Law, Bubbles, and Financial Regulation

Five years after the failure of Lehman Brothers, asset price bubbles remain in forefront of the public imagination. Commentators see potential bubbles from Bitcoin to Chinese real estate. Three articles in this week’s edition of the Economist examine whether bubble are afflicting various economies and markets. This year’s Nobel prizes in economics brought to the forefront questions of market efficiency and whether bubbles exist.

My new book, Law, Bubbles, and Financial Regulation, looks at the often overlooked legal dimensions of bubbles. The book examines how market frenzies and regulatory interact in powerful and often destructive ways. (You can read the first chapter of the book, published by Routledge in November, here). Feedback between market and legal dynamics leads to a pernicious outcome: financial regulation can fail when it is needed the most. The dynamics of asset price bubbles weaken financial regulation just as financial markets begin to overheat and the risk of crisis spikes. At the same time, the failure of financial regulations adds further fuel to a bubble.

The book examines the interaction of bubbles and financial regulation through the history of over three centuries of financial frenzies and crises. This perspective reveals that law is crucial to the story of bubbles and that the legal history of the current global crisis has many forerunners. Bubbles involve more than irrational exuberance or low interest rates. Financial law and legal change play critical roles in the severity and consequences of bubbles. The book explores the ways in which bubbles lead to the failure of financial regulation by outlining five dynamics, which it collectively labels the “Regulatory Instability Hypothesis” (with apologies to Hyman Minsky). These five dynamics include:

The regulatory stimulus cycle. As bubbles form and markets boom, policy-makers face increasing pressure to provide regulatory stimulus for financial markets. Policymakers provide this stimulus not only by deregulating financial markets and repealing statutes and regulations, but also by lowering enforcement, providing exemptions to legal rules, and choosing not to apply legal rules to new contexts. In many cases, governments intervene in markets by providing legal preferences, monopolies, and other subsidies to select financial instruments, asset classes, or market participants.

Compliance rot. Bubbles undermine the compliance by market participants with antifraud and other financial rules. Bubbles offer immediate benefits to breaking the law, while pushing expected liability further into the future. Bubbles not only undermine rational deterrence, they also exacerbate behavioral biases and cause market participants to underestimate their liability for violating the law. Moreover, bubbles radically destabilize social norms that reinforce obedience to the law.

Regulatory arbitrage frenzies. Bubbles foster increased gamesmanship of financial regulations by market participants. Bubbles sharpen the creativity of these parties and their appetite for legal risk.

Procyclical regulation. Certain regulations exacerbate boom and bust cycles in financial markets, without policymakers changing legal rules or market participants varying their level of compliance.

Promotion of investment herding. Other legal rules, such as capital requirements, bankruptcy exemptions, and explicit and implicit government guarantees, encourage investors and financial institutions to engage in dangerous herding into particular investments.  This herding can contribute to a bubble’s formation, lead to dangerous correlations of risk in the financial system, and set the stage for bank runs.

These five dynamics become most dangerous when they undermine financial regulations that govern financial institution leverage and the supply of credit. When the five dynamics affect these type of regulations, the feedback between law and markets fuels bubbles, camouflages mistakes in pricing risk, and leaves financial institutions and markets vulnerable to a crash. The current global crisis provided a master class in these five dynamics, as they midwifed the growth of a shadow banking system and shadow banking bubble. The shadow banking bubble, in turn, promoted more regulatory stimulus, compliance rot, regulatory arbitrage frenzies, and investment herding.

My book concludes by outlining approaches to make financial regulation more resilient to these dynamics that undermine financial law. The goal is not to eliminate bubbles; bubbles have proven to be remarkably robust financial phenomena that have occurred throughout financial history and in very different legal environments. Rather the objective should be to give policymakers and regulators the incentives and capacities to regulate financial firms and markets vigorously and to exercise judgment wisely just when markets boom and economic, political, and psychological factors militate against effective regulation. The key question of financial reform is not how to regulate certain securities, derivatives, or financial activities. It is not even what new substantive powers regulators need. Instead, the key question is how to cause policymakers to exercise the powers that they already have at the right moment. Rather than refighting the last war, we need to take a longer term perspective and focus on designing resilient regulatory institutions. Effective financial laws require institutions that adapt to evolving and fluctuating markets and changing political dynamics.