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E-MailThe following post comes to us from Iman Anabtawi, Professor of Law at UCLA School of Law, and Steven L. Schwarcz, Stanley A. Star Professor of Law & Business at Duke University School of Law and Founding/Co-Academic Director of Duke Global Capital Markets Center.
In our forthcoming article, Regulating Ex Post: How Law Can Address the Inevitability of Financial Failure, 92 Texas Law Review (2013), we observe that, unlike many other areas of regulation, financial regulation operates in the context of a complex interdependent system. This, we argue, has implications for financial regulatory policy, especially the choice between ex ante regulation aimed at preventing financial failures and ex post regulation aimed at responding to those failures.
Our article begins by considering the nature of systems and the usefulness of systems analysis as a methodology for studying law. Law-related systems are systems in which the law is an integral element. The financial system can be viewed as a complex network in which financial firms interact directly and indirectly (through markets) against the background of legal rules.
Like any system, the financial system’s behavior depends on its structure—the relationships among its elements. The financial system’s structure, we demonstrate, possesses the characteristics of a high-risk system. High-risk systems are accident prone. They tend to experience long periods of stability and occasional, catastrophic failures. Such behavior has important implications for financial regulation: even assuming that comprehensive ex ante regulation could survive the political opposition of the financial services industry, it is unrealistic to believe that it could prevent all financial crises. Nor, we argue, should it because of the dangers of over-regulation and regulatory arbitrage.
Financial regulation should therefore be designed to operate ex post as well as ex ante. By ex post, we mean financial regulation aimed at mitigating the systemic consequences of localized financial failures. Ex ante versus ex post debates have traditionally been associated with the question whether the law should be given content before harmful conduct has occurred, such as in the case of “bright-line rules,” or afterwards, such as in the case of “flexible standards.” An ex ante versus ex post distinction that turns on conduct is meaningful when deterrence is the law’s primary aim. In a law-related system, however, regulation can operate not only to prevent harmful conduct but also to mitigate the harmful consequences that flow from that conduct. As a result, law has a role to play even after harmful conduct has taken place.
We offer two types of ex post regulatory strategies for mitigating the systemic consequences of a localized financial shock. The first, creating financial safety nets, operates on the elements of the financial system. Financial safety nets are designed to absorb losses of a financial firm or market that has begun failing. The second, disrupting the transmission of systemic risk, operates on the financial system’s interconnections. Both types of intervention can mitigate the spread and severity of a financial failure.
Ex post financial regulatory strategies confront legitimate criticisms, including concerns about moral hazard, taxpayer burden, the danger of unnecessary rescues, and inefficiencies that are often associated with bailouts. For these reasons, the Dodd-Frank Act’s underpinnings reflect a strong ex ante financial regulatory bias, as reflected, for example, by its limit on the Federal Reserve’s authority to act as a lender of last resort to systemically important financial institutions. Our article discusses these criticisms and responds to them, arguing that the potential costs of ex post financial regulation can be managed and are outweighed by its potential benefits of enhancing the financial system’s stability.
Acknowledging the importance of both ex ante and ex post measures in regulating systemic risk is only the first step toward safeguarding the financial system. Regulators must further decide how to balance the two approaches. To that end, our article suggests guidelines for selecting an appropriate mix of ex ante and ex post regulatory strategies for safeguarding the financial system, with the goal of encouraging prudent, while discouraging reckless, risk-taking.
The full article is available for download here.
