The Return of CDOs – Do We Need Dynamic Elements in Financial Regulation?

Despite the role of collateralized debt obligations (CDOs) in the financial crisis of 2007-08, CDOs and other high risk investment products may soon be available again and are likely to proliferate.  The WSJ reports that  J.P. Morgan Chase and Morgan Stanley bankers are assembling synthetic CDOs to satisfy demand for structured products by investors who seek high returns amid low interest rates. This development is not a surprise.  Wall Street will continue to create new, increasingly complex, and riskier financial instruments to capitalize on market demand for such products.

Stable and presumptively optimal rules cannot keep pace with market developments and financial innovation. The economic conditions and the corresponding requirements for optimal and stable rules are constantly evolving, suggesting that a different set of rules could be optimal.  Despite the risk of future crises, anticipation of future developments and preemption of future crises do not play a significant role in the regulatory framework and academic literature.

Dynamic elements in financial regulation as a supplemental optimization process for rulemaking could help facilitate rulemaking when it is most needed – ex-ante before crises – to curtail the effects of crises and suboptimal regulatory outcomes – ex-post after crises.

The concept of dynamic financial regulation describes the study of financial regulatory phenomena in relation to preceding and succeeding events.  Rulemaking is no longer a mere reactive process based only on preceding events and driven by the collective action problem of rulemaking. Rather, rulemaking in a dynamic framework increasingly utilizes institution specific and decentralized information reflecting preceding events and attempting to anticipate succeeding future contingencies.

Rulemaking with dynamic elements increases the adaptive capabilities of financial regulation through the increasing use of institution specific information. This may include information on the functioning of financial institutions and financial products. Information pertaining to how financial institutions, or decision makers in financial institutions, actually act and how they are expected to react to unforeseen contingencies can help incorporate dynamic elements into financial regulation.

Dynamic elements in financial regulation could help support regulators in their efforts to continually adapt to new market environments, financial innovation, and to the given regulatory environment. Dynamic elements in financial regulation may also support regulators in anticipating changes and adapt stable rules accordingly.

To improve quality and sustainability of legal rules, dynamic regulation may facilitate experimentation with different combinations of stable and dynamic elements in rulemaking. Experimentation with different combinations of regulatory approaches can be effective when several different approaches can be tried simultaneously. A mixture of market solutions, private ordering, and mandatory rules could help increase adaptive capabilities of rulemaking.  These dynamic changes in rulemaking could help create a governance mechanism that is constantly adapting to the given market environment, financial innovation, and the given regulatory environment.

Dynamic regulation is not just a theoretical concept. Several governance mechanisms with dynamic elements combined with existing stable and presumptively optimal rules could become part of a dynamic optimization and supplementation process for rulemaking.  Institution specific rules could be facilitated through the increasing use of institution specific information and private ordering. Contingent Capital Securities, Corporate Integrity Agreements, and Deferred Prosecution Agreements are among the governance mechanisms that can provide institutions specific information for financial rulemaking.

The return of the CDO market and the proliferation of high risk structured products could justify considering dynamic elements in financial regulation.

For more details see:

Evolution of Law: Dynamic Regulation in a New Institutional Economics Framework – Festschrift in Honor of Christian Kirchner

Dynamic Regulation of the Financial Services Industry – Wake Forest Law Review 

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  1. June 24th, 2013

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