Racism and Systemic Risk

Abstract

This article draws from several theoretical frameworks such as Critical Race Theory, 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 risk events. This article begins by first introducing a novel model created by the author through which to dissect this claim. This “Systemic Risk and Racism Model” provides a visual depiction of how racism drives every stage along the life cycle continuum of a systemic risk event. First, with respect to the Model’s “Introduction” phase, this article contends that racist practices and policies incentivize systemic risk by transforming Black communities (and other vulnerable areas) into ideal dumping grounds for negative externalities produced by the private sector. For example, redlining and restrictive racial covenants made Black communities ideal targets for subprime mortgages during the initial stages of the financial crisis of 2007-09. Racism then leads to “blind spots” where market participants magnify the economic benefits flowing from such negative externalities while underestimating its resulting costs. Second, during its “Growth” phase, these blind spots cause the systemic risk disruption to expand exponentially since market participants create additional avenues for exclusive commodification. During the financial crisis of 2007-09 for instance, subprime mortgages were repackaged into financial instruments and sold to elite counterparties across the globe. Relying on the quintessential free market to resolve these harms has therefore proven inadequate. Third, when the systemic risk event reaches its “Maturity” phase, the disparate harms experienced by Black people and other vulnerable communities spill over into the masses. The excessive leverage pumped into the market during the financial crisis led to the cascading failures and losses that spread to every corner of the market. Based on this novel Systemic Risk and Racism Model, this article therefore argues that Professor Derrick Bell’s “interest convergence theory” firmly takes root within this Maturity phase since this spillover effect is a necessary condition for meaningful regulatory intervention. Racism however can extend the depth and duration of this Maturity phase given the tendency of lawmakers to grant selective relief for elite classes. As the systemic risk event goes into its fourth and last stage of “Decline”, racism causes lawmakers to underestimate the long-term costs accruing to vulnerable communities which creates a fertile breeding ground for future systemic risk events. This article applies this same analytical frame in assessing how the systemic risk generated by climate change is similarly interconnected to racism.

A formal recognition by FSOC that recognizes racism as a threat to financial stability could significantly disrupt this deeply troubling cycle. Such a designation would first concede limitations of preexisting protections that arise under federal and state law, as well as privately ordered responses, which could increase the likelihood for more inclusive rulemaking going forward. It could further serve as a framework for formalizing data collection mechanisms, coordination across regulatory agencies, and expertise building within every corner of the financial markets. Finally, an FSOC designation could spur investors, asset managers, stakeholders, and NGOs to advocate for meaningful reform, while stimulating integral rulemaking from applicable regulatory agencies. For example, this could be a vital step in prompting the Securities and Exchange Commission (“SEC”) to promulgate rules within the context of its ongoing commitment to streamline the Environmental, Social, and Governance (“ESG”) metrics utilized by its registrants. Mandatory racial equity disclosures implemented by the SEC could assist in weeding out systemically racist practices that compromise investor protection, while increasing competition and accountability.