Reframing Financial Regulation
This paper has been published in Boston University Law Review, vol. 90, no. 1 (2010). It is available online at: http://scholarship.law.cornell.edu/facpub/42/.
Financial regulation today is largely framed by traditional business categories. The financial markets, however, have begun to bypass those categories, principally over the last thirty years. Chief among the changes has been convergence in the products and services offered by traditional intermediaries and new market entrants, as well as a shift in capital-raising and risk-bearing from traditional intermediation to the capital markets. The result has been the reintroduction of old problems addressed by (but now beyond the reach of) current regulation, and the rise of new problems that reflect change in how capital and financial risk can now be managed and transferred.
Consider the growth of the private credit markets. Risk management is a key function of intermediation and at the heart of financial regulation. Banks and insurance companies, however, can now rely on new capital markets instruments, including credit default swaps, to transfer risk to third parties – in effect, outsourcing risk management to new entrants, like hedge funds, which largely fall outside the current regulatory framework. Among old problems, hedge funds (like banks and other intermediaries) are likely to incur greater risk than is socially optimal, absent regulation or other restraint. New problems include the difficulty of managing risk among a diverse group of capital markets investors. Recent crises involving American International Group (AIG), Bear Stearns, and money market funds tell a similar story.
In this Article, I begin to assess the current U.S. approach to financial regulation, in light of recent changes in the financial system, and offer a tentative way to address gaps in proposals for regulatory reform. Regulators must focus on the principal problems that financial regulation is intended to address – relating to financial stability and risk-taking – without regard to fixed categories, intermediaries, business models, or functions. Doing so, however, requires a prospective assessment of the markets, a different approach from the reactive process that characterizes much of financial regulation today.