In their lively disagreement about the role of deregulation in contributing to the 2007-2009 financial crisis, professors Arthur Wilmarth and Paul Mahoney inadvertently illuminate why the processes through which finance is regulated are so ill-suited to that purpose. Finance is dynamic. Today’s financial system bears only a coarse resemblance to the financial system of the 1950s. Tomorrow, the system will evolve yet further and in ways we may not be able to imagine today. In contrast, the legal regime is designed to stagnate. Frictions make statutes and regulations difficult to change, even when market changes have already altered the substantive effects of the current regime. And because regulatory arbitrage contributes to the evolving structure of finance, rules that stay the same tend to be deregulatory in effect.
As I explain in a new piece, “Regulation and Deregulation: The Baseline Challenge,” responding to Professor Mahoney, the mismatch between finance and the mechanisms through which laws are promulgated comes through in the deregulation debate as a disagreement about baseline. Professor Arthur Wilmarth and other advocates of the deregulation hypothesis see the trend toward less stringent bank rules in the years leading up to the crisis and regulators’ failure to stop shadow banking as core causes of the crisis. Professor Paul Mahoney challenges this claim by focusing on the way macroeconomic trends undermined the viability and substantive impact of the earlier regime, making the legal changes second order and reactive to these broader trends. Critical to understanding these very different assessments of whether deregulation was a major factor behind the crisis is a profound disagreement about the balance struck by the original legal regime and hence the range of actions that undermined its efficacy.
To oversimplify, Wilmarth sees the original bargain as a commitment to keep banking boring. Hence mainstays of the pre-crisis system of finance, such as money market funds and large, complex banking organizations ran directly contrary to the original deal. Had we instead kept banks small and boring, the whole fiasco might have been averted. Mahoney, again to simplify, is focused on the content of the rules themselves, and the challenge of mapping the changing substance of those rules onto the extension of risky mortgages and other developments at the core of the crisis. Regardless of where one comes down on this issue, this disagreement matters.
Moreover, this issue is not just about making sense of the last crisis, nor is it just about stability. Consider the opportunities and challenges that fintech currently poses for the future of financial intermediation. Should regulators try to keep innovative new modes of extending credit within banks or outside of banks? Or should they try to shut down those innovations altogether, even if they might expand the pool of borrowers who have access to credit on favorable terms? These are not the questions that Wilmarth or Mahoney purport to be asking, but they are precisely the types of questions that are at stake in their disagreement.
The financial system is structured to change. No matter what rules are adopted at Time A, their substantive effect will often be quite different at Time B. The processes for financial regulation are not well suited to address this dynamic. Laws are difficult to change. And those processes require engagement only when the rules are changed, not when their substantive effect is undermined, changing the option available when lawmakers make it to the table. There is no easy answer to this challenge, but taking it seriously is a critical threshold for both policymakers and academics to understand what went wrong in the past and how best to improve financial regulation in the years ahead.
This post comes to us from Professor Kathryn Judge at Columbia Law School.