Why Financial Regulation Keeps Falling Short

Why Financial Regulation Keeps Falling Short

Dan Awrey, Kathryn Judge

March 18 2020

Modern finance is fast moving, complex, and the source of pervasive unknowns. Yet the processes governing how finance is regulated are typically slow, highly deliberative, and reflect optimistic assumptions about our ability to understand the financial system and the potential impact of regulatory intervention. In this paper, we identify the key drivers of this mismatch between finance and financial regulation, demonstrate how it contributes to undesirable policy outcomes, and lay the conceptual foundations for understanding how the processes governing how financial regulation is made can be improved.

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.

Almost a decade has passed since the adoption of these reforms: making this an opportune time to evaluate what we have learned about the processes governing financial regulation. What arguably stands out most is how much uncertainty and contestation remains. Indeed, while the core objective of these reforms was to promote greater financial stability, it is far from clear whether the system is more stable today than it was ten years ago. Global SRISK, for example, a measure of systemic risk, is higher today than in 2008. Nor is it clear whether specific reforms—from the Volcker Rule, to mandatory clearing for derivatives—have made the financial world a safer place.

We see this level of ongoing contestation as extremely important. The devastation the financial crisis wreaked on the global 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 reform was uncontested, even if many of the specific reforms were. Given the immense public resources that have been brought to bear, that there remain so many questions about the impact of these reforms is itself deeply troubling.  Our aim is to explore how this is possible: to ask why these reforms have not produced a demonstrably more stable financial system.

The academic literature already offers a number of explanations for why financial regulation keeps falling short. One explanation is that crisis-driven regulation is often designed more to quell public outrage than to address underlying problems. A second explanation, rooted in public choice theory, is that regulated actors exert influence over the lawmaking process, resulting in rules that protect their narrow self-interest at the expense of the wider public. A third is 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 explanations sheds some light on why recent reforms have not been more successful. Yet they also fail to fully explain the disconcerting state of affairs we now face. Our paper expands this list of potential explanations to include the nature of finance itself.  It shows that financial regulation keeps falling short because the processes through which it is made are often poorly suited to the dynamic and complex nature of modern finance. Policymakers thus 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 of today’s system will be among the factors driving that change.

In contrast with the complex and dynamic nature of modern finance, the processes governing financial regulation are often rooted in procedural frameworks designed to accommodate far more stable and predictable areas of human endeavor.  The results of this mismatch range from excessive expenditure of public and private resources before new rules are adopted, to counterproductive efforts to perfect rules, to too little meaningful accountability.  We argue that this mismatch helps explain the ongoing contestation around 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 not the only dynamic, complex, and incompletely understood system in which we are 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 can be enhanced by moving past efforts to narrowly address specific market failures and toward a more holistic approach to finance.

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