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Financial Markets, Institutions, and Transaction Costs: The Endogeneity of Financial Governance

A common distinction in political economy contrasts the dynamics of free markets with the ‘political’ dynamics of governance. That distinction portrays ‘economic’ competition as separate from the deployment of private political resources to affect the terms of competition in line with agent preferences. This yields a distorted view of how real-world economic agents compete with each other, and the market-governance/state-market dichotomy creates more confusion than it clarifies, failing to account for the empirical observation that complex market systems and institutions of governance cannot be found apart. Even as an analytical distinction, the dichotomy blinds us to the ways in which states are active constituents of the market place, and the ways in which market actors and their constituencies are part of the wider process of governance shaping the terms of competition. This paper will extend the transaction cost approach and the insights of institutional economics to demonstrate that the emergence of the institutions of financial governance is endogenous to the utility-maximising behaviour of economic agents. Utility-maximising behaviour and conflict over the terms of competition in the market generate both the formal and informal institutions and processes of governance such as regulation and dispute settlement. The paper then presents a conceptual model for understanding the essential integration of market and governance processes, the ‘state-market condominium’, in which markets are not just about what firms do in competition with each other, but are conceptualized as an ensemble of regulatory authority operating simultaneously through policy processes and the competitive interaction of firms. Contrasting forms of market correspond to political compromises based on the preferences of interacting agents. The model hypothesises reflexively that conflict over the terms of competition in markets generates changes in actor preferences concerning regulation and governance simultaneously, and that the outcome of conflict over divergent actor preferences concerning governance and regulation generates changes in market structures. Changes in preferences concerning governance therefore are intimately bound up with preferences concerning market structure. The theoretical model is then illustrated with a case study of international financial governance and market change related to the spread of the sub-prime financial crisis. By this reckoning, agents at first sought to set the terms of competition by promoting cross-border market integration and their preferences later underpinned the emerging fabric of multi-level governance in the sector. This approach brings the work of economists and political scientists closer together in revealing the nature and origins of a mix of global financial regulations that have given rise to the present economic crisis. The argument is that, in contrast to the public choice position that more market-based competition is likely to reduce the room for policy capture, financial liberalisation and the subsequent establishment of a market-based approach to financial governance constituted a process of policy-rent seeking which yielded important competitive advantages for the major international investment banks and financial conglomerates who pursued the policy in the first place. State agencies involved in financial governance also had a crucial interest in financial liberalisation and frequently made common cause with the financial sector. Basel II and its use of the advanced internal ratings based approach of “self supervision” for major banks is an example of such policy change. In turn, changes in risk management techniques and financial supervision directly contributed to the growth of leverage and product innovation associated with the outbreak of financial crisis. The crisis was a direct result of policy rent-seeking and capture: private interests simultaneously reshaped both market and governance in line with their own perceived utility functions. The real cost of risk was successfully transferred to the public domain as ultimate guarantor of financial system integrity. The model predicts that similar policy rent-seeking will dominate the reform process.