Risks, Rules, and Institutions: A Process for Reforming Financial Regulation

University of Memphis Law Review, The, Summer 2009 by Omarova, Saule, Feibelman, Adam

The world has changed dramatically since the Department of Treasury released its Blueprint for a Modernized Financial Regulatory Structure in March of 2008. 1 It has changed in ways that make the topic of the Blueprint all the more important than it was a few short months ago. In the midst of a genuine once-in-alifetime global crisis in financial markets, questions about how to regulate and channel the provision of financial services within and between jurisdictions have become paramount. It now seems likely that individual countries and international institutions will reconsider the shape of regulation of capital markets in the short- or intermediate-terms; in fact, much reshaping has already occurred in the ad hoc responses that regulatory entities and firms have made in recent moments of acute peril. Such a time is rich with opportunities for improvement and fraught with potential for mistakes.

As policymakers and scholars have begun struggling with crisis containment and looking forward to the post-crisis environment, the Blueprint has drifted from center-stage. There are signs, however, that its focus on regulatory structure is still central to unfolding policy debates. To the extent that this is true, it is unfortunate. Institutional and regulatory structure can promote effective regulation, but it is unlikely to do so unless the goals and tools of a regulatory regime are carefully defined. In calmer periods, other writers have tried to deemphasize concerns about the allocation of regulatory functions. During the last round of debates over financial regulatory reforms of the late 1990s, for example, Michael Taylor and Richard Abrams noted that "institutional structure is a second order issue."2 In the current, highly-politicized climate, however, such a claim sounds discordant. As Brunnermeier, et al. have recently observed, "[tjhere is a tendency, commonly observed amongst politicians, to review the structure of the regulatory system before considering die potential instruments to achieve better regulatory control."3

The current economic crisis has arguably vindicated die view that policymakers are mistaken to focus initially on questions of regulatory structure. There is a reasonable case to be made that today's crisis is not solely, perhaps not even primarily, due to lack of coordination among regulators or a misaUocation of turf and regulatory responsibility.4 It appears likely diat a host of different regulatory actors either failed to perceive fundamental risks or refused to address them. This experience has underscored that two primary challenges in regulating capital markets are, first, to identify risks within these markets and, second, to identify mechanisms that can lessen or manage those risks. Questions about how to allocate these mechanisms within a regulatory structure should be answered in light of policymakers' conclusions regarding what to regulate and how to regulate it.

The recent crisis will provide a partial roadmap to a better understanding of the types of risks embedded in different financial activities. It should now be clearer to policymakers, for example, that consumer lending is fraught with risks - thus giving rise to regulatory concerns - that flow well beyond die interests of die initial parties to these transactions. These risks flow through the institutions that purchase and pool consumer obligations, institutions that purchase interests in these pooled assets, and others that buy and sell products diat are derivative of these interests. Each of these subsequent transactions gives rise to distinct risks diat implicate parties forward and backward in the chain of relationships. In the wake of the current crisis, it is also now clearer that institutionlevel (that is, micro-prudential) regulation can be in tension with systemic stability.5

It is important, however, for policymakers not to assume that the particular risks that gave rise to the current crisis will reemerge in the post-crisis context. It is equally important for policymakers not to ignore other fundamental risks inherent in capital markets that might not have been revealed in recent months. Identifying the full range of risks and potential market failures in domestic and international financial systems requires both a keen appreciation of economic theory and a comprehensive understanding of the actual practices of market actors. The latter can be anticipated to some extent, but imperfectly. It is simply impossible to know exactly how financial markets will look when they reemerge from the current crisis. If policymakers do not wait long enough to have some meaningful understanding of how private actors will respond to the crisis, they run the risk of designing a regulatory system that is weak where it should be strong and strong where it should be weak.

Assuming that policymakers have an accurate assessment of the nature of financial firms, products, and services going forward, they must then develop criteria for distinguishing risks that should be borne by private parties from those that justify regulatory intervention. This will inevitably require a balancing of various potential policy objectives, such as protecting consumers and investors, promoting an efficient allocation of financial resources, and ensuring systemic stability. This analysis should be based upon a realistic assessment of available regulatory tools, such as activity restrictions, capital adequacy requirements, reserve requirements, conditions on affiliate transactions, disclosure requirements, etc. It should also take into account the potential modes of interaction between the regulators and the regulated, as well as improvements in private risk-managements strategies, both of which may vary across different segments of the re-emergent financial services sector.