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Dynamic Regulation of the Financial Services Industry
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# 金 UNIVERSITY of ST.THOMAS MINNESOTA
**SCHOOL OF LAW**
**Legal Studies Research Paper Series**
## **DYNAMIC REGULATION OF THE FINANCIAL SERVICES INDUSTRY**
**Wake Forest Law Review(forthcoming 2014)**
### **Wulf A. Kaal Associate Professor of Law**
#### **University of St. Thomas School of Law Legal Studies Research Paper No. 13-24**
This paper can be downloaded without charge from The Social Science Research Network electronic library at: http://papers.ssrn.com/abstract=2273857
A complete list of University of St. Thomas School of Law Research Papers can be found at: http://www.ssrn.com/link/st-thomas-legal-studies.html
DYNAMIC REGULATION OF THE FINANCIAL SERVICES INDUSTRY
DYNAMIC REGULATION OF THE FINANCIAL SERVICES INDUSTRY
_Forthcoming Wake Forest Law Review_
> * Associate Professor, University of Saint Thomas School of Law (Minneapolis). The author would like to thank Alan Palmiter and the participants at the Spring 2013 Wake Forest Law Review Symposium for helpful comments. He is also grateful to research librarian Valerie Aggerbeck for outstanding support.
DYNAMIC REGULATION OF THE FINANCIAL SERVICES INDUSTRY
# ABSTRACT
Governance adjustments via stable rules in reaction to financial crises are inevitably followed by relaxation, revision, and retraction. 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 possible 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. By including dynamic elements, the regulatory sine curve of financial regulation could be optimized in relation to the phase-shifted first derivative (cosine curve) that describes common elements of financial crises. Dynamic regulation could help dampen the degree of volatility of both the cosine curve and the regulatory sine curve by creating an anticipatory regulatory response to financial crises.
DYNAMIC REGULATION OF THE FINANCIAL SERVICES INDUSTRY
# TABLE OF CONTENTS
|I.<br>I|NTRODUCTION............................................................................................................................................... 4|
|---|---|
|II.|THEPOLITICALECONOMY OFFINANCIALREGULATION............................................................. 10|
|1.|_Common Denominators of Financial Crises .................................................................................... 11_|
|_2._|_Regulatory Sine Curve ............................................................................................................................... 14_|
||a)<br>Expansion...................................................................................................................................................................................... 14|
||b)<br>Contraction................................................................................................................................................................................... 15|
|_3._|_Financial Crises and the Regulatory Sine Curve ........................................................................... 19_|
|III.|DYNAMICREGULATION OF THEFINANCIALSERVICESINDUSTRY......................................... 20|
|_1._|_Rulemaking with Dynamic Elements ................................................................................................... 22_|
|_2._|_Optimizing the Regulatory Sine Curve................................................................................................ 23_|
||a)<br>Trailing Sine Curve................................................................................................................................................................... 24|
||b)<br>Anticipatory Sine Curve.......................................................................................................................................................... 25|
|IV.|IMPLEMENTATION................................................................................................................................... 26|
|V.|CONCLUSION.............................................................................................................................................. 29|
DYNAMIC REGULATION OF THE FINANCIAL SERVICES INDUSTRY
# **I. Introduction**
Much of the theoretical work on financial stability of the last several years suggests that financial instability is endogenous to the financial system. The Office of Financial Research (OFR) reports that the financial crisis of 2007 "served as a painful reminder that the financial system is prone to internal instability."<sup>1</sup> Policy makers have and continue to struggle with determining financial fluctuations and shocks and the role the government and regulation can play in making financial institutions less disruptive.<sup>2</sup> Academics debate what kind of limits should be imposed on financial institutions to curtail the propensity of the financial industry to careen towards disaster.<sup>3</sup> The predominant approach in most jurisdictions entails tightening financial regulation, requiring banks to raise more capital, and applying stricter rules to larger and potentially systemically significant financial institutions.<sup>4</sup> There is no consensus on the kind of institutions that may be needed to adequately monitor and temper the financial industry.<sup>5</sup> There is also no broad agreement on the appropriate level of intensity for rules governing financial institutions.<sup>6</sup>
> 1 OFFICE OF FIN. RESEARCH, U.S. DEP’T OF THE TREASURY, 2012 ANNUAL REPORT 1 (2012) (defining financial stability as "[a] financial system [that] is operating sufficiently to provide its basic functions for the economy even under stress.").
> 2 Eduardo Porter, _Economist Agree: Solutions are Elusive_ , N.Y. TIMES, Apr. 24, 2013, at B1& B6 ("We don't have a clue of what financial stability actually means." (quoting Oliver Blanchard, chief economist of monetary fund)).
> 3 John C. Coffee, Jr., _The Political Economy of Dodd-Frank: Why Financial Reform Tends to Be Frustrated and Systemic Risk Perpetuated_ , 97 CORNELL L. REV. 1019 (2012); JILL M. HENDRICKSON, REGULATION AND INSTABILITY IN U.S. COMMERCIAL BANKING: A HISTORY OF CRISES (2011); MARKUS BRUNNERMEIR ET AL. THE FUNDAMENTAL PRINCIPLES OF FINANCIAL REGULATION: GENEVA REPORTS ON THE WORLD ECONOMY 11(2009); Gary Gorton and Andrew Metrick, _Regulating the Shadow Banking System_ , 41 BROOKINGS PAPERS ON ECON. ACTIVITY261 (2010); Nicola Gennaioli, Andrei Shleifer, & Robert W. Vishny, _Neglected Risks, Financial Innovation, and Financial Fragility_ , 104 J. FIN. ECON.452 (2012); PERRY MEHRLING, THE NEW LOMBARD STREET (2011); Jean Tirole, _Illiquidity and All Its Friends_ , 49 J. ECON. LIT. 287 (2011); CHARLES KINDLEBERGER & ROBERT ALIBER, MANIAS, PANICS AND CRASHES: A HISTORY OF FINANCIAL CRISES (2011); CHRIS BRUMMER, SOFT LAW AND THE GLOBAL FINANCIAL SYSTEMS (2012); Andreas F. Lowenfeld, _The International Monetary System: A Look Back Over Seven Decades_ , 13 J. INT’L ECON. L. 575, 594-595 (2010); ANDERS LUND, PETERSON INST. INT’L ECON., POL’Y BRIEF NO. PB11-9, LESSONS FROM THE EAST EUROPEAN FINANCIAL CRISIS, 2008-10, (2011).
> 4 U.S.DEP’T OF THE TREASURY, FINANCIAL REGULATORY REFORM: A NEW FOUNDATION: REBUILDING FINANCIAL SUPERVISION AND REGULATION (2009), _available at_
http://www.treasury.gov/initiatives/Documents/FinalReport_web.pdf; _Getting a Grip: How Financial Regulation Is Being Tightened_ , GUARDIAN, June 18, 2009,
http://www.guardian.co.uk/business/2009/jun/18/financial-regulation-america-uk-europe; Patrick Jenkins & Brooke Masters, _RBS and Lloyds to Raise Extra £9bn_ , FIN. TIMES, Mar. 27, 2013 (“The FPC, which is charged with spotting and defusing threats to the financial system, said supervisors should also consider even higher capital requirements for banks with concentrated exposures to risky areas or large trading books.”).
> 5 Porter, _supra_ note 2.
> 6 Howell E. Jackson, _Variation in the Intensity of Financial Regulation: Preliminary Evidence and Potential Implications_ , 24 YALE J. ON REG. 253 (2007) (“Compared to at least the United Kingdom and Germany, the intensity of securities enforcement actions in the United States appears to be strikingly higher. Not only are there more financial regulators in the United States, but they also carry bigger sticks than their foreign counterparts. While the laws on the books may be converging, the level of enforcement efforts seems to vary widely across national boundaries and even within regions such as Europe.“)
DYNAMIC REGULATION OF THE FINANCIAL SERVICES INDUSTRY
Financial regulation is usually enacted in the aftermath of financial crises.<sup>7</sup> Reinhart and Rogoff have demonstrated that bank crises are and will likely continue to be an integral part of economic cycles.<sup>8</sup> Financial regulation has followed most financial crises in the history of the United States.<sup>9</sup> Since 1792, the United States has experienced more than a dozen bank crises, including panics, bank runs, credit crises, and the collapse of Long Term Capital Management.<sup>10</sup> Since 2002, corporate governance in the United States has been, not just once but twice, substantially upgraded in response to crises, after more than seventy years of comparative regulatory inactivity. At the most general level,
> 7 Stuart Banner, _What Causes New Securities Regulation? 300 Years of Evidence_ , 75 WASH. U. L.Q. 849 (1997); STUART BANNER, ANGLO-AMERICAN SECURITIES REGULATION: CULTURAL AND POLITICAL ROOTS, 1690-1860 (1998); Coffee, _supra_ note 3.
> 8 CARMEN M. REINHART & KENNETH ROGOFF, THIS TIME IS DIFFERENT: EIGHT CENTURIES OF FINANCIAL FOLLY (2011). 9 Daniel K. Tarullo, Governor, Fed. Reserve System, Speech at the Peterson Institute for International Economics: Financial Regulation in the Wake of the Crisis (June 8, 2009) (“Following the banking crisis of the early 1930s, and the famous bank holiday declared by President Roosevelt soon after his inauguration, Congress enacted dramatic new measures that would define financial regulation for decades.”).
> 10 REINHART & KENNETH ROGOFF, _supra_ note 8; CHARLES P. KINDLEBERGER & ROBERT ALIBER, MANIAS, PANICS, AND CRASHES: A HISTORY OF FINANCIAL CRISES (2005); SCOTT B. MACDONALD & JANE E. HUGHES, SEPARATING FOOLS FROM THEIR MONEY: A HISTORY OF AMERICAN FINANCIAL SCANDALS (2007); HISTORY OF FINANCIAL DISASTERS, 1763-1995 (Stefan Altorfer ed., 2006); RICHARD DALE, THE FIRST CRASH: LESSONS FROM THE SOUTH SEA BUBBLE (2004); ECONOMIC DISASTERS OF THE TWENTIETH CENTURY (Michael J. Oliver & Derek H. Aldcroft eds., 2007); GAGARI CHAKRABARTI & CHITRAKALPA SEN, ANATOMY OF GLOBAL STOCK MARKET CRASHES: AN EMPIRICAL ANALYSIS (2012); _“Black Monday:” The Stock Market Crash of October 19, 1987: Hearing Before the Comm. on Banking, Housing, & Urban Affairs,_ 100th Cong. (1988); MAURY KLEIN, RAINBOW'S END: THE CRASH OF 1929 (2001); PANIC: THE STORY OF MODERN FINANCIAL INSANITY (Michael Lewis ed., 2009); _Learning From The Past: Lessons From the Banking Crises of the 20th Century_ : _Hearing Before the Congressional Oversight Panel_ , 111th Cong. 18 (2009); MATHIAS DEWATRIPONT, JEAN-CHARLES ROCHET, & JEAN TIROLE, BALANCING THE BANKS: GLOBAL LESSONS FROM THE FINANCIAL CRISIS (2010); THE PANIC OF 2008: CAUSES, CONSEQUENCES AND IMPLICATIONS FOR REFORM (Lawrence E. Mitchell & Arthur E. Wilmarth, Jr. eds., 2010); YOUSSEF CASSIS, CRISES AND OPPORTUNITIES: THE SHAPING OF MODERN FINANCE (2011); THE FINANCIAL CRISIS AND THE REGULATION OF FINANCE (Chrisopher J. Green, Eric J. Pentecost, & Tom Weyman-Jones eds., 2011); JOHAN A. LYBECK., A GLOBAL HISTORY OF THE FINANCIAL CRASH OF 20072010 (2011) Massive hedge fund failures include Amaranth Advisors (most significant loss of value) _,_ Bailey Coates, Cromwell Fund, Marin Capital, Aman Capital, Tiger Funds, and Long-Term Capital Management (most famous hedge fund collapse) _see_ ROGER LOWENSTEIN, WHEN GENIUS FAILED: THE RISE AND FALL OF LONG-TERM CAPITAL MANAGEMENT (2000); Franklin R. Edwards, _Hedge Funds and the Collapse of Long-Term Capital Management_ , 13 J. ECON. PERSP. 189 (1999); Linda Chatman Thomsen, Daniel M. Hawke & Pauline E. Calande, _Hedge Funds: An Enforcement Perspective_ , 39 RUTGERS L.J. 541, 545-47 (2008); HEDGE FUNDS, LEVERAGE, AND THE LESSONS OF LONG-TERM CAPITAL MANAGEMENT: REPORT OF THE PRESIDENT'S WORKING GROUP ON FINANCIAL MARKETS 1 (1999), _available at_ http://www.treasury.gov/resource-center/fin-mkts/Documents/hedgfund.pdf (discussing the LTCM incident and recommending a number of measures to constrain excessive leverage); U.S. GEN. ACCOUNTING OFFICE, REPORT TO CONGRESSIONAL REQUESTERS, LONG-TERM CAPITAL MANAGEMENT: REGULATORS NEED TO FOCUS GREATER ATTENTION ON SYSTEMIC RISK (1999) [hereinafter LTCM Report]; Joseph G. Haubrich, _Some Lessons on the Rescue of Long-Term Capital Management_ (Fed. Res. Bank of Cleveland Policy Discussion Paper No. 19 Apr. 2007), _available at_ http://ssrn.com/abstract=987558 (reviewing the restructuring and recapitalization of LTCM); Michael R. King & Philipp Maier, _Hedge Funds and Financial Stability: Regulating Prime Brokers Will Mitigate Systemic Risks_ , 5 J. FIN. STABILITY 283 (2009) (“Prominent victims of funding illiquidity are LTCM, Amaranth Advisors, Bear Stearns and Lehman Brothers. In all cases, their asset positions had a positive mark-to-market value, but they were unable to meet margin calls.”).
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the Sarbanes-Oxley Act (SOX) of 2002 aimed at increasing board independence, fixing the audit process, and improving disclosure and transparency.<sup>11</sup> Only eight years after enacting SOX, Congress again substantially overhauled the corporate governance regime via the Dodd-Frank Act.<sup>12</sup> Although SOX and the Dodd-Frank Act address different concerns, precipitated by different causes, in different market environments and different world economic outlooks, it seems striking that so much regulatory activity was necessary in such a comparatively short timespan.
The literature on financial regulation may not have addressed the underlying causes and consequences of cyclical regulation adequately. Since the early 1980s, trends in the law and finance literature have been changing roughly every five years. In the 1980s, the Law & Economics movement gained substantial influence in legal academia, the courts, and the legislature.<sup>13</sup> In the early 1990s, Bernard Black precipitated a new
> 11 Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 (2002); Roberta Romano, _The Sarbanes-Oxley Act and the Making of Quack Corporate Governance_ , 114 YALE L.J. 1521 (2005) (providing an evaluation of the substantive corporate governance mandates of the Sarbanes-Oxley Act of 2002); Stephen M. Bainbridge, _CORPORATE GOVERNANCE AFTER THE FINANCIAL CRISIS_ (2012); Larry E. Ribstein, _Market vs. Regulatory Responses to Corporate Fraud: A Critique of the Sarbanes-Oxley Act of 2002_ , 28 J. CORP. L. 1, 11-18 (2002) (reviewing some of the reforms in the Sarbanes-Oxley Act and discussing how these reforms purportedly respond to the problems discussed in the first part of the article). 12Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203 §§ 954-956, 124 Stat. 1376, 1899-1903 (2010).
> 13 Richard A. Posner, _The Law and Economics Movement_ , 77 AM. ECON. REV. 1 (1987); A NTHONY T. KRONMAN & RICHARD A. POSNER, THE ECONOMIC STRUCTURE OF TORT LAW (1987); WILLIAM LANDES & RICHARD A. POSNER, THE ECONOMIC STRUCTURE OF TORT LAW (1987); FRANK H. EASTERBROOK & DANIEL R. FISCHEL, THE ECONOMIC STRUCTURE OF CORPORATE LAW (1991); David Friedman, _An Economic Analysis of Alternative Rules for Breach of Contract_ , 32 J.L. & ECON. 281 (1989); Robin Paul Malloy, _Invisible Hand or Sleight of Hand_ , 36 U. KAN. L. REV. 209 (1988); Herbert Hovenkamp, _Law and Economics in the United States: A Brief Historical Survey_ , 19 CAMBRIDGE J. ECON. 331 (1995); Herbert Hovenkamp, _Rationality in Law and Economics_ , 60 GEO. WASH. L. REV. 293 (1992); R ICHARD A. POSNER, ECONOMIC ANALYSIS OF LAW (4th ed. 1992); John Shepard Wiley, _Antitrust and Core Theory_ , 54 U. CHI. L. REV. 556 (1987); G ERARD RADNITZKY & PETER BERNHOLZ, ECONOMIC IMPERIALISM: THE ECONOMIC APPROACH APPLIED OUTSIDE THE FIELD OF ECONOMICS (1986); Robert E. Scott, _A Relational Theory of Secured Financing_ , 86 COLUM. L. REV. 901 (1986); Robert D. Cooter & Thomas S. Ulen, _An Economic Case for Comparative Negligence_ , 61 N.Y.U. L. REV. 1067 (1986); Jack Hirshleifer, _The Expanding Domain of Economics_ , 75 AM. ECON. REV. 53 (1985); Richard A. Posner, _An Economic Theory of the Criminal Law_ , 85 COLUM. L. REV. 1193 (1985); OLIVER E. WILLIAMSON, THE ECONOMIC INSTITUTIONS OF CAPITALISM: FIRMS, MARKETS, RELATIONAL CONTRACTING (1985); MILTON FRIEDMAN & ROSE FRIEDMAN, TYRANNY OF THE STATUS QUO (1984); George L. Priest & Benjamin Klein, _The Selection of Disputes for Litigation_ , 13 J. LEGAL STUD. 1 (1984); PAUL H. RUBIN, BUSINESS FIRMS AND THE COMMON LAW: THE EVOLUTION OF EFFICIENT RULES (1983); Robert D. Cooter, _The Cost of Coase_ , 11 J. LEGAL STUD. 1 (1982); Charles J. Goetz & Robert E. Scott, _Principles of Relational Contracts_ , 67 VA. L. REV. 1089 (1981); RICHARD A. POSNER, THE ECONOMICS OF JUSTICE (1981); R. Peter Terrebone, _A Strictly Evolutionary Model of Common Law_ , 10 J. LEGAL STUD. 397 (1981); Ronald M. Dworkin, _Is Wealth a Value?_ , 9 J. LEGAL STUD. 191 (1980); MILTON FRIEDMAN & ROSE FRIEDMAN, FREE TO CHOOSE (1980); Duncan Kennedy & Frank I. Michelman, _Are Property and Contract Efficient_ , 8 HOFSTRA L. REV. 711 (1980); A. Mitchell Polinsky, _Resolving Nuisance Disputes: The Simple Economics of Injunctive and Damage Remedies_ , 32 STAN. L. REV. 1075 (1980); William Landes & Richard A. Posner, _Adjudication as a Private Good_ , 8 J. LEGAL STUD. 235 (1979); THE ECONOMICS OF CONTRACT LAW (Anthony T. Kronman & Richard A. Posner eds., 1979); Oliver E. Williamson, _Transaction-Cost Economics: The Governance of Contractual Relations_ , 22 J.L. & ECON. 233 (1979); J ohn L. Goodman, _An Economic Theory of the Evolution of the Common Law_ , 7 J. LEGAL STUD. 393 (1978); Anthony T. Kronman, _Specific Performance_ ,45 U. CHI. L. REV. 351 (1978); Ian R. Macneil, _Contracts: Adjustment of Long-Term_
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wave of legal scholarship that emphasized the role of institutional investors in corporate governance.<sup>14</sup> In the late 1990s, the debate on global convergence in corporate governance preoccupied many leading legal minds.<sup>15</sup> The next wave of legal scholarship in the post-Enron era discussed the role of SOX and the function of gatekeepers such as
_Economic Relations Under Classical, Neo-Classical, and Relational Contract Law_ , 72 NW. U. L REV. 854 (1978); Frank I. Michelman, _Norms and Normativity in the Economic Theory of Law_ , 62 MINN. L. REV. 1010 (1978); George L. Priest, _The Common Law Process and the Selection of Efficient Rules_ , 6 J. LEGAL STUD. 65 (1977); Paul H. Rubin, _Why Is the Common Law Efficient_ , 6 J. LEGAL STUD. 51 (1977); FRIEDRICH A. HAYEK, RULES AND ORDER (1973); George J. Stigler, _The Theory of Economic Regulation_ , 2 BELL J. ECON. 3 (1971); GUIDO CALABRESI, THE COSTS OF ACCIDENTS: A LEGAL AND ECONOMIC ANALYSIS (1970); Guido Calabresi, _Transaction Costs, Resource Allocation and Liability Rules_ , 11 J.L. & ECON. 67 (1968); Harold Demsetz, _The Exchange and Enforcement of Property Rights,_ 7 J.L. & ECON. 11 (1964); Gary S. Becker, _Irrational Behavior and Economic Theory_ , 70 J. POL. ECON. 1 (1962); MILTON FRIEDMAN, CAPITALISM AND FREEDOM (1962); Ronald H. Coase, _The Problem of Social Cost_ , 3 J.L & ECON. 1 (1960); FRIEDRICH A. HAYEK, THE CONSTITUTION OF LIBERTY (1960); FRIEDRICH A. HAYEK, THE ROAD TO SERFDOM (1944).
> 14 Bernard S. Black, _Agents Watching Agents: The Promise of Institutional Investor Voice_ , 39 UCLA L. REV. 811 (1992); Bernard S. Black, _The Value of Institutional Investor Monitoring: The Empirical Evidence_ , 39 UCLA L. REV. 895 (1992); John C. Coffee, Jr., _Liquidity Versus Control: The Institutional Investor as Corporate Monitor_ , 91 COLUM. L. REV. 1277, 1336-38 (1991); Ronald J. Gilson & Reinier Kraakman, _Reinventing the Outside Director: An Agenda for Institutional Investors_ , 43 STAN. L. REV. 863 (1991); Edward B. Rock, _The Logic and (Uncertain) Significance of Institutional Shareholder Activism,_ 79 GEO. L. J. 445 (1991); Mark J. Roe, _A Political Theory of American Corporate Finance_ , 91 COLUM. L. REV. 10 (1991); Joseph A. Grundfest, _Just Vote No: A Minimalist Strategy for Dealing with Barbarians Inside the Gates_ , 45 STAN. L. REV. 857 (1993); Roberta Romano, _Public Pension Fund Activism in Corporate Governance Reconsidered_ , 93 COLUM. L. REV. 795 (1993); Jill E. Fisch, _Relationship Investing: Will It Happen? Will It Work?_ , 55 OHIO ST. L.J. 1009 (1994); Stephen Thurber, _The Insider Trading Compensation Contract as an Inducement to Monitoring by the Institutional Investor_ , 1 GEO. MASON U.L. REV. 119 (1994); Manuel A. Utset, _Disciplining Managers: Shareholder Cooperation in the Shadow of Shareholder Competition_ , 44 EMORY L. J. 71 (1995); Arthur Pinto, _Corporate Governance: Monitoring the Board of Directors in American Corporations_ , 46 AM. J. COMP. L. 317 (1998); Robert C. Illig, _What Hedge Funds Can Teach Corporate America: A Roadmap for Achieving Institutional Investor Oversight_ , 57 AM. U. L. REV. 225 (2007); Richard A. Posner, _From the New Institutional Economics to Organization Economics: With Applications to Corporate Governance, Government Agencies, and Legal Institutions_ , 6 J. INSTITUTIONAL ECON. 1 (2010).
> 15 Henry Hansmann & Reinier Kraakman, _The End of History for Corporate Law_ , 89 GEO. L.J. 439 (2001); John C. Coffee, Jr., _The Future as History: The Prospects for Global Convergence in Corporate Governance and its Implications_ , 93 NW. U. L. REV. 641 (1998); Lawrence A. Cunningham, _Commonalities and Prescriptions in the Vertical Dimension of Global Corporate Governance_ , 84 CORNELL L. REV. 1133 (1999); Jeffrey N. Gordon, _Pathways to Corporate Convergence? Two Steps on the Road to Shareholder Capitalism in Germany_ , 5 COLUM. J. EUR. L. 219 (1999); E dward B. Rock, _America’s Shifting Fascination with Comparative Corporate Governance_ , 74 WASH. U. L.Q. 367 (1996); Klaus J. Hopt, _Comparative Corporate Governance: The State of the Art and International Regulation_ , 59 AM. J. COMP. L. 1 (2011); Kresimir Pirsl, _Trends, Developments, and Mutual Influences Between United States Corporate Law(s) and European Community Company Law(s)_ , 14 COLUM. J. EUR. L. 277 (2008); Katharina Pistor et al., _The Evolution of Corporate Law: A Cross-Country Comparison_ , 23 U. PA. J. INT’L ECON. L. 791 (2002); Douglas M. Branson, _The Very Uncertain Prospect of “Global” Convergence in Corporate Governance_ , 34 CORNELL INT’L L.J. 321 (2001); William W. Bratton & Joseph A. McCahery, _Comparative Corporate Governance and the Theory of the Firm: The Case Against Global Cross Reference_ , 38 COLUM. J. TRANSNAT’L L. 213 (1999); Brian R. Cheffins, _Current Trends in Corporate Governance: Going from London to Milan via Toronto_ , 10 DUKE J. COMP. & INT'L L. 5 (1999); T homas J. Andre, _Cultural Hegemony: The Exportation of Anglo-Saxon Corporate Governance Ideologies to Germany_ , 73 TUL. L. REV. 69 (1998); Mary E. Kissane, _Global Gadflies: Applications and Implementations of U.S.-Style Corporate Governance Abroad_ , 17 N.Y.L. SCH. J. INT'L & COMP. L. 621, 672-73 (1997).
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lawyers and accountants.<sup>16</sup> With the appearance of the 2007 credit crisis, legal scholars moved on to discuss the causes of the crises and possible regulatory responses.<sup>17</sup> Some scholars have begun to question the existing regulatory paradigm.<sup>18</sup> However, initiatives for sustainable financial regulation are still largely missing. Anticipation of unknown future contingencies and the preemption of possible future crises do not play a significant role in the current regulatory framework or in the literature on financial regulation.
A common denominator of regulatory responses to crises is the reliance on stable and presumptively optimal rules.<sup>19</sup> Congress, financial regulators, and the literature on financial regulation rely almost exclusively on “stable” and presumptively “optimal” rules. Economic and market conditions, and the corresponding requirements for optimal
> 16 John C. Coffee Jr., _The Attorney as Gatekeeper_ , 103 COLUM. L. REV. 1293 (2003); JOHN C. COFFEE JR., GATEKEEPERS: THE PROFESSIONS AND CORPORATE GOVERNANCE (2006); J ohn C. Coffee, Jr., _Can Lawyers Wear Blinders? Gatekeepers and Third-Party Opinions_ , 84 TEX. L. REV. 59 (2005); Donald C. Langevoort, _Chasing the Greased Pig Down Wall Street: A Gatekeeper’s Guide to the Psychology, Culture, and Ethics of Financial Risk Taking_ , 96 CORNELL L. REV. 1209 (2011); Lawrence A. Cunningham, _Beyond Liability: Rewarding Effective Gatekeepers_ , 92 MINN. L. REV. 323 (2007); Richard W. Painter, _Convergence and Competition in Rules Governing Lawyers and Auditors_ , 29 J. CORP. L. 397 (2004); R oberta Romano, _The Sarbanes-Oxley Act and the Making of Quack Corporate Governance_ , 114 YALE L.J. 1521 (2005); Stephen M. Bainbridge et al., _Managerialism, Legal Ethics, And Sarbanes-Oxley Section 307_ , 2004 MICH. L. REV. 299; Jeffrey N. Gordon, _What Enron Means for the Management and Control of the Modern Business Corporation: Some Initial Reflections_ , 69 U. CHI. L. REV. 1233 (2002); Lisa H. Nicholson _, Hobson's Choice for Securities Lawyers in the Post-Enron Environment: Striking a Balance between the Obligation of Client Loyalty and Market Gatekeeper_ , 16 GEO. J. LEGAL ETHICS 91 (2002); Donald C. Langevoort, _Seeking Sunlight in Santa Fe’s Shadow: The SEC’s Pursuit of Managerial Accountability_ , 79 WASH. U. L. Q. 449 (2001); George H. Brown, _Financial Institution Lawyers as Quasi-Public Enforcers_ , 7 GEO. J. LEGAL ETHICS 637 (1994).
> 17 Lucian A. Bebchuk et al., _Managerial Power and Rent Extraction in the Design of Executive Compensation_ , 69 U. CHI. L. REV. 751 (2002); Doug Branson, Jie Cai & Ralph A. Walkling _, Shareholders’ Say on Pay: Does It Create Value?_ , 46 J. FIN. & QUANTITATIVE ANALYSIS 299 (2011); Tiffany Roddenberry, _Say-on-Pay: Cautionary Notes on the Use of Third Party Compensation Guidelines in the United States_ , 38 FLA. ST. U. L. REV.933 (2011); Jeffrey N. Gordon, _“Say on Pay”: Cautionary Notes on the U.K. Experience and the Case for Shareholder Opt-_ in, 46 HARV. J. ON LEGIS. 323 (2009); Thomas W. Briggs, _Corporate Governance and the New Hedge Fund Activism_ , 32 J. CORP. L. 681 (2007).
> 18 Coffee, _supra_ note 3; Roberta Romano, _Regulating in the Dark_ (Yale Law & Econ. Research Paper No. 442, 2012), _available at_ http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1974148; Charles K. Whitehead, _Goldilocks Approach: Financial Risk and Staged Regulation_ , 97 CORNELL L. REV. 1267 (2012); KATHLEEN C. ENGEL & PATRICIA A. MCCOY, THE SUBPRIME VIRUS: RECKLESS CREDIT, REGULATORY FAILURE, AND NEXT STEPS (2011); Brett McDonnell, _Dampening Financial Regulatory Cycles_ (Minnesota Legal Stud. Research Paper No. 13-09, 2013), _available at_ http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2217806.
> 19 Wulf A. Kaal, _Evolution of Law: Dynamic Regulation in a New Institutional Economics Framework_ , _in_ FESTSCHRIFT KIRCHNER (Wulf Kaal et al. eds. forthcoming 2014) (“Dynamic and anticipatory elements in rules were less topical at the inception of institutional arrangements for rulemaking. Indeed, the institutional infrastructure for rulemaking was geared towards the creation of rules for governing a relatively stable society with less upward mobility and relatively stable economic and market environments. Since then, society and markets have evolved rapidly and are becoming increasingly more complex. The growing number of rule enactments, revisions, and revocations suggests that existing rules and institutional structures for rulemaking are becoming less capable of addressing the rapid pace of change. Financial innovation and the complexities of financial markets require institutional arrangements and a rulemaking process that continuously adjust to these challenges. In other words, the complexities of today’s society and markets may benefit from dynamic institutional arrangements and processes for rulemaking.”).
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and stable rules, are constantly evolving and create substantial future contingencies for rulemaking. Although they do not take unknown future contingencies into account, stable and presumptively optimal rules remain the uniform response to financial crises. To attain certainty and increase predictability, rulemakers discount or often willingly accept unknown future contingencies and the inevitable need for rule revision, amendments, and retractions. If and when future contingencies are realized and the existing sets of rules prove to be suboptimal, Congress and/or financial regulators propose and/or enact additional stable sets of rules to address shortcomings in financial regulation. In an increasingly innovative, complex, and globalized financial environment, future financial crises may require perhaps even more extensive governance adjustments.
A regulatory framework that relies exclusively on stable and presumptively optimal rules may not be able to adequately address future challenges. Amendments, revisions, and retractions of existing rules create substantial transaction costs and uncertainty. Rules established in reaction to financial crises also inevitably fail to soften, curtail, or preempt the effects of financial crises because reactive rules are mostly tailored to the economic and regulatory issues at the time of their enactment and often ignore possible future contingencies. A preferable solution would avert the downsides of cyclical and merely responsive regulation.
This paper outlines the possible role of dynamic elements in financial regulation. Dynamic regulation may supplement the existing regulatory framework and may help remedy its shortcomings such as the need for perpetual rule enactment, adjustment, and revision. Dynamic elements in the regulatory structure may allow regulators to continually adapt to new market environments, financial innovation, and to changes in financial markets as a result of financial regulation. Dynamic regulation may help create a governance mechanism that is constantly evolving and adapting to the given market environment, financial innovation, and the given regulatory environment. Although the implementation of dynamic elements in regulatory structures is uncertain, some promising regulatory tools with dynamic elements already exist, including contingent capital securities, corporate integrity agreements, and deferred prosecution agreements.
The concept of dynamic regulation supports a regulatory structure that curtails the regulatory sine curve and its negative and costly consequences _._ The regulatory sine curve illustrates rulemaking following financial crises and the inevitable relaxation, retraction, and revision of established rules thereafter.<sup>20</sup> While the sine curve may be inevitable, its costly and suboptimal regulatory effects can be limited. Dynamic regulation as a supplemental optimization process for rulemaking can help curtail the negative effects and regulatory outcomes generated by the sine curve of regulation. The author shows how dynamic elements in financial regulation could help change the relationship between the occurrence and timing of common elements of financial crises and the regulatory sine curve. Including dynamic elements in regulation changes the relationship between the sine curve of financial regulation and common elements of financial crises. The author evaluates these possible changes by depicting the sine curve, with and without dynamic elements, in relation to the phase-shifted first derivative (cosine curve), describing common elements of financial crises. As events in the real economy (cosine curve) spiral towards financial disaster, the dynamically enhanced regulatory sine curve expands. Accordingly, dynamic elements could facilitate rulemaking when it is most needed – _ex-_
> 20 Coffee, _supra_ note 3.
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_ante_ before crises – to curtail the effects of crises and suboptimal regulatory outcomes _expost_ after crises.
After a short introduction in Part I, the paper in Part II introduces the literature on the political economy of financial regulation, delineates common denominators of financial crises, and illustrates the sine curve of financial regulation by discussing examples of regulatory expansion and contraction post SOX and Dodd Frank. In Part III, the author outlines the concept of dynamic regulation of the financial services industry. The author suggests that the existing regulatory sine curve could be optimized with dynamic elements and outlines how dynamic elements in financial regulation could change the relationship between the regulatory sine curve and the occurrence and timing of common elements of financial crises. Part IV outlines possible implementation alternatives for dynamic regulation with a focus on contingent capital securities, deferred prosecution agreements, and corporate integrity agreements. Part V concludes.
# **II. The Political Economy of Financial Regulation**
Financial crises throughout history,<sup>21</sup> including the Great Depression and the 2007 financial crisis, have demonstrated that financial rulemaking does not happen when it is most needed. Rather, it takes place when it is politically opportune.<sup>22</sup> Financial rulemaking is most needed _ex-ante_ before financial crises, not _ex-post_ after crises created steep costs on the economy, impacted markets and financial institutions, and affected the rulemaking process.
The aftermath of financial crises creates suboptimal conditions (shock conditions) for rulemaking. Rulemaking takes place in an economic, political, and legal environment that creates a sense of urgency for rulemaking and may not permit a full evaluation of the possible consequences for all constituencies. Shock conditions that call for rulemaking often have not been appropriately analyzed and absorbed in a systematic fashion and are, thus, often associated with high levels of incomplete information. The bounded rationality of public rulemakers—who are satisfying their respective constituencies rather than all affected parties and, therefore, may be more willing to act in an environment of incomplete information—can aggravate shock conditions during the rulemaking process.
The literature on the financial economy of financial regulation has attempted to conceptualize the processes that are involved in the existing framework for rulemaking.<sup>23</sup>
> 21 REINHART & ROGOFF, _supra_ note 8.
> 22 Coffee, _supra_ note 3.
> 23 Gary S. Becker, _A Theory of Competition Among Pressure Groups for Political Influence_ , 98 Q. J. ECON. 371 (1983); Coffee, _supra_ note 3; Romano, _supra_ note 18; Katharina Pistor, _On the Theoretical Foundations for Regulating Financial Markets_ (Columbia Law Sch. Pub. Law Research Paper No. 12-304, (2012), _available at_ http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2113675; Steven L. Schwarcz, _Ex Ante Versus Ex Post Approaches to Financial Regulation_ , 15 CHAPMAN L. REV. 257, 260 (2011); David A. Hirshleifer, _Psychological Bias as a Driver of Financial Regulation_ , 14 EUR. FIN. MAN. 856 (2008); Christopher Carrigan & Cary Coglianese, _Oversight in Hindsight: Assessing the U.S. Regulatory System in the Wake of Calamity, in_ REGULATORY BREAKDOWN: THE CRISIS OF CONFIDENCE IN U.S. REGULATION (Cary Coglianese ed., 2012); McDonnell, _supra_ note 18; Whitehead, _supra_ note 18; FINANCIAL MARKET REGULATION IN THE WAKE OF FINANCIAL CRISES: THE HISTORICAL EXPERIENCE (Alfredo Gigliobanco & Gianni Toniolo eds., 2009); Colin Mayer & Jeffery N. Gordon, _The Micro, Macro and International Design of Financial Regulation_ (Columbia Law & Econ. Working Paper No. 422, 2012), _available at_ http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2047436; Stigler, _supra_ note 13, at 3; MICHAEL SMALLBERG, PROJECT ON GOVERNMENT OVERSIGHT, REVOLVING REGULATORS: SEC FACES ETHICS
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Financial regulation is characterized and controlled by a classic collective action problem. As a result, regulatory oversight is never constant. In the competition to shape policies and attain the most favorable conditions for themselves via rulemaking, small and wellorganized special interest groups (such as the financial industry) dominate latent groups (such as dispersed investors).<sup>24</sup> During and after crises, however, political entrepreneurs assume the transaction costs of organizing the otherwise disinterested latent groups to temporarily overcome the predominance of special interest groups in the rulemaking process.<sup>25</sup> Following crises, the process is reversed and regulatory oversight diminishes as societies and markets return to their prior equilibrium. As a result of this dichotomy, reform and deregulatory legislation are often enacted in quick succession. Balanced and sustainable rulemaking is largely elusive.
# 1. _Common Denominators of Financial Crises_
The causes of bank instability and financial crises are manifold; pinpointing a particular cause may be impossible. Some scholars point to the structure of commercial banking and argue that the structure of banking and banking practices were determined by suboptimal regulation and regulatory policy not by market forces.<sup>26</sup> Others contend that the health of the banking sector is related to the health of the real estate sector and view bank failures as an inevitable part of the contraction in consumer spending.<sup>27</sup> Central Bank policies may be another possible explanation for bank (in)stability.<sup>28</sup> There
CHALLENGES WITH REVOLVING DOOR (2011), _available at_ http://www.pogo.org/pogofiles/reports/financial-oversight/revolving-regulators/fo-fra-20110513.html.; Stephen J. Choi & A.C. Pritchard, _Behavioral Economics and the SEC_ , 56 STAN. L. REV. 1 (2003); Jeffrey J. Rachlinski & Cynthia R. Farina, _Cognitive Psychology and Optimal Government Design_ , 87 CORNELL L. REV. 549 (2002); SIMON JOHNSON & JAMES R. KWAK, 13 BANKERS: THE WALL STREET TAKEOVER AND THE NEXT FINANCIAL MELTDOWN (2010); Zachary J. Gubler, _Public Choice Theory and the Private Securities Market_ , 91 N.C. L. REV. (forthcoming 2013); Eric Helleiner & Stefano Pagliari, _The End of Regulation? Hedge Funds and Derivatives in Global Financial Governance_ , _in_ GLOBAL FINANCE IN CRISIS: THE POLITICS OF INTERNATIONAL REGULATORY CHANGE 74 (Eric Helleiner, Stefano Pagliari & Hubert Zimmermann eds., 2010); Pierre-Hugues Verdier, _The Political Economy of International Financial Regulation_ , 88 IND. L.J. (forthcoming 2013); Marco Pagano & Paolo Volpin, _The Political Economy of Finance_ , 17 OXFORD REV. ECON. POL’Y 502 (2001); HENDRICKSON, _supra_ note 3; Randall S. Kroszner, _On the Political Economy of Banking and Financial Regulatory Reform in Emerging Markets_ , 10 RES. IN FIN. SERVICES 33 (1998); Efraim Benmelech & Tobias J. Moskowitz, _The Political Economy of Financial Regulation: Evidence from U.S. State Usury Laws in the 19th Century_ , 65 J. FIN. 1029 (2010); Banner, _supra_ note 7; BANNER, _supra_ note 7, at 1690-1860; John C. Coffee, _Systemic Risk After Dodd-Frank: Contingent Capital and the Need for Regulatory Strategies Beyond Oversight_ , 111 COLUM. L. REV. 795, 819 (2011); John Nugee, _Current Issues in Financial Regulation and the Return of the Political Economy_ , 11 J. INT’L BUS. & L. 333, 334 (2012).
> 24 MANCUR OLSON, THE LOGIC OF COLLECTIVE ACTION (1965).
> 25 ELINOR OSTROM, GOVERNING THE COMMONS: THE EVOLUTION OF INSTITUTIONS FOR COLLECTIVE ACTION 41 (1990).
> 26 Charles W. Calomiris & Gary Gorton, _The Origins of Banking Panics: Models, Facts, and Bank Regulation, in_ FINANCIAL MARKETS AND FINANCIAL CRISES 109 (R. Glenn Hubbard ed., 1991); Mark Carlson & Kris James Mitchener, _Branch Banking as a Device for Discipline: Competition and Bank Survivorship during the Great Depression_ , 117 J. POL. ECON. 165 (2009); Richard S. Grossman, _The Shoe That Didn’t Drop: Explaining Banking Stability During the Great Depression_ , 54 J. ECON. HIST. 654 (1994).
> 27 PETER TEMIN, DID MONETARY FORCES CAUSE THE GREAT DEPRESSION? (1976); Grossman, _supra_ note 26.
> 28 KINDLEBERGER & ALIBER, _supra_ note 10.
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is some evidence that banking instability and crises characterized the early history of U.S. commercial banking<sup>29</sup> while the creation of the Federal Reserve Bank in later years created stability and resulted in fewer crises.
Bank crises share several core characteristics. The common characteristics include the following core elements: (i) an exogenous shock, (ii) a favorable response to the exogenous shock, (iii) favorable conditions dissipate, and (iv) a systemic rise in bank failures.<sup>30</sup> An exogenous shock in the economy often starts this sequence of events by creating conditions for optimism in the real and financial sectors of the economy. Exogenous shocks often include fundamental technological advancements.<sup>31</sup> The response to exogenous shocks historically entailed an expansion of credit.<sup>32</sup> By lowering credit requirements in an economic environment in which loans were perceived as less risky, bankers capitalized on the new opportunities created by entrepreneurs who were
> 29 _Id._
> 30 HENDRICKSON, _supra_ note 3.
31 For instance, the telegraph, the telephone and the Internet, sixty consecutive years of rising real estate prices at around ten percent may all be viewed as exogenous shocks. Other examples include the vast expansion of the US railway system and fundamental shifts in production methods, such as automation and mass production, among many others. Kevin J. Lansing, _Speculative Growth, Overreaction, and the Welfare Cost of Technology-Driven Bubbles_ , 83 J. ECON. BEHAV. & ORG. 461 (2012) (“A reading of stock market history suggests that speculative bubbles are often linked to technological innovation. Shiller (2000) argues that major stock price run-ups have generally coincided with the emergence of some superficially plausible “new era” theory that involves the introduction of new technology. Fig. 1 depicts four major runups in real U.S. stock prices. Shiller associates each run-up with the following technological advances that contributed to new era enthusiasm: Early 1900s: high-speed rail travel, transatlantic radio, long-line electrical transmission,:1920s: mass production of automobiles, travel by highways and roads, commercial radio broadcasts, widespread electrification of manufacturing; 1950s and 1960s: widespread introduction of television, advent of the suburban lifestyle, space travel; Late 1990s: widespread availability of the internet, innovations in computers and information technology, emergence of the web-based business model. In comparing the late 1920s with the late 1990s, Gordon (2006) and White (2006) both emphasize the simultaneous occurrence of major technological innovations, a productivity revival, excess capital investment, and a stock market bubble fueled by speculation.”); Eugene N. White, _Bubbles and Busts: The 1990s in the Mirror of the 1920s_ , _in_ THE GLOBAL ECONOMY IN THE 1990S 193 (P.W. Rhode & G. Toniolo eds., 2006); Henry Benavides Puerto, _Evolution from Invention to Technological Innovation and Influence of “Objects” on Economic Cycles and on Paradigms_ , _in_ INNOVATION AND TECHNOLOGY — STRATEGIES AND POLICIES 61 (Oliverio D. D. Soares et al. eds., 1997); Roger W. Ferguson, Jr. & William L. Wascher, _Distinguished Lecture on Economics in Government: Lessons from Past Productivity Booms_ , 18 J. ECON. PERSP. 3, 7 (2004).
> 32 _Id._
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ready to seize on the expectation of future profits.<sup>33</sup> In more recent years, rapid financial innovation accompanied this credit expansion.<sup>34</sup> An inevitable loss in confidence often followed the favorable conditions, because of a fall in real estate prices, a sharp decline in the stock markets, or large business or bank failures, among many other factors. These
33 Leading up to the 2007 credit crisis, the credit expansion was facilitated and accelerated by “covenantlite loans” and public policies that allowed creditors who previously would not qualify for loans to participate in the value creation. Matthew T. Billett et al., _Bank Skin in the Game and Loan Contract Design: Evidence from Covenant-Lite Loans_ 2 (2013), _available at_ http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2169624 (“First introduced in 2005, covenant-lite loans rose in popularity with issuance of $140 billion in 2007. Covenant-lite loan activity virtually disappeared during the crisis, only to return at a record pace and at record levels with covenant-lite loans accounting for 20% of the $465 billion leveraged loan market in 2012 and reaching 48% in January 2013.”); Albert Choi & George Triantis, _Market Conditions and Contract Design: Variations in Debt Contracting_ , 88 N.Y.U. L. REV. 51, 53-54 (2013) (“Covenant-lite deals became increasingly common through the 2000s until the onset of the financial crisis in 2007. Market observers attributed this to an excess supply of credit. The market for covenant-lite loans collapsed in the second half of 2007. A period of tighter and more extensive covenants followed until 2009. Reports suggested that covenant-lite deals then resurfaced, at least for higher-grade borrowers, because of an excess supply of investment funds.”); MARCO ANNUNZIATA, THE ECONOMICS OF THE FINANCIAL CRISIS: LESSONS AND NEW THREATS 27 (2011); Charles K. Whitehead, _The Evolution of Debt: Covenants, the Credit Market, and Corporate Governance,_ 34 J. CORPORATION L. 641 (2009); Justin Y. Lin & Volker Treichel, _The Unexpected Global Financial Crisis: Researching its Root Cause_ (World Bank Policy Research Working Paper No. 5937, 2012) (“With signs that the incessant rise in real estate was coming to an end, banks decided to end teaser rates on subprime mortgages and ask borrowers of the so-called ―NINJA‖ loans—i.e., loans that had been made without any declaration of income from the borrower—to start paying off debt. However, as the downturn in house prices intensified, mortgage delinquencies, charge-offs and defaults accelerated.”); Michael D. Bordo & Christopher M. Meissner, Does inequality lead to a financial crisis?, 31 J. Int’l Money & Fin. 2147 (2012) (“During this period, lending standards were relaxed and practices like NINJA and NODOC loans were condoned. These developments led to the growth of subprime and Alt A mortgages which were securitized and bundled into mortgage backed securities and then given triple A ratings which contributed to the financial fragility.”); A. David Austill, _Legislation Cannot Replace Ethics in Regulatory Reform_ , 2 INT’L J. BUS. & SOCIAL SCIENCE 61, 62 ((“It was during President Bill Clinton’s administration with Andrew Cuomo as Housing and Urban Development (HUD) Secretary when the rules for home ownership financing became relaxed in 1996 (Roberts, 2008). For 1996, HUD gave the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation an explicit target of 42 percent of their mortgage financing had to go to borrowers with income below the median in their area.”).
34 Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities, Release No. 34–49830, 69 Fed. Reg. 34428 (June 21, 2004); Ross Levine, _An Autopsy of the U.S. Financial System_ 20-21 (NBER Working Paper No. 15956, 2010) (“Consider three interrelated SEC decisions regarding the regulation of investment banks. First, the SEC in 2004 exempted the five largest investment banks from the net capital rule, which was a 1975 rule for computing minimum capital standards at broker-dealers. Second, in a related, coordinated 2004 policy change, the SEC enacted a rule that induced the five investment banks to become “consolidated supervised entities” (CSEs): The SEC would oversee the entire financial firm […] Given the size and complexity of these financial conglomerates, overseeing the CSEs was a systemically important and difficult responsibility. The investment banks were permitted to use their own mathematical models of asset and portfolio risk to compute appropriate capital levels. The investment banks responded by issuing more debt to purchase more risky securities without putting commensurately more of their own capital at risk. Leverage ratios soared from their 2004 levels, as the bank’s models indicated that they had sufficient capital cushions. Third, the SEC neutered its ability to conduct consolidated supervision of major investment banks. With the elimination of the net capital rule and the added complexity of consolidated supervision, the SEC’s head of market regulation, Annette Nazareth, promised to hire high-skilled supervisors to assess the riskiness of investment banking activities. But the SEC didn’t.”); Stephen Labaton, _U.S. Regulator's 2004 Rule Let Banks Pile Up New Debt_ , N.Y. TIMES, Oct. 3, 2008.
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factors exposed the fragility of credit expansion and financial innovation and resulted in a significant and often systemic rise in bank failures.
# _2. Regulatory Sine Curve_
The cyclical nature of public rulemaking under conditions of incomplete information and bounded rationality is costly and can produce suboptimal regulatory outcomes, often with long-term implications for financial markets and the economy. Regulatory cycles also make it nearly impossible to adequately address financial regulatory concerns. Systemic risk is particularly difficult to address if rules are enacted in a cyclical and reactive format.<sup>35</sup>
The regulatory sine curve describes governance adjustments in reaction to financial crises and the inevitable relaxation, revision, and retraction of rules that were enacted as part of the governance adjustment.<sup>36</sup> The phrase “regulatory sine curve,” means: “that (1) regulatory intensity is never constant, but rather increases after a market crash, and then wanes as (and to the extent that) society and the market return to normalcy, and (2) the public’s passion for reform is short-lived and the support it gives to political entrepreneurs who seek to oppose powerful interest groups on behalf of the public also wanes after a brief window of opportunity.”<sup>37</sup> Others have described “regulatory sine curves” as a budgetary phenomenon: regulatory budgets increase after a downturn and drop when markets rebound.<sup>38</sup> The sine curve reflects competing demands and desires.<sup>39</sup> The public demands tough regulation with a large role for the regulator after crises.<sup>40</sup> In the absence of crises, however, the intensity of regulation diminishes because regulators are unable to commit to long-term regulatory strategies and instead use private strategies like self-regulation to overcome resource constraints.<sup>41</sup>
# a) Expansion
The New Deal securities legislation that defined the structure of financial regulation for the better part of the 20<sup>th</sup> century, and continues to define it today, was largely a legislative response to the Great Depression, banking panics, and the overabundance of leverage in equity markets.<sup>42</sup> Twenty years prior to the enactment of the New Deal legislation, the creation of the Federal Reserve had been intended as both a financial stability measure in response to crises and as an instrument of monetary policy.<sup>43</sup> Banking law reforms enacted after the 1980s savings and loan crisis emphasized
> 35 Coffee, _supra_ note 3.
> 36 _Id._
> 37 _Id._ at 14.
> 38 Howell E. Jackson & Mark Roe, _Public and Private Enforcement of Securities Laws: ResourceBased Evidence_ (Harvard Law Sch. Pub. Law & Legal Theory Research Paper Series
> Paper No. 0-28, 2009), _available at_ http://www.law.harvard.edu/programs/olin_center/.
> 39 Eric J. Pan, _Understanding Financial Regulation_ 40 (Benjamin N. Cardozo Sch. of Law, Jacob Burns Inst. for Advanced Legal Studies, Working Paper No. 329, 2011).
> 40 _Id._
> 41 _Id._ at 41.
> 42 Banner, _supra_ note 7; BANNER, _supra_ note 7.
> 43 _Id_ . _See also_ Kara Karlson, _Checks and Balances: Using the Freedom of Information Act to Evaluate the Federal Reserve Banks_ , 60 AM. U. L. REV. 213, 220 (2010).
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the regulation of depository institutions.<sup>44</sup> Financial stability, while partially motivating these reforms, was not a major aspect of the reform legislation following the 1980s savings and loan crisis.<sup>45</sup>
The Sarbanes-Oxley Act (SOX) and the Dodd-Frank Act are the two most substantial regulatory upgrades to the New Deal legislation<sup>46</sup> and illustrate the regulatory expansion that follows crises. SOX’s focus on investor protection, while far reaching in many respects, makes it a traditional piece of securities regulation. By contrast, the DoddFrank Act expands the framework for securities and financial regulation in an unprecedented fashion.<sup>47</sup> By creating new supervisory entities with an emphasis on systemic risk,<sup>48</sup> among other measures, the Dodd-Frank Act attempts to address systemic concerns that regulators in the United States largely ignored in the decades preceding the 2007 credit crisis.<sup>49</sup> European financial regulation following financial crises displays similar characteristics and illustrates the inevitable regulatory expansion and contraction that follows crises.<sup>50</sup> An evaluation of European regulatory trends is, however, beyond the scope of this paper.
# b) Contraction
The regulatory expansion that follows crises inevitably leads to amendments, revisions, and retractions of previously established rules. For instance, the changes in financial and banking laws in the 1980s and 1990s were mostly deregulatory.<sup>51</sup> Deregulation in the late 1990s culminated in the Gramm-Leach-Bliley Act of 1999, which allowed the combination of investment banking, commercial banking, and insurance services<sup>52</sup> by partially repealing the Glass Steagall Act of 1933.<sup>53</sup> These deregulatory laws, in combination with administrative actions that implemented and often preceded them, removed many restrictions on the geographic reach of commercial banks as well as their activities and affiliations.<sup>54</sup>
Both SOX and the Dodd-Frank Act were amended and revised. Some of their most controversial provisions were not enforced. A few highlights include the lack of
> 44 Michael P. Malloy, _Nothing to Fear but FIRREA Itself: Revising and Reshaping the Enforcement Process of Federal Bank Regulation_ , 50 OHIO ST. L.J. 1117, 1117-18(1989).
> 45 _Id_ . at 1118.
> 46 Coffee, _supra_ note 3, at 120.
> 47 Cheryl D. Block, _A Continuum Approach to Systemic Risk and Too-Big-to-Fail_ , 6 BROOK. J. CORP. FIN. & COM. L. 292, 292-93 (2012).
> 48 Section 111 of the Dodd-Frank Act established the Financial Stability Oversight Council whose mission is to identify risks and respond to emerging threats to financial stability. 12 U.S.C. § 5321 (2006). Section 152 of the Dodd-Frank Act established the Office of Financial Research which collects data, conducts research and develops new tools to measure and monitor risk. 12 U.S.C. § 5342 (2006). Section 1011 created the Bureau of Consumer Financial Protection to implement consumer financial laws. 12 U.S.C. § 5491 (2006).
> 49 Jeffrey N. Gordon & Christopher Muller, _Confronting Financial Crisis: Dodd-Frank’s Dangers and the Case for a Systemic Emergency Insurance Fund_ , 28 YALE J. ON REG. 151, 177-78 (2011).
> 50 Jennifer Welch, _The Financial Crisis in the European Union: An Impact Assessment and Response Critique_ , 2 EUR. J. RISK REG. 481, 481-84 (2011).
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enforcement of congressional pronouncements in Sections 307 and 402 of SOX,<sup>55</sup> the partial repeal of section 404 of SOX<sup>56</sup> via the Dodd-Frank Act, and the repeal of certain provisions of the Dodd-Frank Act and SOX via the Jumpstart our Business Startups Act.<sup>57</sup>
Section 307, which can be traced back in large part to a proposal penned by Richard Painter,<sup>58</sup> was implemented as part of SOX.<sup>59</sup> Section 307 requires the SEC to adopt standards for the professional conduct of attorneys who represent public companies before the SEC.<sup>60</sup> The reporting requirement under section 307 requires attorneys to report material violations of federal or state securities laws or breaches of fiduciary duty to the issuer’s chief legal officer or to its chief executive officer.<sup>61</sup> If the issuer fails to take action, the attorney may be required to report “up the ladder” to the company’s audit committee,<sup>62</sup> and under more limited circumstances, the attorney may be permitted to disclose a material violation of the law to the SEC.<sup>63</sup> Although some lawyers were inevitably aware of executive misconduct in numerous instances,<sup>64</sup> there is no evidence that the SEC ever charged an attorney with a violation of Section 307.<sup>65</sup>
> 55 Sung Hui Kim, _Naked Self-Interest ? Why the Legal Profession Resists Gatekeeping_ , 63 FLA. L. REV. 129, 132-33 (2011); Robert A. Prentice & David B. Spence, _Sarbanes-Oxley as Quack Corporate Governance: How Wise Is the Received Wisdom ?_ , 95 GEO. L.J. 1843, 1896 (2007). 56 15 U.S.C. § 7262 (2006).
57 Jumpstart Our Business Startups Act (JOBS Act), Pub. L. No. 112-106, 126 Stat. 306 (codified as amended in scattered sections of 15 U.S.C.).
> 58 Richard W. Painter & Jennifer E. Duggan, _Lawyer Disclosure of Corporate Fraud: Establishing a Firm Foundation_ , 50 SMU L. REV. 225, 261-63 (1996).
59 Sarbanes-Oxley Act of 2002, § 307, 15 U.S.C. § 7245 (2006). 60 _Id_ .
61 17 C.F.R. § 205.3(b) (2012).
> 62 _Id_ .
> 63 _See_ 17 C.F.R. § 205.3(d)(2) (2012).
64 Lawyers were implicated in misconduct involving violations of the federal securities laws in the context of mutual fund market timing scandal and the stock option backdating scandal. Tamar Frankel & Lawrence A. Cunningham, _The Mysterious Ways of Mutual Funds: Market Timing_ , 25 ANN. REV. BANKING & FIN. L. 235 (2006) _; Fund Directors Are Feeling the Heat_ , WALL ST. J., Mar. 25, 2013; Jesse M. Fried, _Option Backdating and Its Implications_ , 65 WASH. & LEE L. REV. 853 (2008); Daniel J. Morrissey, _The Path of Corporate Law: Of Options Backdating, Derivative Suits, and the Business Judgment Rule,_ 86 OR. L. REV. 973 (2007); Press Release, SEC, SEC Files Settled Enforcement Actions Against UnitedHealth Group and Former General Counsel in Stock Options Backdating Case (Dec. 22, 2008), _available at_ http://www.sec.gov/news/press/2008/2008-302.htm. Cease and desist orders are available at S.E.C. Release Nos. 2108, 50428, 34-50428; S.E.C. Release No. AE - 2108, 83 S.E.C. Docket 2413, 2004 WL 2114057; In the Matter of John E. Isselmann, Jr., Release No. 33-8523, 84 S.E.C. Docket 2293, 2005 WL 82435; In the Matter of Google, Inc. & David C. Drummond. Administrative Proceeding File No. 3-11795 (Jan. 13, 2005); In the Matter of J. Kenneth Alderman et al, Release No. 30300 (Dec. 10, 2012), _available at_ http://www.sec.gov/litigation/admin/2012/ic-30300.pdf.
> 65 _Id_ . David B. Bayless & Tammy Albarrán _, Recent Sec Enforcement Actions Against In-House Lawyers: An Ominous Trend for the Legal Profession_ , 13 ANDREWS LITIG. REP. 1, 4 (2007) (“In the first eight months of 2007, the SEC has settled one enforcement action against a former general counsel, and filed eight other enforcement actions against former in-house counsel of public companies (and, in one of these actions, it also sued the company’s top in-house securities lawyer) -- an unprecedented event. Historically, the Commission has not pursued enforcement actions against lawyers (much less against general counsel) as aggressively as it has in the last eight months.”).
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Section 402 SOX prohibits public companies from providing credit to their directors or officers.<sup>66</sup> Section 402 is codified in Section 13(k) of the Securities Exchange Act of 1934<sup>67</sup> and precludes issuers from extending or maintaining credit as well as arranging for the extension of credit or the renewal of any extension of credit.<sup>68</sup> The SEC, however, never actually interpreted section 402 and merely acquiesced with a law firm memorandum interpreting section 402.<sup>69</sup> In effect, private entities fulfilled the SEC mandate in section 402. While not a formal retraction, the SEC’s lack of interpretation underscores that section 402 provides another instance of politically motivated rulemaking that later has to be scaled back.
The partial repeal of section 404 of SOX<sup>70</sup> via the Dodd-Frank Act is another example that illustrates how broad rules enacted during times of political expediency are often later retracted. Section 404 required the SEC to adopt and management to prepare a report on internal controls and to disclose this report in the disclosure as part of issuers’ annual reports.<sup>71</sup> Additionally, section 404 (b) SOX required the issuer’s outside auditor to report on and attest to the issuer’s annual report filed by management.<sup>72</sup> Subsequently, the Public Company Accounting Oversight Board (“PCAOB”) in its Auditing Standard No. 2 required the auditor<sup>73</sup> to evaluate the design and operating effectiveness of the issuer’s internal controls in addition to the traditional audit of the company’s financial statements. While profitable for the accounting profession, Auditing Standard No. 2 proved to be rather controversial. Issuers, lobbyists, and others called for Auditing Standard No. 2 to be curtailed soon after its enactment. Foreign issuers began to delist from U.S. exchanges after the enactment of section 404, referred to this section as a leading cause for their decision to delist.
In part in reaction to this criticism, the SEC created an exemption from section 404 SOX for companies with a market capitalization under $125 million.<sup>74</sup> To reduce audit costs,<sup>75</sup> especially for smaller companies, the PCAOB soon also replaced Auditing
> 66 _See_ 15 U.S.C. § 78m (k) (2006).
> 67 _Id_ .
> 68 See _Id_ .
> 69 _See_ Memorandum from Sullivan & Cromwell on Sarbanes-Oxley § 402 – Interpretations Issued by 25 Law Firms (Oct. 15, 2002), _available at_ http://www.adrbnymellon.com/files/climail4.pdf). Other major law firms later joined the memorandum.
70 15 U.S.C. § 7262 (2006).
> 71 _Id_ .
> 72 _Id._
> 73 _See_ Order Approving Proposed Auditing Standard No. 2: An Audit of Internal Control Over Financial Reporting Performed in Conjunction with an Audit of Financial Statements ("Auditing Standard No. 2"), Exchange Act Release No. 34-49884(June 17, 2004), _available at_ http://www.sec.gov/rules/pcaob/3449884.htm. Section 404 (b) SOX authorized the PCAOB to adopt this rule: The attestation “shall be made in accordance with standards for attestation engagements issued or adopted by the [Public Company Accounting Oversight Board.]” _Id._
> 74 _See_ Final Report of the Advisory Committee on Smaller Public Companies to the U.S. Securities and Exchange Commission, SEC Release No. 33-8666 (Apr. 23, 2006).
> 75 PCAOB Release No. 2007-005A, Auditing Standard No. 5 (June 12, 2007), _available at_ http://pcaobus.org/Rules/Rulemaking/Docket%20021/2007-06-12_Release_No_2007-005A.pdf. _See also_ Order Approving Proposed Auditing Standard No. 5, An Audit of Internal Control Over Financial Reporting that is Integrated with an Audit of Financial Statements, a Related Independence Rule, and Conforming Amendments, SEC Release No. 34-56152 (July 27, 2007); Dechun Wang & Jian Zhou, _The Impact of PCAOB Auditing Standard No. 5 on Audit Fees and Audit Quality_ (2012), _available at_
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Standard No. 2 with Auditing Standard No. 5, in effect diluting the requirements.<sup>76</sup> Despite these existing partial retractions of Section 404 SOX, Congress further softened section 404 SOX via section 989G of the Dodd-Frank Act,<sup>77</sup> which exempts issuers with a market capitalization of $75 million or less from filing the auditor’s attestation to the managements’ evaluation of internal controls.<sup>78</sup>
Another powerful example of the regulatory sine curve and the impact of crisesdriven regulation is the retraction of several governance provisions set out in the Dodd– Frank Act.<sup>79</sup> The Jumpstart our Business Startups Act<sup>80</sup> exempts Emerging Growth Companies<sup>81</sup> from section 404 (b) SOX<sup>82</sup> and section 14A of the 34 Act (Say-on-Pay),<sup>83</sup> which mandate a shareholder advisory vote on executive compensation at least once every three years.<sup>84</sup> The Act also exempts these companies from section 953 (b) (1) of the Dodd-Frank Act, which requires companies to disclose the median annual total compensation of all their employees.<sup>85</sup> Congress reasoned that these exemptions were necessary to increase the creation of new jobs and to incentivize smaller growth
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1434141## (“Using a large sample of accelerated filers subject to AS5, we find evidence that audit fees decrease upon the adoption of AS5. More importantly, even though AS5 adoption reduces audit fees for our test sample, we find no evidence of a decrease in audit quality. In summary, we document evidence that AS5 improves the efficiency of internal control audits.”) 76 _Id_ .
> 77 _See_ Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203 § 989G, 124 Stat. 1376, 1948 (2010) (adding section 404(c) to the Sarbanes-Oxley Act).
> 78 _See_ Internal Control Over Financial Reporting in Exchange Act Periodic Reports of Non-Accelerated Filers, SEC Release No. 33-9142 (Sept. 15, 2010) (stating that filers other than “accelerated filers” or “large accelerated filers” are still required to include managers’ evaluation of its internal controls in their annual Form 10-K filings but are freed from an audit under the PCAOB rules).
> 79 Eric Lipton, _Banks Resist Strict Controls of Foreign Bets – Regulations that Stem From Fiscal Crisis_ , N.Y. TIMES, May 1, 2013, at A1, B2 (“Industry players have spent tens of millions of dollars to avert, delay or weaken new rules that are being drafted as part of the [Dodd-Frank Act].”).
80 Jumpstart Our Business Startups Act (JOBS Act) Pub. L. No. 112-106, 126 Stat. 306 (codified as amended in scattered sections of 15 U.S.C.).
81 U.S. Sec. & Exch. Comm’n, Jumpstart Our Business Startups Act Frequently Asked Questions: Generally Applicable Questions on Title I of the JOBS Act (Sep. 28, 2012), _available at_ http://www.sec.gov/divisions/corpfin/guidance/cfjjobsactfaq-title-i-general.htm (“An ‘emerging growth company’ is defined in the Securities Act and the Exchange Act as an issuer with “total annual gross revenues” of less than $1 billion during its most recently completed fiscal year.”) 82 15 U.S.C. § 7262 (2006).
83 Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111- 203, §951, 124 Stat. 1376, 1899 (2010). Dodd-Frank Section 951 amended the Securities Exchange Act of 1934 by adding Section 14A (codified as amended at 15 U.S.C. §78n-1). _See also_ Press Release, SEC, SEC Adopts Rules for Say-on-Pay and Golden Parachute Compensation as Required Under Dodd-Frank Act (Jan. 25, 2011), _available at_ http://www.sec.gov/news/press/2011/2011-25.htm.
> 84 _Id_ . Dodd-Frank Section 951 requires any publicly traded company to hold a shareholder vote at least once every six years on the frequency of the say-on-pay vote. _See_ Dodd-Frank Section 951(a)(2); Exchange Act Section 14A(a)(2); 15 U.S.C. §78n-1(a)(2). The first such vote on frequency was required in 2011. The longest interval between say-on-pay votes permitted under Dodd-Frank is three years. _See_ Dodd-Frank Section 951(a)(1); Exchange Act Section 14A(a)(1); 15 U.S.C. §78n-1(a)(1).
85 Memorandum from Dorsey Whitney on Dodd-Frank Wall Street Reform and Consumer Protection Act 11 (May 17, 2010), http://www.dorsey.com/files/upload/DoddFrankOverview.pdf.
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companies’ initial public offerings.<sup>86</sup> These exemptions again illustrate the easing of constraints imposed on the financial services industry after a crisis. Several other exemptions and regulatory retractions, often intended to address unintended consequences of the Dodd-Frank Act, are still pending.<sup>87</sup>
# _3. Financial Crises and the Regulatory Sine Curve_
An evaluation of the relationship between the common elements of financial crises and the regulatory sine curve may help researchers understand possible optimization processes for financial regulation.
Figure 1. Common Elements of Financial Crises vs. Regulatory Sine Curve
<!-- Start of picture text -->
creditèexpansion Regulatoryèxpansion<br>--- -1.0-<br>ess?<br>optimism<br>Exogenous<br>shock bank<br>failure<br>---1.0<br>Regulatorytontraction<br><!-- End of picture text -->
Figure 1 shows the relationship between the common elements of banking and financial crises and the regulatory sine curve. The black line illustrates the core common elements of financial crises: (i) an exogenous shock, (ii) credit expansion (or other favorable response to the exogenous shock), (iii) less optimism (favorable conditions dissipate), and (iv) bank failure (often a systemic rise in bank failures).<sup>88</sup> The exogenous shock precipitates an expansion in credit and/or other measures such as financial innovation or sales of risky financial products such as CDOs. The favorable economic conditions peak and then dissipate. As the favorable conditions for credit expansion and/or other favorable conditions dissipate, the probability of systemic bank failures increases.
> 86 Press Release, White House, Remarks by the President at JOBS Act Bill Signing (Apr. 05, 2012), http://www.whitehouse.gov/the-press-office/2012/04/05/remarks-president-jobs-act-bill-signing; SEC, IPO TASK FORCE, REBUILDING THE IPO ON-RAMP: PUTTING EMERGING COMPANIES AND THE JOB MARKET BACK ON THE ROAD TO GROWTH (Oct. 20, 2011), _available at_ http://www.sec.gov/info/smallbus/acsec/rebuilding_the_ipo_on-ramp.pdf.
> 87 DAVID SKEEL, THE NEW FINANCIAL DEAL: UNDERSTANDING THE DODD-FRANK ACT AND ITS (UNINTENDED) CONSEQUENCES (2011).
> 88 _See supra_ discussion of common elements of crises.
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The blue line represents the regulatory sine curve and illustrates the relationship between governance adjustments in reaction to financial crises and their inevitable relaxation, revision, and retraction.<sup>89</sup> The regulatory sine curve (blue line) starts its upward slope when the positive economic conditions following the exogenous shock dissipate, resulting in conditions that are more likely to cause systemic bank failures (illustrated by the black line). The upward slope of the blue line is motivated by an upsurge in regulatory activity as a result of increasing bank failures.<sup>90</sup> When the blue and black lines intersect, the level of regulatory activity has not reached its peak, yet bank failures are increasing. As more banks fail, regulatory activity continues to increase but reaches its peak in the aftermath of bank failures and/or financial crises.
The relationships described by the three lines in Figure 1 helps illustrate the suboptimal relationship between the regulatory sine curve and common elements of banking and financial crises (and/or other events influencing economic conditions that could lead to financial crises). The author does not claim that any of the lines in Figure 1 accurately describes the relationship between common elements of banking and financial crises and the regulatory sine curve. Rather, the different lines (black and red) demonstrate that multiple different relationships may exist between the common elements of financial crises and the regulatory sine curve (blue line). In the current regulatory environment a suboptimal relationship exists between the regulatory sine curve and the common elements of banking and financial crises.
# **III. Dynamic Regulation of the Financial Services Industry**
Future financial crises may be inevitable. Factors such as globalization, financial innovation, ethical challenges, suboptimal institutional designs, and the bounded rationality of decision makers may create conditions that result in future crises. Future crises may require perhaps even more extensive governance adjustments. These factors in combination with the suboptimal relationship between common elements of banking and financial crises (including other possible indicators for financial crises) and the regulatory sine curve may justify an evaluation of optimization procedures for rulemaking. While business and regulatory cycles are bound to persist, optimizing the relationship between indicators for financial crises and the regulatory sine curve, especially the timing of regulatory responses to crises, could soften some of the effects of regulatory crises.
The concept of dynamic regulation supports a regulatory structure that curtails the regulatory sine curve and its negative and costly consequences _._ Increasing the availability of relevant information for rulemaking in a countercyclical and dynamic process could be a starting point for improved rulemaking. Dynamic regulation may be seen as the antithesis of static, stable, and presumptively “optimal” regulation and it may help counterbalance the effects of stable and presumptively optimal rules.<sup>91</sup> Synonyms for the word “dynamic” in the context of regulation may include self-motivated, vibrant, energetic, and forceful. Dynamic elements in regulation have previously been described as “dynamic games,”<sup>_92_</sup> “regulatory dialectic,” and “dynamic adjustment process.”<sup>_93_</sup>
> 89 Coffee, _supra_ note 3.
> 90 _See supra_ – Part II discussing the collective action problem of rulemaking.
> 91 Kaal, _supra_ note 19 (evaluating dynamic regulation in the New Institutional Economics Framework).
> 92 Edward Kane, _Extracting Nontransparent Safety Net Subsidies by Strategically Expanding and_
> _Contracting a Financial Institution’s Accounting Balance Sheet_ , 36 J. FIN. SERVICES RES. 161 (2009)
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Economists have used this concept in the context of innovation and learning by doing,<sup>94</sup> principal-agent and adverse selection problems,<sup>95</sup> continuing regulatory relationships,<sup>96</sup> and regulation of quality.<sup>97</sup> The majority of scholars who discuss the concept of dynamic regulation, however, do so in the context of the telecommunications industry.<sup>_98_</sup> The rapid pace of technological developments in telecommunication appears to have necessitated the use of dynamic elements in regulation.<sup>99</sup> The increasing volatility of financial markets in combination with financial innovation shows some parallels to the pace of technological developments in telecommunications markets.
Scholarly proposals for curtailing the effects of regulatory cycles include a preference for general exemptive authority under section 36 of the 34 Act,<sup>100</sup> agency independence,<sup>101</sup> regulatory contrarians,<sup>102</sup> mandated studies,<sup>103</sup> automatic triggers,<sup>104</sup> mandatory sunset provisions,<sup>105</sup> a general state law preference,<sup>106</sup> and possible synergies in regulatory cooperation.<sup>107</sup> Brett McDonnell classifies scholarly contributions in the context of regulatory cycles into three general categories:<sup>108</sup> (1) scholars who argue that
(“[R]egulation is best understood as a dynamic game of action and response, in which either regulators or regulatees may make a move at any time. In this game, regulatees tend to make more moves than regulators do. Moreover, regulatee moves tend to be faster and less predictable, and to have less-transparent consequences than those that regulators make.”).
> 93 Edward Kane, _Interaction of Financial and Regulatory Innovation_ 78 AM. ECON. REV. 328 (1988).
> 94 Tracy R. Lewis & Huseyin Yildirim, _Learning by Doing and Dynamic Regulation_ , 33 RAND J. ECON. 22, 23-25 (2002).
> 95 JOHN M. LITWACK, DYNAMIC REGULATION, DEMAND INFORMATION AND MARKET PRICES (1992).
> 96 David P. Baron & David Besanko, _Regulation and Information in a Continuing Relationship,_ 1 INFO. ECON. & POL’Y 267 (1984); David P. Baron & David Besanko _, Commitment and Fairness in a Dynamic Regulatory Relationship,_ 54 REV. ECON. STUD. 413 (1987).
> 97 Stephane Auray, Thomas Mariotti, & Fabien Moizeau, _Dynamic Regulation of Quality_ , 42 RAND J. ECON. 246 (2011).
> 98 MACHIEL VAN DIJK & MACHIEL MULDER, CPB MEMORANDUM 131, REGULATION OF TELECOMMUNICATION AND DEPLOYMENT OF BROADBAND (2005), _available at_ http://www.cpb.nl/sites/default/files/publicaties/download/memo131.pdf; Paul W.J. de Bijl & Martin Peitz, _Dynamic Regulation and Entry in Telecommunications Markets: A Policy Framework_ , 16 INFO. ECON. & POL’Y 411 (2004); Johannes M. Bauer & Erik Bohlin, _From Static to Dynamic Regulation - Recent Developments in US Telecommunications Policy_ , INTERECONOMICS, Jan./Feb. 2008, at 38.
> 99 _Id_ .
> 100 Coffee, _supra_ note 3.
> 101 McDonnell, _supra_ note 18.
> 102 Brett McDonnell & Daniel Schwarcz, _Regulatory Contrarians_ , 89 N.C. L. REV. 1629 (2011).
> 103 McDonnell, _supra_ note 18.
> 104 Wulf A. Kaal, _Contingent Capital in Executive Compensation,_ 69 WASHINGTON & LEE L. REV. 1821 (2012) [hereinafter Kaal Executive Compensation]; Wulf A. Kaal, _Initial Reflections on the Possible Application of Contingent Capital in Corporate Governance_ , 26 NOTRE DAME J.L. ETHICS & PUB. POL'Y 101 (2012) [hereinafter Kaal Initial Reflections]; McDonnell, _supra_ note 18.
> 105 Roberta Romano, _supra_ note 18; 4 REVUE TRIMESTRIELLE DE DROIT FINANCIER: CORP. FIN. & CAPITAL MARKETS L. REV. 175-76 (2011),
> 106 ERIN A. O'HARA & LARRY E. RIBSTEIN, THE LAW MARKET (2009); Larry E. Ribstein, _Limited Liability and Theories of the Corporation_ , 50 MD. L. REV. 80 (1991).
> 107 Kenneth M. Rosen, _Who Killed Katie Couric? And Other Tales from the World of Executive Compensation Reform_ , 76 FORDHAM L. REV. 2907 (2008).
> 108 Brett McDonnell, _supra_ note 18.
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regulators overreact during regulatory expansion and regulatory contraction,<sup>109</sup> (2) scholars who argue that overregulation follows crises,<sup>110</sup> and (3) scholars who argue that there is excessive deregulation during booms.<sup>111</sup>
While some regulators use the term “dynamic regulation” in the context of SEC exemptive powers,<sup>_112_</sup> the literature on financial regulation mostly ignores dynamic elements for regulation. Lyman Johnson has considered dynamic elements in the context of corporate law.<sup>113</sup> Some scholars recognize that the existing regulatory framework does not adequately address the concerns pertaining to regulatory cycles.<sup>114</sup> This paper adds to and expands that literature. The author identifies common elements of regulatory crises and suggests normatively that regulatory cycles could benefit from supplementing the existing regulatory framework with dynamic elements.
# _1. Rulemaking with Dynamic Elements_
Similar to economic dynamics,<sup>115</sup> the concept of dynamic financial regulation describes the study of financial regulatory phenomena in relation to preceding and succeeding events. Rulemaking is not longer a mere reactive process based only on preceding events and driven by the collective action problem of rulemaking. Rather,
> 109 _Id_ . OLSON, _supra_ note 24; Coffee, _supra_ note **3** ; Gregg A. Jarrell, _Change at the Exchange: The Causes and Effects of Deregulation_ , 27 J.L. & ECON. 273 (1984); George J. Benston, _Federal Regulation of Banking: Historical Overview_ , _in_ DEREGULATING FINANCIAL SERVICES: PUBLIC POLICY IN FLUX 1 (George G. Kaufman & Roger C. Kormendi eds., 1986); Edward J. Kane, _Changing Incentives Facing Regulators_ , 2 J. FIN. SERV. RES. 265 (1986); ERIK F. GERDING, BUBBLES, LAW AND FINANCIAL REGULATION (2013).
> 110 Brett McDonnell, _supra_ note 18; Romano, supra note 18; David D. Haddock & Jonathan R. Macey, _Regulation on Demand: A Private Interest Model, with an Application to Insider Trading Regulation_ , 30 J. L. & ECON. 311 (1986); Stephen M. Bainbridge, _Dodd-Frank: Quack Corporate Governance Round II_ , 95 MINN. L. REV. 1779 (2011); Larry E. Ribstein, _Bubble Laws_ , 40 HOUSTON L. REV. 77 (2003); Stigler _, supra_ note 13, at 3.
> 111 Brett McDonnell, _supra_ note 18; SIMON JOHNSON & JAMES R. KWAK, 13 BANKERS: THE WALL STREET TAKEOVER AND THE NEXT FINANCIAL MELTDOWN (2010); ENGEL & MCCOY, _supra_ note 18; Kimberly D. Krawiec, _Don’t Screw ‘Joe the Plumber’: The Sausage-Making of Financial Reform_ , 55 ARIZ. L. REV. 53103 (2013) (“I analyze the roughly 8000 public comment letters received by FSOC in advance of its study regarding Volcker rule implementation, and the meeting logs of the Treasury Department, Federal Reserve, CFTC, SEC, and FDIC prior to the Notice of Proposed Rulemaking.”).
112 Luis A. Aguilar, Commissioner, U.S. Sec. & Exch. Comm’n, Speech at the North American Securities Administrators Association’s Winter Enforcement Conference: Empowering the Markets Watchdog to Effect Real Results (Jan. 10 2009), _available at_ http://www.sec.gov/news/speech/2009/spch011009laa.htm (“Personally, I support the SEC's model of regulation, which focuses on investors and markets, and provides for strong and broad regulatory authority and vigorous enforcement, coupled with flexible exemptive power to permit dynamic regulation where needed.”).
> 113 Lyman P. Q. Johnson, _Dynamic, Virtuous Fiduciary Regulation_ , _in_ Festschrift Kirchner (Wulf Kaal et al. eds. forthcoming 2014).
> 114 Whitehead, _supra_ note 18, at 1307-08 (“The Goldilocks approach strikes a compromise between finalizing new rules at the outset and implementing new rules with sunset provisions. The former forces regulators to assess the effect of new rules with incomplete information; the latter increases the risk of regulatory capture around the time a sunset period ends. Staging new regulation--so long as the criteria used to assess regulation, and the procedures used to monitor and modify regulation, are specified up front-can help minimize unanticipated consequences and create more effective rules based on more complete information. Moving the regulatory process in that direction may be particularly timely in light of recent concerns over ineffective cost-benefit analyses undertaken by financial regulators under the Dodd-Frank Act.”); Krawiec, _supra_ note 111.
> 115 WILLIAM J. BAUMOL, ECONOMIC DYNAMICS: AN INTRODUCTION 4 (1951).
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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. Information pertaining to how financial institutions, or decision makers in financial institutions, actually act and how they are expected to react to unforeseen contingencies in the future helps incorporate dynamic elements into financial regulation. Social and mental properties of decision makers in financial institutions together with the incentive structure in the respective institutional setups can help determine a financial institution’s adaptive capability.
Dynamic elements in financial regulation could help facilitate a regulatory structure that curtails the regulatory sine curve and its negative and costly consequences and supports 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 future changes and challenges and adapt stable rules accordingly.<sup>116</sup>
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 in different jurisdictions. A mixture of market solutions, private ordering, and mandatory rules in different jurisdictions 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.
# _2. Optimizing the Regulatory Sine Curve_
The concept of the regulatory sine curve describes the phenomenon of rulemaking following financial crises and the inevitable relaxation, retraction, and revision of established rules thereafter.<sup>117</sup> This article suggests that while the regulatory sine curve may be inevitable and public rulemaking will likely continue to be subject to the collective action problem, the suboptimal effects of the collective action problem of rulemaking and the regulatory sine curve can be curtailed. Dynamic elements in financial regulation as a supplemental optimization process for rulemaking may help curtail the negative effects and regulatory outcomes generated by the sine curve of regulation.
Dynamic elements in financial regulation may enable regulation to more accurately trace developments that may lead to financial crises. Dynamic elements in financial regulation may even help anticipate and/or preempt financial crises by changing the timing, availability and quality of information, and the emphasis of regulation.
> 116 Contrasting dynamic regulation with other forms of governance and enforcement, private ordering focuses on the sharing of regulatory authority with private actors; self-regulation emphasizes the voluntary abiding by stricter standards; and self-policing highlights the monitoring of own adherence to legal and ethical standards.
> 117 Coffee, _supra_ note 3.
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Dynamic regulation could thus help optimize the regulatory sine curve. If appropriately implemented, the sine curve of regulation, supplemented and optimized with dynamic elements, may become an optimized sine curve in relation to the phase-shifted first derivative (cosine curve) that describes common elements of financial crises. Financial regulation (sine curve) would, thus, expand before financial crises occur (cosine curve). Through dynamic elements, rulemaking takes place when it is most needed – _ex-ante_ before crises – to help curtail the effects of crises and of suboptimal regulatory outcomes _ex-post_ after crises.
# a) Trailing Sine Curve
The relationship between the regulatory sine curve and common elements of banking and financial crises<sup>118</sup> can be optimized. Dynamic elements in financial regulation may enable regulation to more accurately trace developments that may lead to financial crises.
Figure 2. Trailing Sine Curve
<!-- Start of picture text -->
---2.0-<br>creditexpansion<br>---1.0-<br>Regulatorytexpansion x<br>π2 3π/2<br>---1.0<br>---2.0-<br><!-- End of picture text -->
Figure 2 shows a possible relationship between the regulatory sine curve (blue line) in relation to common elements of banking and financial crises (black and/or red line). Figure 2 suggests that the sine curve of regulation could merely trace the common elements of banking and financial crises such as credit expansion and or other events and indicators for events in the real economy that signal possible crises. As the black/red line start their downward slope, suggesting a systemic rise in bank failures, financial regulation with dynamic elements, as illustrated by the enhanced regulatory sine curve (blue line), may not necessarily increase disproportionally to avert the events signaling pending crises. The author does not claim that there would be a particular relationship or that the lines in Figure 2 accurately describe the possible relationship(s). Figure 2 merely illustrates a possible effect of adding dynamic elements to financial regulation.
> 118 _See supra_ text accompanying notes 35-41.
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# b) Anticipatory Sine Curve
Dynamic elements in financial regulation could also help optimize the regulatory sine curve to include anticipatory elements. A core problem for financial regulation is its timing. Governance improvements are not enacted when they are most needed - before crises. Rather, because of the collective action problem, financial regulation is mostly reactive, following business cycles.<sup>119</sup> Financial rulemaking also often utilizes centralized rather than decentralized information.<sup>120</sup> Dynamic elements in financial regulation may help adjust the timing of rule enactment and increase the availability and quality of information for financial rulemaking.<sup>121</sup> In effect, financial regulation that incorporates dynamic elements could help create an anticipatory regulatory response before financial crises occur. Dynamic elements in financial regulation could change the relationship between the regulatory sine curve and the occurrence and timing of common elements of financial crises. By including dynamic elements, the sine curve of financial regulation becomes an anticipatory sine curve in relation to the phase-shifted first derivative (cosine curve) that describes common elements of financial crises.
Figure 3. Anticipatory Sine Curve
<!-- Start of picture text -->
1.00<br>credit Regulatory sin x-<br>0.75 expansion expansion cos x<br>0.50<br>Less<br>0.25 Exogenous[] optimism<br>shock<br>0.00<br>bank<br>failure<br>0.25<br>0.50<br>0.75<br>1.00<br>-3n 5n2 �2n 3n 2 - 2 0 n 3π2 2n 3n<br>X<br><!-- End of picture text -->
Figure 3 describes how dynamic elements in financial regulation could help improve the relationship between the regulatory sine curve (red line) and common elements of financial crises (including other indicators for events in the real economy that signal possible crises), illustrated by the cosine curve (dotted blue line). The cosine curve (dotted blue line) describes the core common elements of financial crises: (i) exogenous shock, (ii) credit expansion (or other favorable response to exogenous shock such as increased financial innovation), (iii) less optimism (favorable conditions dissipate), and (iv) bank failure (often systemic rise in bank failures).<sup>122</sup> The sine curve of regulation (red line) describes the intensity of financial regulatory supervision via the enactment of rules.
> 119 _See supra_ text accompanying notes 24-25.
> 120 Kaal, _supra_ note 19.
> 121 _Id._
> 122 _See supra_ discussion of common elements of crises.
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Figure 1 has demonstrated that without dynamic elements, the regulatory sine curve starts its ascent and regulatory activity increases when banks fail or other indicators of financial crises are more prevalent. By contrast, Figure 3 suggests that dynamic elements in financial regulation could optimize the relationship between the regulatory sine curve and the common elements of banking and financial crises. Figure 3 shows the sine curve in a dynamic regulation framework (red line). The regulatory engagement increases as credit becomes more readily available and/or other favorable responses to the exogenous shock occur – the cosine curve starts its descent. As the downward sloping line of the cosine curve continues its descend, describing the systemic rise in bank failures, the sine curve of regulation in a dynamic framework reaches its peak, regulatory engagement reaches its highest level.
Figure 3 illustrates that a regulatory framework supplemented with dynamic elements could help create an anticipatory regulatory response because financial rulemaking takes place when it is most needed – _ex-ante_ before crises. Dynamic regulation could, thus, help flatten out and dampen the volatility of both the cosine curve and the regulatory sine curve.
# **IV. Implementation**
Dynamic regulation can be more than a theoretical concept. While outlining strategies and procedures for implementing different forms of dynamic regulation is beyond the scope of this article, several governance mechanisms with dynamic elements already exist and merit a short introduction. If combined with existing stable and presumptively optimal rules in the existing regulatory framework and the existing rulemaking process, these governance mechanisms, among others, could become part of a dynamic optimization and supplementation process for rulemaking.
The theoretical framework outlined above suggests that adding dynamic elements to the rulemaking process could help increase the adaptive capabilities of financial regulation. This may be accomplished by including institution specific rules in financial rulemaking. Institution specific rules could be facilitated through the increasing use of institution specific information and private ordering.<sup>123</sup> Contingent Capital Securities (CCS or CoCos), Corporate Integrity Agreements (CIAs), and Deferred Prosecution Agreements (DPAs) are among the governance mechanisms that can provide institutions specific information for financial rulemaking.
CoCos are debt securities that convert into equity or are written down upon a triggering event.<sup>124</sup> Depending on the respective CoCo designs, CoCos can function as an early warning system to preempt financial crises.<sup>125</sup> Through their trigger design, CoCos can help assess the risk of institution specific credit expansion, among other indicators, before financial crises. Institution-specific transactional and automatic triggers are privately negotiated terms for CoCo triggering events. These triggers can convert debt into equity when a certain capital ratio, stock price, index value, CDS spread, or other
> 123 Steven L. Schwarcz, _Private Ordering_ , 97 NW. U. L. REV. 319 (2002) available at: http://ssrn.com/abstract=298409 or http://dx.doi.org/10.2139/ssrn.298409.
> 124 _See_ Kaal Executive Compensation, _supra note_ 104; Kaal Initial Reflections, _supra note_ 104.
> 125 _Id._ CoCos have already been successfully issued by European Systemically Important Financial Institutions (SIFIs). _Id._
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institution specific trigger is reached.<sup>126</sup> Because institution-specific automatic triggers are independent from regulatory discretion, they have the advantage of being flexible and can be tailored to the parties’ respective needs.<sup>127</sup>
CoCos can help signal the need for regulatory action and may help facilitate an incentive structure that allows regulators to rely partially on private ordering, effectuating increased adaptability of the rulemaking process. Managers are incentivized to manage their respective entities to avoid CoCo triggers, which can help optimize governance of financial institutions.<sup>128</sup> While the threat of conversion of CoCos alone could help institute governance improvements, should CoCos ever get triggered in a specific institutional setting, the resulting conversion from debt to equity could enable rule makers to evaluate the need for regulatory action pertaining to other institutions or the industry at large.<sup>129</sup> While regulators have other means of monitoring debt/equity ratios and capital adequacy ratios, a CoCo triggering event signals that management was unable to manage the entity to avoid the triggering event, suggesting that regulatory action may be needed. Because CoCos can thus signal the institution specific need for regulatory action, rule makers can act with more institution specific information and draw conclusions as to whether stable rulemaking is needed for the market segment in which the affected entity operates. CoCo issuances with institution-specific automatic triggers may thus help facilitate dynamic elements in the rulemaking process and increase the adaptability of rules.
> 126 _See_ Mark J. Flannery, _Stabilizing Large Financial Institutions with Contingent Capital Certificates_ 11– 12 (Working Paper, 2009), _available at_ http://papers.ssrn.com/sol3/papers.cfm? abstract_id=1485689; Mark J. Flannery, No Pain, No Gain? Effecting Market Discipline via “Reverse Convertible Debentures” 30 (Nov. 2002) (unpublished manuscript), _available at_
http://bear.warrington.ufl.edu/flannery/No%20Pain,%20No%20Gain.pdf (“Frequent trigger evaluations eliminate moral hazard incentives and expose the RCD to surprisingly low default risk.”); John C. Coffee, Jr., _Systemic Risk After Dodd–Frank: Contingent Capital and the Need for Regulatory Strategies Beyond Oversight_ , 111 COLUM. L. REV. 795, 806 (2011); Robert L. McDonald, _Contingent Capital with a Dual Price Trigger_ 2 (Working Paper, 2010), _available at_ http://ssrn.com/abstract=1553430, at 2 (proposing “a form of contingent capital for financial institutions that converts from debt to equity if two conditions are met: the firm’s stock price is at or below a trigger value and the value of a financial institutions index is also at or below a trigger value.”); Paul Glasserman & Behzad Nouri, _Contingent Capital with a CapitalRatio Trigger_ (Aug. 31, 2010), _available at_ http://ssrn.com/abstract=1669686 (analyzing the case of contingent capital with a capital-ratio trigger and partial and on-going conversion).
> 127 _See_ Kaal Executive Compensation, _supra note_ 104 (some possible downsides to using CoCos with automatic institution specific triggers for dynamic regulation include: accounting-based measures in institution-specific automatic triggers may not be able to respond adequately in financial crises because they are arguably too infrequently updated. Market-based measures, on the other hand, could be susceptible to market manipulation and banking runs _._ )
> 128 _Id._ (assessing the role of CoCos as a new power player in corporate governance through, among others, the effect of the (threat of) conversion and dilution, reduced incentives for shareholders to encourage management to take higher risks for higher returns, vote by former CCS holders to remove management upon conversion, reputational loss for management upon conversion, and incentives to manage against bad outcomes - not just manage for good outcomes.)
> 129 For a discussion of incentive optimization through the use of CoCo triggers _see_ Kaal Initial Reflections, _supra note_ 104; and _see_ Kaal Executive Compensation, _supra note_ 104.
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Deferred Prosecution Agreements (DPA)<sup>130</sup> and Corporate Integrity Agreements (CIAs), among other forms of cooperation,<sup>131</sup> may be able to provide institution specific information and feedback effects between the affected entities, the markets or market segments in which they operate, and regulators. This can help facilitate cooperation between regulators, between regulators and financial institutions, and between regulators and the public. Through increased institution specific information, feedback effects, and cooperation, DPAs and CIAs may provide dynamic elements for financial regulation.
DPAs allow financial institutions to negotiate cooperative settlements with prosecutors. Prosecutors are increasingly using DPAs.<sup>132</sup> In the context of a particular allegation of corporate misconduct, the prosecutor agrees to defer or refrain from prosecuting a financial institution in return for the institutions’ agreement to undertake reforms such as increased compliance programs, governance changes, and/or public disclosures of information pertaining to the matter in question. While prosecutors may not have the necessary expertise to negotiate high level corporate governance changes, such as personnel changes and internal corporate and compliance procedures, DPAs can successfully address externalities such as the adverse collateral consequences of corporate prosecution and conviction, among others.<sup>133</sup>
Important for the use of DPAs in the context of dynamic regulation, DPAs can generate institution specific information and provide institution specific solutions for governance shortcomings<sup>134</sup> while at the same time creating a signaling effect for regulators. With the institution specific and decentralized information generated by DPAs, regulators may be able to better understand shortcomings in a particular market segment or industry. Rulemaking can, thus, be more narrowly tailored and adjusted to the specific circumstances of the respective institution, industry, or market segment. With the increased availability of reliable institution specific information, rules may become more adaptable over time.
CIAs are in many ways comparable to DPAs. CIAs are compliance programs primarily used for healthcare companies that are enforced by the government but funded by the respective institution that negotiated the CIA with the government.<sup>135</sup> To facilitate the detection of compliance issues, a CIA gives the government improved access to the
> 130 Lawrence A. Cunningham, _Deferred Prosecutions and Corporate Governance: An Integrated Approach to Investigation and Reform_ , 65 FLORIDA L. Rev. [_] (2013) available at: http://ssrn.com/abstract=2256624 or http://dx.doi.org/10.2139/ssrn.2256624.
> 131 David A. Katz et al., _Wachtell Lipton Discusses the SEC and “Exceptional” Cooperation_ , CLS BLUE SKY BLOG (Apr. 26, 2013), http://www.wlrk.com/webdocs/wlrknew/AttorneyPubs/WLRK.22453.13.pdf (“Earlier this week, the SEC announced that it had entered into a non-prosecution agreement (NPA) with Ralph Lauren Corporation to resolve an investigation under the Foreign Corrupt Practices Act (FCPA). While the Department of Justice also announced that it had entered into an NPA with Ralph Lauren, it is the SEC agreement that is most notable. This agreement, only the fourth publicly reported NPA that the SEC has entered since it announced that it would begin using such agreements – and the first such agreement in an FCPA case – illustrates the potential benefits of cooperation.”).
> 132 Almost 300 DPAs have been executed since 2003. Before 2003, DPAs were rarely used. _See_ http://lib.law.virginia.edu/Garrett/prosecution_agreements/
> 133 Cunningham, _supra_ note 130, at 16.
> 134 _Id._
> 135 Wulf A. Kaal & Elizabeth Malay, _Corporate Integrity Agreements as Quasi Fiduciary Duties,_ (forthcoming 2013).
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respective institution.<sup>136</sup> Institutions that are subject to a CIA agree to increased government supervision during the term of the CIA,<sup>137</sup> which can result in costly additional mandatory compliance measures and may carry the risk of further penalties.<sup>138</sup> Penalties for the breach of a CIA may include exclusion from federally funded healthcare programs, criminal prosecution, fines, and additional CIAs.<sup>139</sup> In a civil or criminal trial, CIAs can heighten the legal standards for the respective institution<sup>140</sup> and may, thus, facilitate its prosecution. The government can more easily reopen a case for an institution that was subject to a CIA,<sup>141</sup> especially if the government finds that certifications required under the terms of a CIA misstate the institution’s true compliance. The ease of prosecution, the increased scrutiny by the government, and the potential for crippling penalties can improve boards’ and managements’ knowledge of pertinent issues in the institution and its monitoring. CIAs can, thus, improve corporate governance.
If broadly applied to financial institutions, DPAs and CIAs could help increase the adaptive capabilities of financial regulation. The threat of heightened scrutiny for institutions subject to a DPA/CIA may help optimize incentives because financial institutions would be subjected to increased monitoring by government regulators only after a first time offense had occurred. Financial institutions would have incentives to comply with governance requirements and self-regulate to avoid being subjected to increased monitoring and continuous heightened government scrutiny. Once a DPA/CIA is in place, the increased scrutiny by the government for institutions that operate under a DPA/CIA can provide enhanced institution specific information for regulators that would otherwise not be available. With more institution specific information available, regulators can improve their understanding as to when institution specific regulatory action may be needed and how it may be adequately implemented. Regulators can draw conclusions as to whether stable rulemaking is needed for the particular market segment in which the affected institution operated. DPAs and CIAs may thus help increase the adaptability of rules and facilitate dynamic elements in the rulemaking process.
# **V. Conclusion**
This article makes a contribution to the literature on financial regulation and the literature on the political economy of financial regulation. Rules established in reaction to financial crises mostly fail to curtail or preempt the effects of financial crises. The resulting amendments, revisions, and retractions of existing rules create substantial
> 136 _See Corporate Integrity Agreement FAQ_ , U.S. Dept. Health and Human Services Office of Inspector General, https://oig.hhs.gov/faqs/corporate-integrity-agreements-faq.asp
> 137 _Id._
> 138 For instance, an institution that operates under a CIA may give the Office of the Inspector General (OIG) permission to inspect their compliance documents and conduct on-site inspections to assess the company’s compliance with the CIA. Greg Luce, _Health Care Litigation Strategies: Leading Lawyers on Analyzing Recent Health Care Litigation Trends, Developing Successful Case Strategies, and Protecting Client Rights, Defending the Health Care Industry Against the Government’s Expanding and Novel Theories of Liability_ , ASPATORE 2011 WL 4453324 (2011).
> 139 The $2.3 billion Pfizer settlement in 2009 illustrates the significant ramifications of illegal activity while operating under a CIA _see In re Pfizer_ , 722 F.Supp.2d at 457.
> 140 Gabriel L. Imperato & Marc S. Raspanti, _Compliance and Governance for Health Care Organization and Marketing and Sales Activities_ , 11 No. 3 J. HEALTH CARE COMPLIANCE 5, 7 (2009).
> 141 James N. Czaban, _Meeting the Challenge of Increased Enforcement for Food and Drug Industry Clients_ , ASPATORE 2011 WL 5833342, 3 (Nov. 2011).
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transaction costs and uncertainty. A preferable regulatory solution would avert the downsides of cyclical and merely responsive regulation.
Dynamic elements in financial regulation as a supplemental optimization process for rulemaking could help facilitate effective and anticipatory rulemaking before crises. Dynamic elements in financial regulation could help support regulators in their efforts to continually adapt to financial innovation and new market environments. A mixture of mandatory rules, market solutions, and private ordering could help increase the adaptive capabilities of rulemaking, curtail the effects of the collective action problem of rulemaking, and dampen regulatory cycles.
Epitomizing the adaptive and anticipatory capabilities of dynamic regulation, dynamic elements in financial regulation could change the relationship between the occurrence and timing of common elements of financial crises and the regulatory sine curve. By adding dynamic elements to financial regulation, the sine curve of financial regulation may start its upward slope before the occurrence of financial crises. Dynamic regulation could, thus, help dampen regulatory cycles.