Calls to dismantle the legal framework that was developed in response to the financial crisis have begun to multiply and gain momentum. Pursuant to a Trump Administration executive order, the Treasury Department has released a series of reports that undertakes a comprehensive review of existing financial regulations. And in Congress, the proposed Financial CHOICE Act sets forth a roadmap for replacing the Dodd-Frank Act in full. Some of that roadmap was enacted earlier this year with the passage of the Economic Growth, Regulatory Relief, and Consumer Protection Act.
The recent wave of reforms is as much about a change in regulatory philosophy as about technical matters and reflects a wholesale critique of the post-crisis status quo under Dodd-Frank. It is therefore useful to consider how these competing visions for the future of financial regulation measure up by revisiting first principles of legal structure and design. That is the aim of my recent working paper, “Overlapping Legal Rules in Financial Regulation and the Administrative State.”
It argues that the policy debate itself has gotten off track. Despite endless sparring over the need to crack down on Wall Street or to rein in the discretion of unaccountable regulators, what is primarily at stake is the role of “regulatory overlap”—meaning the use of multiple legal interventions to address a common market failure. If there is a unifying theme behind post-crisis policymaking, it is a commitment to maximal regulatory overlap. And if the latest reform proposals are adopted, the most direct outcome would be to unwind that commitment by returning reliance on overlapping rules closer to pre-crisis levels.
The paper proceeds by first developing a conceptual framework for evaluating overlapping rules of all kinds. It then shows how that framework can be applied across a number of specific policy questions in financial regulation and also used to clarify how the overall legal architecture fits together. The same analysis carries broader lessons as well. A close look at how overlapping rules work in the financial system sheds light on the dilemmas that they raise for the regulatory process in general.
Regulatory Overlap After the Financial Crisis
Although references to regulatory overlap are commonplace, they are almost always vague. Usually overlap is seen as a dysfunctional side effect of deeper problems concerning regulatory discretion, intensity, or complexity. Properly understood, however, it represents a unique dimension of regulatory design. The distinguishing feature of overlapping rules is that their function in practice depends on how they interact. From a law-and-economics perspective, that interaction forms two basic categories: regulatory substitutes and regulatory complements. Rules that are substitutes become less effective if used in conjunction, while rules that are complements work better when applied together.
This simple distinction exposes weaknesses on both sides of the debate over the appropriate structure of post-crisis financial regulation. For proponents of the Financial CHOICE Act and other reforms that take a more streamlined approach, the standard move of condemning overlapping rules as duplicative or redundant skips a step. That conclusion only follows for regulations that act as substitutes. When overlapping rules are complements, they generate efficiencies, not redundancies.
Advocates of the multi-faceted arrangement put in place after the crisis run into trouble as well. While it is typically safe to assume that a legal intervention can be justified by a credible showing that it will further some legitimate policy goal, that is not necessarily the case where there is overlap, because the value of introducing a new rule will always be at least partially offset when it is imposed along with a regulatory substitute. Given that the Dodd-Frank Act directs federal agencies to promulgate nearly 400 rules, the failure to account for that scenario is problematic.
One area where these blindspots are most glaring involves capital adequacy requirements, which are the first of the paper’s two case studies. On one hand, the Dodd-Frank Act’s laundry list of stress tests, loss absorbers, and capital buffers has escalated the scale of regulatory overlap past any defensible limit. On the other hand, the Financial CHOICE Act’s signature off-ramp mechanism goes to the opposite extreme by stripping those overlapping rules away until all of capital regulation is reduced to a single leverage ratio. The second case study details how the same pattern appears in the context of resolution authority, where pending reforms such as the Financial Institutions Bankruptcy Act propose to roll back post-crisis rules that were designed to overlap with the bankruptcy process for large non-bank financial institutions.
To a certain extent, the deep divide on regulatory overlap can be seen good news. That is because it turns on abstract considerations that have simply been misunderstood or overlooked rather than on more intractable disputes over the wisdom of regulation versus deregulation or government discretion versus rule-of-law accountability. As the case studies demonstrate, this makes it possible to identify some common ground for incremental policy changes that would make financial regulation work better.
Implications Beyond Finance
Overlapping rules are endemic to many areas of the law, not just finance. This means that a number of the challenges that regulatory overlap raises for financial regulation also carry over to the modern administrative state as a whole. The paper closes by discussing three in particular.
First, the paper’s analysis points to some neglected limitations of cost-benefit analysis, which is often a part of the rulemaking process for financial regulators and other federal agencies. As a practical matter, regulatory costs and benefits are assessed by taking each rule in isolation. That automatically obscures any effect that regulatory overlap may have because, by definition, the impact of overlapping rules depends on how they are combined with other substitutes or complements.
Second, it has implications for the problem of policymaking under uncertainty, a classic issue in finance as well as other areas of administrative law, such as environmental regulation, where risk assessment is central. Here again, it is standard for leading theories to assume away the possibility of regulatory overlap and attempt to identify a single rule or procedure that will perform best under conditions of uncertainty. This overlooks the basic logic of risk diversification, which suggests that the primary response to an uncertain regulatory environment should be a shift toward greater regulatory overlap.
And third, the paper’s framework provides a way to think through the problem of “overlapping agencies,” where multiple decisionmakers have the power to intervene in the same policy area. The fragmented structure of federal regulatory authority is a constant source of controversy that is not limited to finance. Analyzing familiar turf wars between regulators like the SEC and CFTC as a matter of overlapping jurisdictional rules that may function as either substitutes or complements can clarify those debates.
As the example of agency jurisdiction indicates, the problem of regulatory overlap can apply to legal rules in any form. That is because it turns on a basic question which arises in every area of the law but, for whatever reason, is rarely addressed on its own terms: For any given policy issue, when is it better to use two (or more) rules rather than one? The broader contribution of my working paper is to show why post-crisis financial regulation provides fertile ground for making progress in answering that under-appreciated question.
This post comes to us from Matthew C. Turk, assistant professor of business law at Indiana University’s Kelley School of Business. It is based on his recent paper, “Overlapping Legal Rules in Financial Regulation and the Administrative State,” available here.