For a number of years, commentators have noted that securities “reform” legislation seems to be passed only in the wake of major stock market crashes, with this pattern dating back to the South Sea Bubble. Some have argued that this pattern demonstrates the undesirability of such legislation, arguing that laws passed after a market crash are invariably flawed, result in “quack corporate governance” and “bubble laws,” and should be discouraged. Recently, this criticism has been directed at both the Sarbanes-Oxley Act and the Dodd-Frank Act. The forthcoming Cornell Law Review article, The Political Economy of Dodd-Frank: Why Financial Reform Tends to be Frustrated and Systemic Risk Perpetuated, presents a rival perspective. Investors, it argues, are naturally dispersed and poorly organized and so constitute a classic “latent group” (in Mancur Olson’s terminology). Such latent groups tend to be dominated by smaller, but more cohesive and better funded special interest groups in the competition to shape legislation and influence regulatory policy. This domination is interrupted, however, by major crises, which encourage “political entrepreneurs” to bear the transaction costs of organizing latent interest groups to take effective action. But such republican triumphs prove temporary, because, after the crisis subsides, the hegemony of the better organized interest groups is restored.
The problem is not only that the financial services industry has much greater resources than the representatives of investors (e.g., pension funds, unions, and the plaintiff’s bar) and a greater ability to employ those resources after the Citizens United decision, but also (and at least equally) that there is no natural champion for investors with respect to the issue of systemic risk. Even the normal representatives of investors may side with the industry in political contests relating to systemic risk because curtailing systemic risk may reduce lending and adversely affect job creation. Accordingly, systemic risk prevention tends to be a political orphan.
As a result, a persistent cycle that this article calls the “Regulatory Sine Curve” can be observed: the legislative success of the political entrepreneur in enacting the reform legislation is followed by increasingly equivocal implementation of the new legislation, tepid enforcement, and eventual legislative erosion. This article traces that pattern with respect to both the Sarbanes-Oxley Act and the ongoing implementation of the Dodd-Frank Act, where the rules on executive compensation have already been significantly relaxed.
This article does not deny that “reform” legislation often contains flaws (as does much deregulatory legislation). But these are usually quickly eliminated in the latter half of the cycle. The greater dilemma is instead whether the problem of systemic risk can be satisfactorily addressed in the presence of the Regulatory Sine Curve.
The full paper is available for download here.