Crafting appropriate financial regulation is difficult. Policymakers worry that excessive regulation might inhibit capital formation and reduce economic growth. Even funding policymakers is hard; the SEC, for example, has the budget to review the operations of investment advisors only once per decade. Self-regulation by the industry through bodies like the Financial Industry Regulatory Authority (FINRA) offers a solution. But in a recent paper, forthcoming in the Cincinnati Law Review, I argue that self-regulation presents its own problems because it allows industry insiders to shape regulation that favors their own interests.
Financial self-regulatory bodies seem to solve these problems by allowing the industry to regulate itself. Industry members have significant expertise: their informational advantages may allow them to craft more thoughtful regulation than any outside policymaker could. Turning regulatory responsibilities over to a wealthy industry also solves a funding problem because membership fees offer more stable funding than the fickle legislative process. Plus, industry has some incentive to police itself. If a few members misbehave, it might increase costs for the entire industry as a result of increased regulation or by customers demanding additional assurances of fidelity.
Despite these benefits, self-regulation also has a dark side. When the industry regulates itself, it can shape regulation to benefit its own interests over that of the public. Self-policing may also turn into cartel-discipline with a self-regulator stifling the competitive forces that would lower consumer costs. Consider the self-regulating New York Stock Exchange (NYSE). Before the Great Depression, the NYSE enforced fixed commission rates and largely ignored members running predatory, market-manipulating, stock pools.
Governance reforms have provided some check on the tendency toward cartelization. The NYSE first appointed three public members to its industry-dominated board after the Great Depression. One of these public members resigned in disgust when the NYSE failed to take action against members that knowingly tolerated the former board president’s embezzlement from widows and orphans. Following other scandals, industry self-regulators increased the number of ‘public’ members serving alongside industry-elected members. Today, FINRA characterizes itself as an independent regulator because the majority of its board seats belong to public members.
Despite these reforms, some doubt the independence of FINRA’s public representatives. While its bylaws simply require that members have no ‘material business relationship’ with any of FINRA’s member firms, public board members have often had long industry careers. In some instances, they serve in perplexing dual roles. For example, one public board member also serves on the board of the US Chamber of Commerce. The US Chamber bills itself as an advocate for ‘business interests’ and accepts a substantial amount of cash from Wall Street firms to fund lobbying operations. Another public member recently resigned to accept a well-compensated board position with a financial services firm. These entanglements contribute to the perception that FINRA’s public governors may not be the most vigorous protectors of the public’s interest.
FINRA plays a vital role in financial regulation and investor protection. Without support for replacing self-regulatory organizations with well-funded public regulators, more incremental reforms may be appropriate. FINRA and the SEC should consider changing the appointment process for public representatives. It would be better to follow the appointment model established by the Public Company Accounting Oversight Board and allow the SEC or another agency to appoint public representatives. More effective oversight might also emerge through increased transparency. FINRA discloses little information about its governance or board members. The SEC oversees FINRA, but the Freedom of Information Act does not currently apply to the SEC’s oversight of financial self-regulatory associations, making it difficult to obtain information.
These reforms would push back against the dark side of self-regulation. Public members appointed through a different process are more likely to press for investor protections, and increased transparency would allow academics and other outsiders to more closely examine FINRA’s functioning. While these modest measures will not solve all problems, they may make FINRA more effective and more responsive to public concerns.
Benjamin P. Edwards is an Assistant Professor at Barry University Dwayne O. Andreas School of Law.