Modern finance is fast moving, extremely complex, and contributes to pervasive unknowns. Yet the processes governing how finance is regulated are typically slow, highly deliberative, and often reflect deeply engrained and incredibly optimistic assumptions about our ability to understand the financial system and the potential impact of regulatory intervention. In our new paper, ‘Why Financial Regulation Keeps Falling Short’, we identify the key drivers of this fundamental mismatch between finance and financial regulation, demonstrate how this mismatch contributes to undesirable policy outcomes, and lay the conceptual foundations for understanding how the processes governing how financial regulation is made can be improved in ways that help close this gap.
The financial crisis triggered a global rulemaking frenzy. In the UK, the prudential rulebook for banks ballooned from roughly 400,000 words in 2007 to over 720,000 in 2017. In the US, the Dodd–Frank Act was a whopping 364,844 words and required eleven different federal agencies to collectively undertake 243 separate rulemaking processes and conduct 67 different studies. Using techniques from software programming, Andrew Lo and co-authors have found that the Dodd-Frank Act is second only to the US tax code in its complexity. They also find that it is complex in ways that make its failure likely—even before accounting for the dense thicket of rules implementing the statutory framework.
Almost a decade has passed since the adoption of the Dodd–Frank Act. Now is thus an opportune time to assess what we have learned about the processes governing financial regulation. One of the most striking features of the current landscape is just how much contestation remains. The core objective of all of this new rulemaking was to promote greater financial stability. Yet it is far from clear whether the system is safer today than it was ten years ago. Global SRISK, a measure of systemic risk designed by Nobel Laureate Robert Engle and colleagues, is higher today than in 2008. Natasha Sarin and Larry Summers, meanwhile, have shown that post-crisis reforms have not had a material impact on key measures of bank risk-taking such as volatility and expected returns.
Shifting from aggregate assessments to the impact of specific reforms reveals further contestation. A recent report from the Congressional Research Service acknowledges that, even though the Dodd–Frank Act was designed to facilitate the resolution of large financial institutions without threatening financial instability, commentators continue to debate whether it has actually decreased systemic risk. The impact of the new regulatory framework for standardized derivatives is similarly mixed. While these reforms have had the intended effect of promoting central clearing and greater transparency, the resulting concentration of market activity has also had the unintended consequences of reducing interbank monitoring and creating new nodes of systemic risk. Other examples abound.
Our aim here is not to condemn any specific post-crisis reforms. We believe that many have improved financial stability, and we are skeptical of recent efforts to roll back the progress that has been made. That said, we see the level of ongoing contestation as itself extremely important. The devastation the financial crisis wreaked on the real economy was unequivocal. In the US, unemployment jumped to ten percent, major stock indices fell by half, and nearly nine million families lost their homes. The need for massive reform was uncontested, even if many of the specific reforms were. Given the immense resources that have been brought to bear, that so many questions about the impact of these reforms remain outstanding is itself deeply troubling. Our aim is to explore how this is possible. Specifically: why haven’t these reforms produced a demonstrably more stable financial system?
The literature already offers a number of explanations for why financial regulation so often falls short. One explanation, advanced by Roberta Romano, is that regulation often reflects an impulsive legislative response to a specific scandal or crisis. The net effect is quack regulation designed more to quell public outrage than to address underlying problems. A second explanation, rooted in public choice theory, posits that the influence of regulated actors over the lawmaking process results in rules that protect their narrow self-interest at the expense of the wider public. A third, related, explanation observes that public pressure to respond to financial crises is often fleeting—with the result that financial regulation tends to weaken as the memory of a crisis fades over time.
Each of these accounts helps explain why financial crises recur so often and in such familiar ways. Each also sheds some light on why recent reforms have not been more successful. Yet these existing accounts fail to completely explain the disconcerting state of affairs we now face. Our paper expands this list of explanations to include the nature of finance itself. It shows that another reason financial regulation keeps falling short is that the processes through which finance is regulated are poorly suited to the dynamic and complex nature of modern finance. In this environment, policymakers inevitably operate with an incomplete understanding of how the financial system works and how it will respond to regulatory intervention. Exacerbating this challenge, finance tends to evolve in ways that minimize the cost of complying with existing rules, thus pushing activity outside the regulatory perimeter. Tomorrow’s financial system will not look like today’s, and efforts to improve the stability and functioning of today’s system will be among the factors driving that change.
Despite the complex and dynamic nature of modern finance, the processes governing financial regulation are often rooted in procedural frameworks designed to accommodate domains that operate quite differently, or that reflect the static financial systems of a bygone era. The result is processes that assume policymakers and other stakeholders understand the system they are regulating and how it will respond to regulatory intervention. The results of this mismatch are myriad. In addition to regulation that fails to achieve its desired aims, they include excessive expenditure of public and private resources before new rules are adopted, counterproductive efforts to perfect rules, and too little meaningful accountability. We argue that this mismatch helps to explain the ongoing contestation surrounding the impact of post-crisis reforms.
In offering a different explanation of the problem, we also advance a different approach for how to fix it. The good news—if it can be called that—is that finance is far from the only dynamic, complex and incompletely understood ecosystem in which we are nevertheless compelled to intervene. The human body is another. Just as morbidity and mortality have declined as doctors have gone from simply treating disease to thinking more broadly about how to promote health, we suggest that the efficacy and resilience of the financial system could be enhanced by moving past efforts to narrowly address specific market failures and toward a more holistic approach to finance.
Dan Awrey is Professor of Law at Cornell Law School.
Kathryn Judge is the Harvey J. Goldschmid Professor of Law at Columbia Law School.