Becoming the Fifth Branch

M. Todd Henderson is Professor of Law and Aaron Director Teaching Scholar at the University of Chicago Law School, and William A. Birdthistle is Associate Professor of Law and Freehling Scholar at Chicago-Kent College of Law.

In our article Becoming the Fifth Branch, we argue that financial self-regulation has changed dramatically and problematically in the past few years. Financial self-regulatory organizations (SROs), such as FINRA and the Chicago Mercantile Exchange’s regulatory arm, are transforming from “self-regulatory” into “quasi-governmental” organizations. We believe this evolution, moreover, may become a serious problem for the stability and efficiency of our financial system.

To SEC Commissioner Daniel Gallagher’s question, “Is FINRA becoming a ‘deputy SEC?,’” we fear the answer is “yes.” We describe an array of forces that we believe may be driving this change, explain the implications of the loss of true self-regulation, and offer some options for restoring a healthier regulatory balance.

SROs are the primary legislators, regulators, and officers on the beat who monitor our financial system. While corporate theorists tend to focus on Congressional legislation and agency rulemaking, self-regulation is the form of financial governance that most directly governs the daily activities of our financial firms. Nearly one hundred and fifty years before the creation of federal and state securities authorities, the financial industry established its own self-regulatory organizations. The growth of private regulation was initially designed to fill a regulatory void that left brokers unable to signal quality and investors reluctant to participate in the market confidence.

Our story, however, traces the dynamic between private and governmental regulators that has been trending in recent decades towards a more governmental style of self-regulation. Although SROs and public authorities coexisted in a complementary array of informal and formal policing mechanisms for much of the past century, that equilibrium is now breaking apart.

In our article, we describe how SROs have lost much of their independence, grown distant from their industry members, and arrogated rulemaking, enforcement, and adjudicative powers that more closely resemble those of governmental agencies such as the SEC and CFTC. Over the past few decades, for instance, the SEC has won the authority to require SROs to adopt rules of the SEC’s choice, to initiate and approve SRO rules directly, and to force industry members into a minority rump on the board of FINRA. To be governed by a financial SRO today is, in effect, to be subject to the power of an additional branch of government.

We then consider the confluence of forces that might be driving this increasingly governmental shift. We examine, among others, demographic changes in the style and size of retail investments in the securities markets, which might be prompting legislators to impose more direct government oversight over the 401(k) accounts of their constituents; the one-way ratchet effect of high-publicity failures and scandals might be provoking legislators to reduce SRO independence, such as when the MF Global scandal prompted lawmakers of both political parties to urge the CFTC to take the reins from the CME; and the public choice incentives of regulators might be prompting those who run SROs to behave more like SEC officials, if they hope to rise to those positions, as Mary Schapiro rose from her position as CEO of FINRA to Chair of the SEC.

In addition, we call into doubt the efficiency of the tremendous growth of the compliance industry within firms. Applying public choice analyses, we argue that forces at work within financial firms may be guiding regulation into a form that is in the narrow interests of particular interest groups but not necessarily the firms or the financial industry as a whole.

We believe this process by which SROs shed their independence for an increasingly governmental role is highly undesirable from an array of normative viewpoints. For those who are skeptical of governmental regulation, deputizing private bodies to increase governmental involvement is clearly problematic. And for those who believe recent financial problems warrant greater oversight, the elimination of an entire species of regulation impoverishes our regulatory spectrum. We therefore conclude by offering proposals for how to forestall this process.

The full article is available for download here.

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