Columbia Law School Scholarship Archive Faculty Scholarship Faculty Publications 2020 Why Financial Regulation Keeps Falling Short Dan Awrey Cornell Law School, [email protected] Kathryn Judge Columbia Law School, [email protected] Follow this and additional works at: https://scholarship.law.columbia.edu/faculty_scholarship Part of the Administrative Law Commons, Banking and Finance Law Commons, and the Law and Economics Commons Recommended Citation Dan Awrey & Kathryn Judge, Why Financial Regulation Keeps Falling Short, BOSTON COLLEGE LAW REVIEW, VOL. 61, P. 2295, 2020; LAW SCHOOL LEGAL STUDIES RESEARCH PAPER NO. 20-03; EUROPEAN CORPORATE GOVERNANCE INSTITUTE (ECGI) LAW WORKING PAPER NO. 494/202; COLUMBIA LAW & ECONOMICS WORKING PAPER NO. 617 (2020). Available at: https://scholarship.law.columbia.edu/faculty_scholarship/2604 This Working Paper is brought to you for free and open access by the Faculty Publications at Scholarship Archive. It has been accepted for inclusion in Faculty Scholarship by an authorized administrator of Scholarship Archive. For more information, please contact [email protected]. Why Financial Regulation Keeps Falling Short Law Working Paper N° 494/2020 Dan Awrey February 2020 Cornell University and ECGI Kathryn Judge Columbia University and ECGI © Dan Awrey and Kathryn Judge 2020. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permis- sion provided that full credit, including © notice, is given to the source. This paper can be downloaded without charge from: http://ssrn.com/abstract_id=3530056 https://ecgi.global/content/working-papers Electronic copy available at: https://ssrn.com/abstract=3530056 ECGI Working Paper Series in Law Why Financial Regulation Keeps Falling Short Working Paper N° 494/2020 February 2020 Dan Awrey Kathryn Judge © Dan Awrey and Kathryn Judge 2020. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source. Electronic copy available at: https://ssrn.com/abstract=3530056 Abstract This article argues that there is a fundamental mismatch between the nature of finance and current approaches to financial regulation. Today’s financial system is a dynamic and complex ecosystem. For these and other reasons, policy makers and market actors regularly have only a fraction of the information that may be pertinent to decisions they are making. The processes governing financial regulation, however, implicitly assume a high degree of knowability, stability, and predictability. Through two case studies and other examples, this article examines how this mismatch undermines financial stability and other policy aims. This examination further reveals that the procedural rules meant to promote accountability and legitimacy often fail to further either end. They result instead in excessive expenditures before new rules are adopted, counterproductive efforts to perfect ever more detailed rules, and too little re-evaluation of existing rules in light of new information or changed circumstances. The mismatch between the nature of finance and how finance is regulated helps to explain why financial regulation has failed in the past and why it will likely fail again. It also suggests the need for a new approach to financial regulation, one that acknowledges the limits of what can be known given the realities of today’s complex and constantly evolving financial ecosystem. Keywords: Financial regulation, financial stability, bank regulation, money market regula- tion, administrative law, experimentalism, dynamism, complexity JEL Classifications: G2, K2 Dan Awrey* Professor of Law Cornell University, Cornell Law School 312 Myron Taylor Hall, Cornell Law School, Ithaca, NY 14853, United States phone: + 1 607 882 1443 e-mail: [email protected] Kathryn Judge Harvey J. Goldschmid Professor of Law Columbia University, Columbia Law School 435 West 116th Street New York, NY 10027, United States phone: +1 212 854 5243 e-mail: [email protected] Electronic copy available at: https://ssrn.com/abstract=3530056 CORNELL LAW SCHOOL LEGAL STUDIES RESEARCH PAPER SERIES Why Financial Regulation Keeps Falling Short Dan Awrey & Kathryn Judge* Cornell Law School Myron Taylor Hall Ithaca, NY 14853-4901 Cornell Law School research paper No. 20-03 *Harvey J. Goldschmid Professor of Law, Columbia Law School This paper can be downloaded without charge from: The Social Science Research Network Electronic Paper Collection: http://ssrn.com/abstract=3530056 Electronic copy available at: https://ssrn.com/abstract=3530056 Why Financial Regulation Keeps Falling Short Dan Awrey* & Kathryn Judge** This article argues that there is a fundamental mismatch between the nature of finance and current approaches to financial regulation. Today’s financial system is a dynamic and complex ecosystem. For these and other reasons, policy makers and market actors regularly have only a fraction of the information that may be pertinent to decisions they are making. The processes governing financial regulation, however, implicitly assume a high degree of knowability, stability, and predictability. Through two case studies and other examples, this article examines how this mismatch undermines financial stability and other policy aims. This examination further reveals that the procedural rules meant to promote accountability and legitimacy often fail to further either end. They result instead in excessive expenditures before new rules are adopted, counterproductive efforts to perfect ever more detailed rules, and too little re-evaluation of existing rules in light of new information or changed circumstances. The mismatch between the nature of finance and how finance is regulated helps to explain why financial regulation has failed in the past and why it will likely fail again. It also suggests the need for a new approach to financial regulation, one that acknowledges the limits of what can be known given the realities of today’s complex and constantly evolving financial ecosystem. * Professor of Law, Cornell Law School. ** Harvey J. Goldschmid Professor of Law, Columbia Law School. 1 Electronic copy available at: https://ssrn.com/abstract=3530056 Table of Contents Introduction ............................................................................................................................. 3 I. The Nature of Modern Finance ...................................................................................... 7 a. Dynamism .................................................................................................................... 7 i. The cyclical nature of finance .................................................................................. 7 ii. Regulatory endogeneity ........................................................................................... 8 iii. Innovation ................................................................................................................ 9 iv. Radical change ....................................................................................................... 11 b. Complexity ................................................................................................................. 12 c. Unknowns .................................................................................................................. 13 II. How Finance is Regulated ............................................................................................. 15 a. International Financial Regulation ............................................................................ 15 b. Statutes ....................................................................................................................... 16 c. Rulemaking ................................................................................................................ 18 d. Supervision ................................................................................................................. 20 e. Where does this leave us? ........................................................................................... 21 III. Financial Regulation in Practice ................................................................................ 22 a. Money market mutual fund reform ........................................................................... 22 b. The Basel capital and liquidity requirements ............................................................ 28 c. Broadening the lens .................................................................................................... 34 IV. Some Progress ............................................................................................................ 36 a. Reforms Underway ...................................................................................................... 37 i. Harnessing New Technology and Data Standardization ........................................... 37 ii. Stress Testing ............................................................................................................. 38 b. Proposals for Further Reform ........................................................................................ 40 i. Automatic Sunset Clauses ........................................................................................ 41 ii. Experimentalism and Experimentation ................................................................... 42