Much of the theoretical work on financial stability of the last several years suggests that financial instability is endogenous to the financial system. The Office of Financial Research (“OFR”) reports that the financial crisis of 2007 “served as a painful reminder that the financial system is prone to internal instability . . . .” Policy makers continue to struggle with determining financial fluctuations and shocks and the role the government and regulation can play in making financial institutions less disruptive. Academics debate what kind of limits should be imposed on financial institutions to curtail the propensity of the financial industry to careen towards disaster. The predominant approach in most jurisdictions entails tightening financial regulation, requiring banks to raise more capital, and applying stricter rules to larger and potentially systemically significant financial institutions. There is no consensus on the kind of institutions that may be needed to adequately monitor and temper the financial industry. There is also no broad agreement on the appropriate level of intensity for rules governing financial institutions.
Financial regulation is usually enacted in the aftermath of financial crises. Reinhart and Rogoff have demonstrated that bank crises are, and will likely continue to be, an integral part of economic cycles. Financial regulation has followed most financial crises in the history of the United States. Since 1792, the United States has experienced more than a dozen bank crises, including panics, bank runs, credit crises, and the collapse of Long-Term Capital Management. Since 2002, corporate governance in the United States has been, not just once but twice, substantially upgraded in response to crises, after more than seventy years of comparative regulatory inactivity. At the most general level, the Sarbanes-Oxley Act (“SOX”) of 2002 aimed at increasing board independence, fixing the audit process, and improving disclosure and transparency. Only eight years after enacting SOX, Congress again substantially overhauled the corporate governance regime via the Dodd-Frank Act. Although SOX and the Dodd-Frank Act address different concerns precipitated by different causes, in different market environments and different world economic outlooks, it seems striking that so much regulatory activity was necessary in such a comparatively short timespan.
The literature on financial regulation may not have addressed the underlying causes and consequences of cyclical regulation adequately. Since the early 1980s, trends in the law and finance literature have been changing roughly every five years. In the 1980s, the Law and Economics movement gained substantial influence in legal academia, the courts, and the legislature. In the early 1990s, Bernard Black precipitated a new wave of legal scholarship that emphasized the role of institutional investors in corporate governance. In the late 1990s, the debate on global convergence in corporate governance preoccupied many leading legal minds. The next wave of legal scholarship in the post-Enron era discussed the role of SOX and the function of gatekeepers, such as lawyers and accountants. With the appearance of the 2007 credit crisis, legal scholars moved on to discuss the causes of the crises and possible regulatory responses. Some scholars have begun to question the existing regulatory paradigm. However, initiatives for sustainable financial regulation are still largely missing. Anticipation of unknown future contingencies and the preemption of possible future crises do not play a significant role in the current regulatory framework or in the literature on financial regulation.
A common denominator of regulatory responses to crises is the reliance on stable and presumptively optimal rules. Congress, financial regulators, and the literature on financial regulation rely almost exclusively on “stable” and presumptively “optimal” rules. Economic and market conditions and the corresponding requirements for optimal and stable rules are constantly evolving and create substantial future contingencies for rulemaking. Although they do not take unknown future contingencies into account, stable and presumptively optimal rules remain the uniform response to financial crises. To attain certainty and increase predictability, rulemakers discount or often willingly accept unknown future contingencies and the inevitable need for rule revision, amendments, and retractions. If and when future contingencies are realized and the existing sets of rules prove to be suboptimal, Congress and financial regulators propose and enact additional stable sets of rules to address shortcomings in financial regulation. In an increasingly innovative, complex, and globalized financial environment, future financial crises may require perhaps even more extensive governance adjustments.
A regulatory framework that relies exclusively on stable and presumptively optimal rules may not be able to adequately address future challenges. Amendments, revisions, and retractions of existing rules create substantial transaction costs and uncertainty. Rules established in reaction to financial crises also inevitably fail to soften, curtail, or preempt the effects of financial crises, because reactive rules are mostly tailored to the economic and regulatory issues at the time of their enactment and often ignore possible future contingencies. A preferable solution would avert the downsides of cyclical and merely responsive regulation.
This Essay outlines the possible role of dynamic elements in financial regulation. Dynamic regulation may supplement the existing regulatory framework and may help remedy its shortcomings, such as the need for perpetual rule enactment, adjustment, and revision. Dynamic elements in the regulatory structure may allow regulators to continually adapt to new market environments, financial innovation, and changes in financial markets as a result of financial regulation. Dynamic regulation may help create a governance mechanism that is constantly evolving and adapting to the given market environment, financial innovation, and regulatory environment. Although the implementation of dynamic elements in regulatory structures is uncertain, some promising regulatory tools with dynamic elements already exist, including contingent capital securities, corporate integrity agreements, and deferred prosecution agreements.
The concept of dynamic regulation supports a regulatory structure that curtails the regulatory sine curve and its negative and costly consequences. The regulatory sine curve illustrates rulemaking following financial crises and the inevitable relaxation, retraction, and revision of established rules thereafter. While the sine curve may be inevitable, its costly and suboptimal regulatory effects can be limited. Dynamic regulation as a supplemental optimization process for rulemaking can help curtail the negative effects and regulatory outcomes generated by the sine curve of regulation. The author shows how dynamic elements in financial regulation could help change the relationship between the occurrence and timing of common elements of financial crises and the regulatory sine curve. Including dynamic elements in regulation changes the relationship between the sine curve of financial regulation and common elements of financial crises. The author evaluates these possible changes by depicting the sine curve, with and without dynamic elements, in relation to the phase-shifted first derivative (“cosine curve”), describing common elements of financial crises. As events in the real economy (“cosine curve”) spiral towards financial disaster, the dynamically enhanced regulatory sine curve expands. Accordingly, dynamic elements could facilitate rulemaking when it is most needed—ex-ante before crises—to curtail the effects of crises and suboptimal regulatory outcomes ex-post after crises.
