Cycles and Romance in Financial Law

Here is my fourth contribution to the Faculty Lounge Online Forum on the legislative and regulatory process of financial reform. Check out the posts by the other contributors including, Kim Krawiec (Duke), Cristie Ford (Univ. British Columbia), Brett McDonnell (Minnesota), Saule Omarova (North Carolina), and Dan Schwarcz (Minnesota). Thank you to Dan for questioning my argument that the political economy of financial institution regulation is different. I agree whole heartedly that there are other areas of law — like environmental law — in which a concentrated industry can externalize cost onto a diffuse public. But there are still crucial differences between the political economy of environmental law and the political economy of financial institution regulation: First, the negative externalities in financial institutions are more closely coupled with the very services that the public demands. We want financial institutions to take risks, extend credit, and provide capital. Too much of these good things, however, can put the government safety net into play. In environmental law by contrast, there is a tradeoff between positives (jobs) and negatives (pollution). No one wants dioxin. It is possible that technological advances or Coasean bargains can mean we can have more jobs without more pollution. But if financial markets are even somewhat efficient, it is hard to have more reward without more risk taking. Second, financial markets are subject to cycles. It is when the political cycle becomes too closely coupled with the financial cycle that we need to be most concerned. Booming financial markets can contribute to disaster myopia among regulators and herd behavior by financial institutions and investors. I looked at the interactions between market cycles and regulatory cycles a few years ago and am exploring them much more in my book. Perhaps similar cycles and feedback loops exist in other regulatory areas (if readers have thoughts on this, please e-mail me), but financial markets makes the feedback stronger. Third, let's talk romance. In environmental law, there is at least a semblance of interest group pluralism because environmental groups are deeply and ideologically committed to defending wildlife, protecting natural spaces, and fighting pollution. Financial regulation doesn't have that same civil society. Claire Kelly has written very creatively about the possible role of civil society in financial regulation. But where is the motivation for people to participate? Where is the ideology? Where is the romance? I am not being facetious. Earlier in the summer, we had dinner with environmentalist friends who described how they met and fell in love in the "movement." Where is the "movement" in our field? (Granted my future wife thought it was cute when I was reading Against the Gods before we were dating, but still…) Moreover, I think "insurance" regulation differs somewhat from "banking." When I pressed you a few years ago, you said that (bond insurance and credit derivatives aside) insurance didn't raise the same systemic risks that banking did. So I think there is less incentive for firms to externalize the cost of their failure on taxpayers (AIG is different, because it involved insuring financial products). That of course doesn't diminish the possibility that "Joe the Plummer" will get screwed when he purchases his life insurance.

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