Regulating After Crises

December 22nd, 2011

Roberta Romano has an article titled Regulating in the Dark that talks about financial regulations following financial crises.

Foundational financial legislation is typically adopted in the midst or aftermath of financial crises, when an informed understanding of the causes of the crisis is not yet available. Moreover, financial institutions operate in a dynamic environment of considerable uncertainty, such that legislation enacted even under the best of circumstances can have perverse unintended consequences, and regulatory requirements correct for an initial set of conditions can become inappropriate as economic and technological circumstances change. Furthermore, the stickiness of the status quo in the U.S. political system renders it difficult to revise legislation, even though there may be a consensus to do so. This essay contends that the best means of responding to this dismal state of affairs is to include, as a matter of course, in crisis-driven financial legislation and its implementing regulation two key procedural mechanisms: (1) a requirement of automatic subsequent review and reconsideration of the legislative and regulatory decisions at some future point in time; and (2) regulatory exemptive or waiver powers, that encourage, where feasible, small scale experimentation, as well as flexibility in implementation. Both procedural devices will better inform and calibrate the regulatory apparatus, and could thereby mitigate, at least on the margin, the unintended errors which will invariably accompany financial legislation and rulemaking originating in a crisis. Given the centrality of financial institutions and markets to economic growth and societal well-being, it is exceedingly important for legislators acting in a financial crisis with the best of intentions, to not make matters worse.

From the article:

simple, but telling, comparison of a commonly-used measure of legislative complexity, a statute’s published length, conveys what Congress has wrought. The Sarbanes-Oxley Act of 2002 is 66 pages long and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 is an astounding 848 pages, whereas, the 20th Century foundational federal banking legislation, the Federal Reserve Act and the Glass-Steagall Act, are 24 and 37 pages, respectively (Perry 2010).1

Can you say fatal conceit and black swan?

Rather, the nub of the regulatory problem derives from the fact that financial firms operate in a dynamic environment in which there are many unknowns and unknowables and state of the art knowledge quickly obsolesces. In such a context, even the most informed regulatory response – which Congress’s reaction in the recent crises was not – will be prone to error, and is likely to produce backward-looking regulation that takes aim at yesterday’s perceived problem, rather than tomorrow’s, for regulators necessarily operate under considerable uncertainty and at a lag behind private actors. But using market actors’ superior knowledge to inform regulation is not necessarily an effective solution, as indicated by the utter failure in the recent crisis of Basel

II, which relied on banks’ internal risk ratings to measure capital requirements. This only further highlights the fluid, fast-moving, and uncertain environment in which financial institutions operate – even firms’ state of the art risk management techniques proved inadequate in the confluence of events that produced the global financial crisis.

In order to understand financial regulation undertaken in a crisis, we need to take account, as Frank Knight (1965:270) put it, of “human nature as we know it.” Human nature in this context is that legislators will find it impossible to not respond to a financial crisis by “doing something,” that is, by ratchetting up regulation, instead of waiting until a consensus understanding of what has occurred can be secured and a targeted solution then crafted, despite the considerable informational advantage from such an approach, which would, no doubt, improve the quality of decisionmaking.

This is somewhat similar to my thinking about repeal provisions for black swan laws:

This essay contends that the best means of responding to the typical pattern of financial regulation – legislating in a crisis atmosphere under conditions of substantial uncertainty followed by status quo stickiness – is for Congress and regulators to include as a matter of course in financial legislation and regulation enacted in the midst or aftermath of a financial crisis, procedural mechanisms that require automatic subsequent review and reconsideration of those

decisions, along with regulatory exemptive or waiver powers that create flexibility in implementation and encourage, where possible, small scale, discrete experimentation to better inform and calibrate the regulatory apparatus. Such an approach, in my judgment, could mitigate, at least at the margin, errors which invariably accompany financial legislation and rulemaking originating in a crisis atmosphere. Given the fragility of financial institutions and markets, and their centrality to economic growth and societal well-being, this is an area in which it is exceedingly important for legislators acting in a crisis with the best of intentions, to not make matters worse.

Ribstein blogs:

It’s worth noting that Henry Butler and I, in our book about SOX (at 96-97, footnotes omitted), also suggested “sunset” provisions as an antidote to crisis-driven regulation:

[S]ignificant new financial and governance regulation like SOX that displaces and supplements prior regulatory approaches should be subject to periodic review and sunset provisions. Although Congress, of course, can always undertake such reviews, prior experience indicates that it will not. Legislation is a one-way regulatory ratchet. It arises when the conditions for reform are ripe for a regulatory panic. The conditions for a “deregulatory panic” are less likely to develop. Firms learn to live with the extra costs and may not be willing or able to bear the costs of lobbying for repeal, at least in the absence of a regulatory cataclysm. Thus, it is not surprising that SOX sponsor Michael Oxley, despite recognizing that SOX was “excessive” in some respects, and admitting that it had been rushed through Congress, suggested that Congress would not be revisiting the issue, even as to the seriously affected small companies. He said, “If I had another crack at it I would have provided a bit more flexibility for small- and medium-sized companies.” In other words, Congress normally does not have “another crack” at regulation. A sunset or review mechanism would change that.

Perhaps Congress can learn some lessons from itself. The USA Patriot Act was passed less than one year before SOX and, like SOX, was passed by an overwhelming majority. Unlike SOX, the USA Patriot Act includes sunset provisions for some of its most controversial provisions. The Patriot Act’s sunset provision forced Congress and the president to reevaluate and debate those provisions, in an atmosphere far  removed from the immediate post-9/11 panic. American investors would benefit from a sober reevaluation of SOX. Perhaps the courts will provide that opportunity. For future regulatory panics, Congress would do well to remember the lessons of the Patriot Act.

Update: Leiter links to excerpts from Coffee’s paper:

Professor Romano has her loyal allies.[1] Together, they comprise what might be called the “Tea Party Caucus” of corporate and securities law professors, and their key themes are: (1) Congress should not legislate after a market crash, because the result will be a “Bubble Law” that crudely overregulates,[2] (2) state laws are superior to federal law in regulating corporate governance, because the states are restrained by the competitive pressure of the market for corporate charters; and (3) federal securities law should limit itself to disclosure (at most) and not attempt substantive regulation of corporate governance.[3] The underlying theory here comes very close to asserting that democracy is bad for corporate efficiency, and thus legislative inertia should be encouraged.


[1] See Stephen M. Bainbridge, THE COMPLETE GUIDE TO SARBANES-OXLEY: UNDERSTANDING HOW SARBANES-OXLEY AFFECTS YOUR BUSINESS (2006); Henry N. Butler & Larry E. Ribstein, THE SARBANES-OXLEY DEBACLE: WHAT WE’VE LEARNED; HOW TO FIX IT (2006); Stephen N. Bainbridge, Sarbanes-Oxley: Legislating in Haste, Repenting in Leisure, 2 Corp. Governance L. Rev. 69 (2006); Larry E. Ribstein, Sarbox: The Road to Nirvana, 2004 Mich. St. L. Rev. 279 (2004); Larry E. Ribstein, Bubble Laws, 40 Hous. L. Rev. 77 (2003-2004); Larry E. Ribstein, International Implications of Sarbanes-Oxley: Raising the Rent on U.S. Law, 3 J. Corp. L. Stud. 299 (2003); Larry E. Ribstein, Markets v. Regulatory Responses to Corporate Fraud: A Critique of the Sarbanes-Oxley Act of 2002, 28 J. Corp. L. (2002-2003); Larry E. Ribstein, Sarbanes-Oxley After Three Years, 2005 N.Z.L. Rev. 365 (2005).


Although these authors do not tire of criticizing SOX, they have not convinced others. Reviewing the same economic evidence, Professor John C. Coates finds it harder to balance the costs and benefits of SOX and generally takes a more balanced position. John C. Coates, The Goals and Promises of the Sarbanes-Oxley Act, 21 J. Econ. Perspectives 91 (2007). Viewing SOX in a less economic light, Professor Donald Langevoort sees SOX as reflecting a shift by Congress from an exclusively contractarian perspective to a more trust-based conception of the corporation. See Donald Langevoort, The Social Construction of Sarbanes-Oxley, 105 Mich. L. Rev. 1817, 1828-1833 (2007).


[2] Both Professors Bainbridge and Ribstein regularly use the term “Bubble Law” to refer to federal legislation adopted in the wake of a crash that tends to displace state corporate law. See Ribstein, Bubble Laws, supra note 13, and Bainbridge, Dodd-Frank: Quack Corporate Governance Round II, 95 Minn. L. Rev. 1779 (2011).


[3] Professor Romano has argued that the federal securities laws had historically avoided substantive regulation of corporate behavior, staying safely “within a disclosure regime.” See Roberta Romano, Does the Sarbanes-Oxley Act Have a Future?, 26 Yale J. on Reg. 229, 231 (2009). The distinctive failure of SOX in her view “is its break with the historic federal regulatory approach of requiring disclosure and leaving substantive governance rules to the states’ corporation codes.” Id. at 232. This is a dubious historical generalization. Although the Securities Act of 1933 and the Securities Exchange Act of 1934 do utilize disclosure as their preferred tool, the federal securities laws have frequently regulated substantive corporate conduct and governance. At the time, the most controversial federal securities statute of the 1930s was the Public Utility Holding Company Act of 1935, which imposed a “death sentence” on public utility pyramids and holding company structures – clearly an example of aggressive substantive regulation. See J. Seligman, supra note 2, at 122-23 (describing the Public Utility Holding Company Act as “the most radical reform measure of the Roosevelt Administration”). Similarly, the Investment Company Act of 1940 regulates the board structure of investment companies; initially, it required a minimum 40% of each investment company’s board be composed of disinterested directors (Id. at 228-229), and it also compels them to hold a diversified portfolio and not sell securities “short” – again substantive regulation. More recently, the Foreign Corrupt Practices Act required stronger internal controls over financial reporting (as Professor Romano acknowledges). See Romano, supra, at 231. Thus, SOX was hardly a break with a past in which the federal securities laws only required full disclosure.