A common denominator of regulatory responses to crises is the use of stable and presumptively optimal rules. The term “stable and presumptively optimal rules” refers to rules that, once in place, do not change other than through other rules and Acts of Congress. Congress, financial regulators, and the literature on financial regulation rely almost exclusively on such rules. However, the economic conditions and the corresponding requirements for optimal and stable rules are constantly evolving, suggesting that different sets of rules could be optimal – in contrast with previous expectations. This has played out in the reaction to the financial crisis. Congress made adjustments via stable rules. Later, these were followed by relaxation, revisions, and retractions. The resulting regulatory cycle has been costly and has produced suboptimal regulatory outcomes. Jack Coffee refers to this phenomenon as the “regulatory sine curve” (see here and here). The regulatory sine curve results in merely reactive financial regulation in response to financial crises. However, effective rules can only mitigate the effects of future crises if they are instituted before financial crises occur.
Exclusive reliance on stable and presumptively optimal rules may not be able to adequately address future challenges. A preferable solution would address the downsides of the regulatory sine curve. While some form of a regulatory sine curve may be inevitable, the outcomes of regulatory cycles could be dampened with dynamic elements in financial regulation. The phrase “dynamic elements in financial regulation” refers to regulatory mechanisms that (i) increase the availability of decentralized and institution specific information for rulemaking, (ii) create feedback effects between public and between private rule makers, and (iii) encourage cooperation between public and between private rule makers. Dynamic regulation as a supplemental optimization process could help create a governance mechanism that is constantly evolving and adapting to the respective market environment, financial innovation, and the given regulatory environment. Dynamic elements in financial regulation could help facilitate effective rulemaking when it is most needed – ex-ante before crises – to curtail the effects of crises and suboptimal regulatory outcomes – ex-post after crises.
Dynamic regulation can be more than a theoretical concept. Although the implementation of dynamic elements in regulatory structures is uncertain, some promising regulatory tools with dynamic elements already exist. These include contingent capital securities (CoCos), corporate integrity agreements (CIAs), and deferred prosecution agreements (DPAs). If combined with stable and presumptively optimal rules in the existing regulatory framework and rulemaking processes, these governance mechanisms, among others, could become part of a dynamic optimization and supplementation process for rulemaking.
CoCos are debt securities that convert into equity or are written down upon a triggering event. Although it is unclear how effective CoCo triggers may be implemented, some trigger designs, if appropriately implemented, could help assess the risk of institution specific credit expansion, among other indicators, before financial crises. Similarly see Jack Coffee’s piece here. I have commented on the use of contingent capital in corporate governance in two prior articles: here and here. Because CoCos could help signal the institution specific need for regulatory action even before the trigger occurs, rule makers may be able to act with more institution specific information and draw conclusions as to whether stable rulemaking is needed for the market segment in which the affected entities operate. CoCo issuances with institution-specific automatic triggers could thus help facilitate dynamic elements in the rulemaking process and increase the adaptability of rules.
DPAs and CIAs allow financial institutions to negotiate cooperative settlements with prosecutors. DPAs and CIAs, among other forms of regulatory cooperation, may be able to provide institution specific information for the rulemaking process. With the institution specific and decentralized information generated by DPAs and CIAs, regulators may be able to better understand shortcomings in a particular market segment or industry. Rulemaking can, thus, be more narrowly tailored and adjusted to the specific circumstances of the respective institution, industry, or market segment. With the increased availability of reliable institution specific information, rules could become more adaptable over time. DPAs and CIAs could also lead to increased feedback effects between the affected entities, the markets or market segments in which they operate, and regulators. Increased institution specific information and feedback effects could help facilitate cooperation between regulators, between regulators and financial institutions, and between regulators and the public.
If more broadly applied to financial institutions, DPAs and CIAs could help increase the adaptive capabilities of financial regulation. The threat of heightened scrutiny for institutions subject to a DPA/CIA may help optimize incentives because financial institutions would be subjected to increased monitoring by government regulators only after a first time offense had occurred. Financial institutions would have incentives to comply with governance requirements and self-regulate to avoid being subjected to increased monitoring and continuous heightened government scrutiny. Once a DPA/CIA is in place, the increased scrutiny by the government for institutions that operate under a DPA/CIA can provide enhanced institution specific information for regulators that would otherwise not be available. With more institution specific information available, regulators can improve their understanding as to when institution specific regulatory action may be needed and how it may be adequately implemented. Regulators can draw conclusions as to whether stable rulemaking is needed for the particular market segment in which the affected institutions operate. DPAs and CIAs may thus help increase the adaptability of rules and facilitate dynamic elements in the rulemaking process.