I looked up online a list of business areas that would fall under this and a term that you use in the paper and your article is, Operation Choke Point. So maybe you should define Operation Choke Point and I'm going to run through a list of examples that the FDIC had listed on its webpage.
Knight: Yeah. So, Operation Choke Point started, as I would say, as a DOJ effort to actually cut down on frauds by saying, "Well, we'll get the banks to police fraudulent businesses. And if a business is fraudulent, there is a at minimum civil legal issue and very possibly a criminal legal issue." But it appears to have expanded through, particularly at the FDIC of saying, "Well, while we're at it, why don't we use this as an opportunity to cut off access to the banking system for payday lenders in particular..." Those were the ones that seemed to be particularly singled out by the FDIC. But then, and I think you're referencing that, the FDIC supervision article, there was this list of other industries that they put out and it does appear that banks looked at, some banks at least, looked at that and said, "Well, it isn't worth the risk of getting crosswise with my regulator to have these businesses as clients."
Because there's no requirement on the part of the regulator to sort of prove up that hey, you doing business with this firm is creating a risk to safety. It's very much sort of impressionistic. The risk is that it allows for personal preferences on the part of someone at the agency or someone who has leverage over the agency to then take on regulatory weight.
Beckworth: Yeah. And this is the list that they put online 2014, it may be down, it may be updated and changed, but this is the one I could find. So this is just a sample of some of the industries and firms they have on here. So they have ammunition sales, ATM operators, coin dealers, credit card schemes, credit repair services, dating services, debt consolidations scams, drug paraphernalia, escort services, firearm sales, get rich products, home-based charities, lifetime memberships, lottery sales, online gambling, pawn shops, payday loans, pharmaceutical sales, pornography, surveillance equipment, tobacco sales, travel clubs and there's a few others. But it's an interesting list, it's not small, that could touch a number of firms. And was there any pushback to the FDIC and the DOJ doing this Operation Choke Point? Because I'd imagine, someone in Congress had to have had someone in their district affected by this and called them up and asked for help.
Knight: There eventually was. As people ended up getting de-banked, and as sort of people started understanding that there might have been something more broad based than just an idiosyncratic case. You did see appeals to Congress. There was congressional oversight on the part of the Republicans, they had hearings and came with a report. There was also at least one lawsuit filed and that ended up being settled by the FDIC.
Knight: Now the settlement was basically, "We understand that this may have been misinterpreted. We understand that maybe some employees got a little over aggressive.” I believe that list was taken down, actually pre-settlement I believe. And so, "We just want to be clear that we don't want, no one here wants a categorical restriction of bank services for any given industry," was the FDIC's position and they their training a little bit and all of that. But there was no change to the law. There was no, the court didn't rule like, "No, I'm sorry FDIC, you've exceeded your authority." It was rather, "Okay. The execution on that was wanting and we're sorry."
Beckworth: So again for me, the big danger I see from this reputational risk factor that one might use in banking, is just that the winds of political change can come and go and you may not be in the right group at a certain time, so it's very unpredictable. It's just, it doesn't seem right and doesn't seem accountable or have political legitimacy. But you bring up two other reasons to be careful when thinking about this. You mentioned that they're very difficult to detect, number one. And two, the powerful can use it to prey on the weak. So maybe speak to those.
Knight: Sure. So in terms of being difficult to detect, a lot of bank supervision is basically sort of relational. There's the phrase, "Regulation by raised eyebrow." Where, instead of say an enforcement action where the bank regulator has to go and do some sort of process and bring you before some sort of arbitrator, be it an internal arbitrator or a court and say, "You violated the law by doing X, Y, and Z." And the bank gets to challenge it if they're so inclined. Here, the risk is that a lot of it and anecdotally, it's been said that a lot of this has been done basically sort of, through raised eyebrow like, "Hmm, Are you banking them? Oh. Well, you should really be worried about the reputational risk of that." And the understood meaning is, you should be worried about us jamming you up over the reputational risk of that.
Knight: And until and unless somebody actually challenges it, or until and unless someone, the regulators actually penalizes you, so you have something you can go to court on, it's all kind of sub rosa. It's all winks and nods and understandings. "Nice bank you have here, would be a shame if something happened to it." And because of the way the regulation is done or the supervision is done, relatively, sort of mid to low level employees have influence. So it isn't necessarily something that there's going to be a huge paper trail on. Though in the course of this litigation there were some embarrassing emails out the FDIC from relatively senior people.
Knight: The other part, that sort of powerful preying on the weak, is I think an important one that we need to sort of face up to. Which is that the logic of reputational risk, even taken neutrally and honestly, is if doing business with person A, or company A, or industry A, will end up costing you more money – because business A, company A, whoever industry or business B, company B, whomever B, won't do business with you now – then that's an issue that you need to be worried about and that's an issue that the regulator could potentially be worried about.
Knight: So even a purely neutral regulator who's just trying to call the balls and strikes might sit there and be like, "Oh yeah, you're doing business with this company, but this bigger company doesn't like them." And you should be worried about that. And then you factor in the or, "Oh. Well, you're highly productive employees don't like it that you do this and they might leave." And then that will compromise your ability. And then you factor in the fact that the regulators themselves are also part of the constituency whose reputation you need to worry about, explicitly in the guidance.
Knight: So now it's like, "Well, the regulators don't like it." Well, okay. They're regulators, they're not at Congress. They don't get to make things legal or illegal. And the problem with that logic I would argue is, it can go to a place where basically, your access to this bank, to the banking system is determined by whether or not you are sufficiently profitable to withstand threat from some other profitable entity. And that could be subject to exploitation or abuse. And sort of to an analogy or an example where, and this predates reputational risk as a concept, but if we were to apply logic, you could see where it'd work. It's like in the 1970s, the Arab League started pushing for a boycott of Israeli businesses and certain businesses that would do business with Israel. And there was dispute on this, but there was an understanding, it also applied to say Jewishly owned businesses.
Knight: And their argument was, to banks, it was like, "Look, we got a lot of money. We have all these petro dollars. If you want our business, you can't do business with those folks over there." In a scenario where that would've been the profit maximizing move to jettison your existing customers to go for them, or alternatively like, "Oh, you might lose this business if you don't do it." The logic of reputational risk kind of points you in that direction of saying, "Yeah, okay, that's the thing you should do,” because you're doing business with this Israeli firm, it's harming your reputation with this Arab League firm, the Arab League firm is more profitable. So, if you are doing this, you risk maybe making your financial situation less strong than it could be.
Knight: Now, our response in the United States to that was basically, "Absolutely not, banks. You're not doing this." We amended the Equal Credit Opportunity Act in part to address this, and part of why we added religion and national origin was for this. Our bank regulators went out to banks and said, "Don't even think about doing this." And there's little evidence that anyone did or anyone really even thought about it. So, I said that that's where this logic can take you, and it can take you somewhere, I think that's just basically is like, "Well, whoever's richer gets to dictate." And there are words for a governmental system like that, but they're not republic and they're not democracy and I don't want to live there, so anyway. And I should say, reputational risk did not start out this broadly, it has grown over time. It used to be pretty narrowly cabined to, "What are you, the bank doing? Are you creating a bunch of fake accounts? Well, that might make people not trust you." Fair, but it is since expanded out.
Beckworth: So in this expanded understanding of reputational risk, is it currently a big issue you think? And we've outlined all the problems it could pose. We talked about past incidences, Operation Choke Point. Is it currently a big deal?
Knight: Hard to tell. Because I mean, now you've seen that concept invoked recently up in New York State, where they invoked the concept of reputational risk to discourage banks and insurance companies from doing business with the National Rifle Association and similar organizations. Framing things in a very sort of explicit political like, "You need to worry about the reputational risk of doing business with gun rights groups, because people want gun control and you need to be worried about that." And they'll never say like, "You cannot..." Right? It's all, "Well, you need to think about this." But of course, you could phrase something like, "Well, you just need to think generally about who you're doing business with." But when you call out a particular industry, or a particular group, or particular whatever, people are going to take note.
Beckworth: So what should we do about reputational risk? What preventative measures can we take so that it doesn't get abused?
Knight: So, Professor Julie Hill at the University of Alabama School of Law has a really good RV paper on this. And I tend to agree with her that, basically, reputational risk doesn't really do any independent work that's worth having the risk. Because as I mentioned earlier, if you're violating the law, that's a legal risk issue. If you're not complying with other regulations, that's a compliance risk issue. If you're making loans you shouldn't be making, that's a credit risk issue. So for all, there's any number of other tools available. The stuff that is just reputational risk, it's hard to see how that's worth the squeeze. And at a minimum, I do think that we should prohibit, sort of that third party customer reputation risk analysis, because it is hard to see what real value there is compared to the very real risk of abuse.
Beckworth: Okay. Well, let's move on to another article of yours that also touches on the politicization of finance. And this is an article titled, “Climate change is a risk for banks but it's not the only one.” And this is an article that makes an argument I'm very sympathetic to. As listeners to the show will know, I've had reservations about the Fed delving into climate change alone when there's other risk that's posed to the financial system and maybe taking a broader approach. But with that said, it is a real issue. I think there's a place for Congress to deal with it. But what arguments are you making in this piece? And I know it refers to ESG more generally. So maybe define ESG for our listeners and then the argument you're making surrounding it and climate change.
The Role of ESG in Financial Regulation
Knight: Sure. So ESG stands for Environmental, Social and Governance and it's a concept that has sort of come out of securities and it's come out, it's also coming out of financial regulation generally. Which is, in the securities context, it's sort of making investment decisions, at least in part on the basis of how a firm performs on matters of environmental, social and governance questions. And if that sounds incredibly broad and vague, it's because it is. And there's a lot of stuff in there. And so, it can range from stuff that makes complete sense like, "Do you have an independent board? Do you have multiple classes of shares? Do you have good internal controls?" All that stuff is corporate governance and makes a lot of sense that you should, that investors should be concerned about it. But then it can expand into things like, "Well, what is your carbon footprint? Do you have a plan to be carbon neutral by 2050? What are you doing to reduce greenhouse gas emissions among your suppliers?"
Knight: And the argument is that, this is an example of trying to use financial services and financial service regulation to get at some other question, which would be in environmental regulation, where we do have environmental law, we do have environmental regulation, we do have an environmental regulator in the EPA. But currently the SEC is moving into that space. And the justification you will often hear for ESG and I reiterate that ESG is very broad, so it's not that this justification is always wrong or always right, is, "No look, companies that do well at ESG will actually perform better in the long run, because they are going to be better suited to handle a future where these things are important." And the challenge there and I think in that piece you just referenced about bank regulation, where you're starting to see calls for bank regulators to sort of adopt this mindset that like, "Hey, we need to be getting banks, encouraging banks, pushing banks, forcing banks, whatever, to start decarbonizing their businesses in terms of their portfolios, the companies they lend to, how they operate." Because there's going to come a future where the firms that are less attached to carbon, less invested in carbon intensive industries, greener, for lack of a better word, will just be better equipped to handle the world.
Knight: And you hear that about things like, a big phrase is, stranded assets. This idea that, oh, if you make an investment in something and then either the climate itself changes to impair the value of that asset, like a beachfront property or something, or the regulatory environment changes to impair the value of that asset, we outlaw coal production. Then you're going to be stuck with a stranded asset and you're going to have to sell it at a massive loss and it's going to hurt your safety and stability. The challenge to that though, is that, to a good extent, banks are already having to think about these issues. And there's research out of the Federal Reserve Bank of New York I believe that points to the idea that banks are already thinking about things like the impact of climate change on coastlines and are changing their portfolio of property lending accordingly either by stepping back or by charging higher interest rates to compensate for greater risk or whatever. And that's the type of thing banks have to do all the time. And there's no evidence to suggest that they aren't doing it.
Knight: So then you get into the regulatorily stranded asset camp, the idea of, well, okay, fine. But if you lend to a coal company, we all know that coal's going to be illegal in 20 years. And then what are you going to do? But that's assuming a future that, one, would be Congress' prerogative to set, not the regulators. And two, there's no reason to believe it's necessarily an accurate future. We don't know if we're going to not be using coal in 20 years. We don't know if even if we do move towards mandatorily reducing something like coal, is it going to be a sudden shift or is it going to be grandfathered in over a long period of time?
Knight: And then the other point in that article about that is that sort of regulatory stranding question applies to anything that can be regulated. It's not just climate. If you think that there's a lot of momentum for climate regulation and you may well be right. But there's no reason to single that out versus any number of other things that where there suddenly may be an increase in regulation. And so should we be mandating that banks worry about all of those things above and beyond what they're already doing? And so the critique is that this is actually a way for the regulators to put their thumb on the scale and say, we are going to raise the real or perceived regulatory cost of doing business with certain firms, because we think these things are bad or we think that they're dangerous or we think there should be enhanced regulation here and we are projecting that will occur. But the question is should that be the bank regulator's prerogative? Are they the sort of the constitutionally appropriate vehicle for that?
The critique is that this is actually a way for the regulators to put their thumb on the scale and say, we are going to raise the real or perceived regulatory cost of doing business with certain firms, because we think these things are bad or we think that they're dangerous or we think there should be enhanced regulation here and we are projecting that will occur. But the question is should that be the bank regulator's prerogative? Are they the sort of the constitutionally appropriate vehicle for that?
Knight: Is there any reason to believe that they're going to be better at predicting the future than anyone else? And what is the risk of them overfocusing on this versus something else? Because one of the risks that you may run into is that they, in shifting allocations, you inflate a bubble somewhere else. This is a good point that John Cochran makes a lot, that you risk driving more money to something else that probably that then is justified by the fundamentals. And then you end up having a bubble that pops. And if they're busy doing this, what are they not doing that we actually need them to be doing? What element of their core mission are they not performing? Because if you live in a world of limited regulatory resources, if you devote resources to something new, presumably that cut's coming from somewhere.
Beckworth: Yeah. I completely agree with you on that. And that's why, as I've mentioned on the show before, I find it entirely unconvincing that the Fed should be doing stress tests for banking based on climate change. Again, climate change is a real issue, but there's a host of other things out there. And this past few years should have taught us that if nothing else. There's prospects of war. We could be facing a war with China. I mean, should we stress test for that? Should we stress test for another pandemic, for asteroids? I mean, if you want something more gradual and slow turning, how about stress testing for the decline in population growth rates or in the decline in productivity growth? There's a host of things out there. And I like your point. If you focus on just one of them, we may lose sight of these other challenges that could pose risk. Because as you said, there's a limited number of resources that these regulatory bodies have to spend on these efforts.
Beckworth: I have stressed that I think it makes more sense to take a general approach where we just talk about funding banks with more capital, a bigger equity cushion. And so if any of one of these threats emerge, they're better suited to deal with them. And as you said, banks aren't idiots. They're already dealing with these risks as they see them unfold in front of them. I just think it's misguided to focus on one risk with such amount of energy and effort that it is going to take away from maybe a healthier, broader look on financial stability.
Knight: So unsurprisingly, I agree. We'll have to get into some disagreement here, give your readers or your listeners some excitement at some point. And our colleagues, Steph and Tom, have said similar things. I understand wanting to make banks more resilient. I completely understand that. I think that's good. I think the problem is we don't know where the risk is going to come from. And if you have banks do something that's sort of risk agnostic to boost resiliency, like sitting on more equity capital, then if the risk comes from a climate issue, a war issue, Yellowstone Caldera blowing up, Martians invading, whatever. Then they have more equity to protect themselves. And if it's sufficiently bad, none of this matters anyway. But yeah, if you fixate on, okay, the risk we need to worry about is this and you're wrong, then you end up with creating some other problem down the line. And even if, whereas if you are risk agnostic, whatever the risk might be, it might be climate. Let's say it is climate. But if you've insulated the banking system from this risk, then that works.
Knight: And that gets to the other point of this, which is there's are you trying to protect the banking system from climate issues? Are you trying to protect the climate from the banking system? And that's the question is it's one thing to say, you should not invest in coal companies because pretty soon coal companies are going to be passe and we don't want you to be exposed. On the other hand, you could just as easily be like, we want coal companies to be passe. And one way to do that is to cut off their funding. And the problem you run into there, besides the fact that's inappropriate for a bank regulator to do. No one authorized them to do that. And that was one of the things that Sarah Bloom Raskin argued for in some of her very high profile writings that got her into trouble during her confirmation process is basically, no, we need to be using bank regulation to help the climate, not insulate the banking system from potential climate change.
Knight: But then you run into the problem that you can argue that the Europeans ran into where they're like, okay, look, we're moving to green energy. We don't want natural gas. We don't want coal. We don't want nuclear in some cases. And so, but in the bridge period before we get to that green utopia, we're just going to buy natural gas from the Russians. Well, so the natural gas still got drilled and still got burned. But then it was the Russians doing it. And we're seeing the fruits of that now. And so that's another concern there is if the regulator sort of uses the power granted to them in one context to forward an earnestly held belief that in another context you risk a lot of unintended consequences that would be detrimental.
Beckworth: So we've been talking about banks, but our colleague, Andy Vollmer, has written on ESG and SEC in particular, in his new climate proposal. And I've had Amanda Rose, law professor at Vanderbilt on. She's written a law article. She's also written for you, Brian, a piece I believe. And they also make similar concerns about the SEC veering into ESG and really going outside its wheelhouse. It doesn't have the expertise in-house. It's going to divert a lot of resources from other areas. So monitoring in more traditional areas maybe diverted into the ESG category. And Andy, in particular, makes the case that they may get shot down by the courts. I mean, we've seen a lot of decisions made by the Biden administration being overturned by the Supreme Court. And he says, look, it's going to really cause some problems if the SEC finds the Supreme court shutting its decisions down. Any thoughts on that angle as it relates to this issue?
Knight: Yeah. So the SEC's environmental disclosure is another sort of good example of this, where the argument that the SEC puts forward is getting companies to disclose sort of their impact on the environment, their greenhouse gas emissions, in some cases, the greenhouse gas emissions of firms and their supply chain and all of that. Well, this is important to our core mission of securities regulation because this is information that investors are going to want to make decisions. And as Andy and Amanda Rose point out, there's a very real question. Well, there's a very real question about whether or not this is statutorily permitted on the part of the SEC if this is the type of information that Congress wants the SEC to be able to enforce disclosure of. And I think Andy makes a great argument that it's not.
Knight: And then the costs of this are going to likely be extremely high. And to say, oh, investors want it. Well, when you look at what the SEC actually says, institutional investors want it, your BlackRocks of the world, your CalPERS of the world, they want it. The underlying people who actually contribute the money? Entirely unclear whether they want it. Nobody knows. I consider it to be dubious. At least when you figure in the cost of actually getting that information. And the SEC and their proposed rules also talk about like, well, look, you can use consultants. You can use advisors to get all this stuff, which is another example of, wow, this is going to be a significantly new burden on you if you have to go outside of your firm to do this and all.
Knight: And so the question is, is this actually motivated by core securities regulation concerns? Or is this utilizing an available tool to try to get at what's perceived to be a very serious issue, like there's a lot of very earnest concern about the impacts of climate change. But are you using the tool available to you because Congress won't pass new, more restrictive environmental regulation? And if you do that, what is the impact on the capital markets? How hard is it for companies to access capital? What does it do to particularly smaller firms, newer firms, insurgent firms? And really, what does it do to the SEC's ability to actually perform its traditional core functions if they're having to then divert their attention to other stuff? And that's a very real concern and I would not be surprised at all if when this rule does get filed and comment period closes, I believe, Friday the 17th. I believe that's when it closes. When the final rule actually comes out, assuming it does, I would not be surprised at all if it gets challenged and actually ultimately struck down. And then what? What have we done?
Beckworth: Well, let's go back to the observation I made at the start of the program. And that is there has been this increase in political activism and the politicization of the financial regulatory space. And let me ask a question, why? Why have we seen this? And you have an article that speaks to it in reason, I believe it is in Reason. And the title is, “Are Financial Regulators Too Political or Not Political Enough?” So how do you explain what we've seen and what we've been talking about in the show?
Are Financial Regulators Too Political?
Knight: Sure. So I think why we're seeing what we're seeing now is a combination of, as we discussed earlier, enhanced politicization and enhanced gridlock. So people can't get the rules or laws they want through the traditional legislative process because it's just so gridlocked. So you look around for other options. And here are all these financial regulators who, to varying degrees, kind of reflect the mindset of the early 20th century progressive movement, like aversion to democracy, preference for technocrats, this view that democracy is kind of icky and grubby. And what we want is we want some very capable, intelligent people to just kind of be technocrats and execute on the policymakers' preferences, but be largely insulated and independent when they do so. And the problem as I see it is that that's a recipe for unaccountability, it's a recipe for the risk of abuse because all of the things that elected officials and, by extension, the voters could use to like reign them in, they tend to be insulated from.
Knight: And I should say each agency is a little different. And so not all of this applies to all agencies equally. But things like the not having to go to Congress for their budget every year. The FDIC, the OCC, the Fed, the CFPB, none of them are on congressional appropriations, right? So that power of the purse that Congress has isn't really valuable. Having leadership that is not necessarily fireable at will by the President. FTC, maybe FDIC, there's a debate on that, and the Fed have these installations. And the Supreme Court has taken the position that the SEC also has four cause protection and can't just be fired at will. Again, our colleague, Andy, has a very compelling argument that that's actually wrong, but it hasn't, until the Supreme Court fully litigates it, we'll have to wait. And the CFPB had that protection for their director until the Supreme Court struck it down a couple years ago.
Here are all these financial regulators who, to varying degrees, kind of reflect the mindset of the early 20th century progressive movement, like aversion to democracy, preference for technocrats, this view that democracy is kind of icky and grubby. And what we want is we want some very capable, intelligent people to just kind of be technocrats and execute on the policymakers' preferences, but be largely insulated and independent when they do so. And the problem as I see it is that that's a recipe for unaccountability, it's a recipe for the risk of abuse because all of the things that elected officials and, by extension, the voters could use to like reign them in, they tend to be insulated from.
Knight: So you have these tools of insulation that, in theory, were there to allow technocrats to do non-controversial technocrat things. We all agree that banks shouldn't be failing, and so you technocrats make certain that the banks aren't engaged in a lot of crazy, ridiculous, risky activity. There isn't a lot of insider abuse or whatever. But now we're seeing that the same agencies be used to further very controversial political goals because they make the appeal that, well, we do have this very broad authority from Congress. It's probably not as broad as they think it is. And agencies have definitely been rapped across the knuckles by the courts before, recently. But they do have broad grants of authority, and they do have this installation from day to day politics. And so I think that's that's part of what you're seeing.
Knight: The other part of it is just the recognition that the financial system is incredibly important. Lots of luck functioning in a modern society if you can't access the tools of the financial system. If you can't get access to... If you're a business, you can't get access to bank loans, you can't get access to the capital markets. Lots of luck. If you are an individual, and you can't access the payment system, and it's hard to safely store your money, life gets hard. Go back to the marijuana point. This is one of the problems with marijuana firms that they often complain about, is because banks won't bank them. They have to keep the cash on site. And that is just a recipe for being robbed. So the realization and the recognition that actually financial regulation is an incredibly powerful tool of universal regulation is part of what is driving this.
Beckworth: That's very interesting. So the desire to get things done, even if Congress is not doing it, the recognition that the financial system is very powerful, it's the bloodline of the US economy, go at it and use it as an alternative way to accomplish your goals. Let's move on to another area, Brian, where you have also been writing and thinking about, and it's related to what we've been discussing, that's woke capitalism. What is woke capitalism in your view, and how is it related to what we've been discussing?
Knight: So, okay. Let me start with the caveat that I'm not a huge fan of the phrase woke capitalism because it's inherently polarizing, and it's also inherently focusing on the progressive side of it, which is the ascendant side right now, but there's no reason to say that would always be that way or has always been that way. But branding is what it is, and so here we are. I think this is another example of frustration with pursuing societal change through the traditional channels, and instead looking around and being like, "What other levers can we pull?" A few years ago, it was well, Congress won't pass gun control. Let's try to get the banks to not do business with gun companies. Because then if people can't make guns, that's effectively similar to banning them, if you can't get them. Same deal with, say, private prisons that are used in the immigration system. Or carbon intensive industries. People should divest from their coal mining or whatever. We can't ban coal, but if coal companies can't get money, they can't function.
Knight: So I think that's part of what's driving this as well is this emerging belief – and it's not that this is entirely new and has never occurred before, but I guess we're going through an up-cycle of it – this idea that people want to do business with businesses that reflect their values. They want to see business as a tool of positive social change. And there's this persuasive version of that. Please advocate for things I like. And then there's the more coercive version of that. Please cut off people we dislike or causes we dislike, so that they can stop being bad. And so, I think that's part of what we're seeing. It's an open question to see how much of this survives the inflation and likely recession that we're staring down at the barrel of, but it very well might, for better or worse. And so I think what we have seen is a cycle of efforts to get businesses to pursue, to try to use corporate power to very directly influence society, sometimes persuasively, sometimes coercively. This isn't unheard of by any stretch, but we're going through an elevated and aggressive cycle of it.
Knight: And that can range from things like asset managers using the fact that they get to vote the shares of underlying investors to push ESG issues at the corporate level. Going to the companies that they own shares of and saying, "You need to do this." I think you could make an argument that the whole cancel culture phenomena of, "Oh, well, so-and-so has this political belief that we find objectionable, so they should be fired," can be an example of that. Obviously it depends on the facts and circumstances. If your belief is preventing you from actually doing your job, that's one thing. But you do see movements that say, "Well, I won't do business with someone who employs someone who holds these views or beliefs," even if it didn't really compromise that person's ability to do their job.
Knight: You have corporate speech and political activity, and it's not that corporations haven't been active politically. It isn't that they haven't engaged in donations or anything like that. But what you do seem to be seeing is an uptick in very pointed and controversial views, where corporations are, instead of just donating to all parties and speaking on issues that are directly related to their business, rather it's "Oh, yes. We're going to take an opinion," like Disney in Florida speaking out against the, depending on who you talk to, the parental rights notification or “Don't Say Gay” bill, depending on your view of it.
Knight: That did not directly relate to Disney's ability to do business in Florida. And the CEO initially apparently tried to stay out of it, but then a group of his employees basically pushed him into doing something. And so they came out with this statement, and they said that they were going to work to prevent similar laws from being passed in other states and all of that. And surprise, that was incredibly controversial and drew the ire of Florida politicians, but it wasn't like someone was talking about prohibiting the use of theme parks or something like that. And then I alluded to earlier the efforts to get banks to de-bank certain customers. Because this is bad, and we shouldn't have it. And some banks quite explicitly did so, in an effort to try to de facto regulate certain areas. And this issue tees up some really challenging questions, especially if your starting point is a presumption that private actors should largely be allowed to do what they want to do, provided they're not violating the law. This seems to be teeing up some very challenging questions.
Beckworth: It's interesting you bring up Disney. It's been in the midst of this controversy many times. Florida's not the first time it's come out in favor of woke issues. But what's interesting about it to me is that it also avoids sometimes being involved when it comes to say China. So there's this tension between promoting maybe woke values at home and then trying to engage these big markets overseas. I also wonder, Brian, do you think this phase of woke capitalism or this push for woke values in capitalism, is it something that's with us? Is it going to pass? Is it just a season? Is it part of the milieu we're in right now? And that, as you mentioned, the recession, the high inflation. People might begin to view these things as luxury goods, and they'll be less interested in it going forward.
I think that's part of what's driving this as well is this emerging belief – and it's not that this is entirely new and has never occurred before, but I guess we're going through an up-cycle of it – this idea that people want to do business with businesses that reflect their values. They want to see business as a tool of positive social change. And there's this persuasive version of that. Please advocate for things I like. And then there's the more coercive version of that. Please cut off people we dislike or causes we dislike, so that they can stop being bad.
Knight: I cannot predict the future. I don't know. I think you could plausibly predict or lay out a scenario where this is significantly reduced or goes away. I think you could predict a scenario where it doubles down, because this is the thing. It becomes part of the marketing and client cultivation of the firm. If we're going through a broader social change, where you're seeing emerging demands for an enhanced pace of social change, this may be one of the ways you get it. On the other hand, there is the risk of backlash. And backlash can take a bunch of different forms, some of which potentially legitimate, some of which not. And let me back up for a second and say, I'm not trying to be normative here on any given issue. Whatever your stance might be, cool, fine. But rather, are these the type of issues that corporate power should be used to influence or resolve or not? And I don't think it's a clear answer one way or the other.
Knight: So, okay. It's one thing for a company to come out and say, "We think this law is bad." Okay. Corporations have first amendment rights. So far, so good. If it's a public corporation and the CEO, they're not the owner of the firm. I'm sure they own some tiny amount of the firm, but they're not the owner of the firm. They're a manager on behalf of underlying shareholders. If they take this position, should the shareholders be able to gripe and complain, and should we care now that a lot of underlying beneficial owners, people that actually put up the money, are intermediated by large asset managers, so they don't even generally get to vote on boards or anything like that? That's one scenario. If people get fired for expressing controversial political views, well, do we care? Well, maybe we should if part of what's happening here is this is chilling people's ability to engage in core political activity, upon which the legitimacy of our system is premised.
Knight: Because of course at the end of the day, some of this is going to be whoever is the most wealthy or productive is going to have an outsized view or an outsized ability of control. If the relatively wealthy say, "Well, these views are verboten. And therefore, if anyone is caught expressing them even off the job, they should really be fired," does that risk chilling political speech and political equality that our system relies on? I don't think that argument could be dismissed. But then on the other hand, we should be wary of a miss or overreaction too. We don't want, at least I don't want all of our political situations fought out in the market. I don't want all of our market situations fought out through politics. But you run the risk that the response is going to be excessive or driven by something other than if there is a legitimate problem, and if it is the type of thing that the law should properly be involved in, then what is the appropriate solution that best respects all the different conflicting, legitimate values involved? Versus what is something that's just driven by basically vindictiveness and well, you hurt members of my coalition, so I'm going to come after you with a bat. And sorting that out is very challenging.
Beckworth: So in the time we have left, Brian, is there anything that can be done to address this issue?
Knight: Well, I guess the first thing is to tease out that fact that there isn't an issue. There's a bunch of different issues. I would say our view and our response to this should be very fact or circumstance specific. And like I said, it's one thing if a company says, "Hey, we don't like this law." Well, the presumption should be, okay, that's your first amendment right to say that. Okay, fine. Now, if it becomes a situation where it's hey, you are misusing funds that were given to you for one purpose. Instead, you're using them for a different purpose. Different question. If you're talking about something like a bank, where their power is so wrapped up in public policy, and that public policy is justified by facilitating lawful commerce, not impeding lawful commerce, that's arguably something different.
Knight: If you're talking about firing people because they engage in political activity that is undesirable, that's one thing. If you're talking about people who are engaging in political activity, perhaps on the job, that might be something different. If you're talking about the role that asset managers play, vis-a-vis corporations, vis-a-vis the underlying investors, that's another thing, versus a purely privately held, closely held corporation, where it's just a family who just owns it and they're doing stuff. All of which is to say, it's incredibly complex and nuanced. And so there's not one answer that is appropriate. The one big answer would be a decline in polarization. And I don't know how you do that. If anyone could figure out how to bring a decline in polarization in this country, please do. Because I think that would make life a lot easier all around. But barring that, if we're going to have to actually deal with all the symptoms, being very precise and specific about what we do and how we conceive of them and all that stuff, I think that's the best we can do right now.
Beckworth: Okay. With that, our time is up. Our guest today has been Brian Knight. Brian, thank you so much for coming on the show.
Knight: Thank you so much for having me.
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