Wall Street as community of fate: toward financial industry self-regulation.

• Author: Omarova, Saule T.

INTRODUCTION A. The Paradox B. Summary of the Argument I. SELF-REGULATION AND NEW GOVERNANCE: THEORETICAL BACKGROUND A. Self-Regulation in Academic Debate: Some Definitional Issues B. Self-Regulation as a Form of New Governance: A Brief Overview II. FINANCIAL INDUSTRY SELF-REGULATION IN THE POSTCRISIS WORLD: RETHINKING THE PARADIGM A. Systemic Risk: A New Rationale for Industry Self-Regulation B. "Embedded" Self-Regulation III. THE ROAD TO SELF-REGULATION: LESSONS FROM OTHER INDUSTRIES A. "Community of Fate" as the Basis for Industry Self-Regulation B. The Rise of Self-Regulation in the Nuclear Power and Chemical Manufacturing Industries: A Brief Overview C. Building a Community of Fate: Key Factors Behind the Transformation IV. ASSESSING INCENTIVES FOR THE EMERGENCE OF A SYSTEM OF EMBEDDED SELF-REGULATION IN THE FINANCIAL SERVICES SECTOR A. Intrasector Homogeneity and Commonality of Interests B. Relationship Between the Industry and the Public C. Regulatory Context and the Tradition of Self-Regulation D. Effects of the Public Safety Net E. Potential for Industry Initiative V. TOWARD EMBEDDED SELF-REGULATION IN THE FINANCIAL SECTOR: SHAPING COMMUNITY OF FATE THROUGH REGULATORY DESIGN? A. Regrouping the Industry B. "Regulating Self-Regulation": Reshaping the Broader Context CONCLUSION Americans are angry at Wall Street, and rightly so. First the financial industry plunged us into economic crisis, then it was bailed out at taxpayer expense. And now, with the economy still deeply depressed, the industry is paying itself gigantic bonuses. If you aren't outraged, you haven't been paying attention. (1)

Paul Krugman

Probably the circumstances most conducive to successful self-regulation are those where an industry, or at least industry leaders, perceive the future prosperity and perhaps even the very survival of the industry as dependent upon some form of self-control. The best examples are those of the nuclear power and chemical industries.... (2)

Neil Gunningham & Joseph Rees

INTRODUCTION

In the wake of the worst financial crisis since the Great Depression, policymakers around the world are searching for ways to manage systemic risk in the global financial market. (3) This Article argues that one key and currently overlooked potential mechanism for controlling and minimizing systemic financial risk is industry-wide self-regulation. This Article advocates a fundamentally new self-regulatory regime in the financial sector, which would focus explicitly on the issue of systemic risk prevention and impose the responsibility of protecting the public from financial crises directly on the financial services industry. (4)

Further, this Article argues that the financial services industry currently lacks meaningful incentives to develop this new type of more publicly minded and socially responsible self-regulation. It examines the experience with self-regulation in other sectors--in particular, the nuclear power and chemical manufacturing industries--and analyzes how the key factors that allowed such self-regulatory regimes to emerge in those industries might play out in the financial sector.

Finally, this Article argues that it is possible to alter the existing incentive structure through thoughtful regulatory design, and it proposes some steps that may be taken in that direction.

1. The Paradox

   The past two years have seen a huge upsurge in proposals to reform the existing system of financial services regulation, both in the United States (5) and abroad. (6) Much of this debate, spurred by the recent turmoil in global financial markets, has centered around issues of agency structure and the redrawing of regulatory and supervisory responsibilities. (7) With respect to more substantive changes to the existing regulation, the tendency has been to focus on specific "fixes" to individual problems widely viewed as key contributors to the recent crisis, including regulation of mortgage brokers, credit rating agencies, and over-the-counter derivatives. (8) The Dodd-Frank Act, which is widely viewed as the most comprehensive and far-reaching financial reform legislation in the United States since the New Deal, reflects these concerns and incorporates many of the ideas these proposals advance. (9) However, what is conspicuously absent from the new legislation, as well as the broader debate among academics and policymakers, is a meaningful discussion of the role and shape of industry self-regulation in the emerging postcrisis regulatory order, either on a national or transnational level.

   Perhaps, to some, this absence is decidedly obvious and defensible: after all, it was the financial industry's unbridled pursuit of economic profit and the government's inability, or unwillingness, to keep it in check that led to the crisis in the first place. In today's postcrisis environment, the idea of financial industry self-regulation is not politically popular. (10) Wall Street's conduct in bringing about the near collapse of the world's credit and capital markets, (11) in arguably taking unfair advantage of governments' bailout programs, (12) and, finally, in paying exorbitantly high bonuses in the midst of a major recession triggered by the financial crisis (13) certainly did little to enhance the public image of the financial services industry. (14) Amid widespread, and largely justified, skepticism toward banks' and other financial institutions' ability to act in a socially responsible or publicly minded manner, a call for allowing them to run their own affairs is counterintuitive, to say the least.

   This anti-industry sentiment, however, obscures an important paradox. Although too much freedom for the financial industry to "innovate" in pursuit of ever-increasing profits may have been a major cause of the current problems in the financial sector, denying industry self-regulation its proper place in the future regulatory architecture will almost certainly foreclose a workable long-term solution to those problems. Given the complexity and global nature of the modern financial market, any government's attempt to regulate it in a purely unilateral command-and-control manner will inevitably encounter the fundamental problem of regulatory arbitrage, whereby financial institutions find new ways to get around government rules, thus creating a never-ending spiral of rulemaking and rule evading. (15) Only by enlisting the industry's active participation in the regulatory process can this vicious circle be broken. Thus, the lack of attention to self-regulation is an important omission in the debate on regulatory reform in the financial services sector. This Article fills that significant gap. (16)

   It is crucial to state from the outset that this Article does not equate "self-regulation" with "deregulation." Nor does it advocate complete withdrawal of the government from the regulatory space in the financial sector. To the contrary, what drives this project is a search for new, creative ways to reinvigorate and strengthen the foundation of government regulation in the financial services sector, to make it more targeted and effective, and to broaden the regulatory perspective by taking a more comprehensive view of the reform process. Accordingly, this Article builds upon the vast and multidisciplinary body of academic literature known as New Governance. (17) The New Governance scholarship posits, generally, that the traditional top-down model of regulation, in which the power to create rules belongs exclusively to the state, is being replaced by a more flexible "governance" model, in which power to set and enforce the rules is increasingly diffused among a variety of societal actors working alongside the governments. (18) Using the insights that literature has developed, this Article seeks to redefine the meaning and goals of self-regulation and, more generally, the mode of interaction between public and private actors in the financial services sector. In that sense, it is a part of the larger process of rethinking the fundamental tenets of regulatory philosophy underlying the existing system of financial sector regulation and supervision. (19)

2. Summary of the Argument

   Financial industry self-regulation has a long history in the United States and elsewhere. However, this Article argues that an understanding of financial sector "self-regulation" based primarily on the existing self-regulatory practices in the U.S. securities and commodity futures industries is fundamentally limited in scope. In the U.S. securities industry, a number of self-regulatory organizations (SROs), including registered stock exchanges and the Financial Industry Regulatory Association (FINRA), operate under strict oversight by the Securities Exchange Commission (SEC) and direct their activities primarily at managing, often in excruciating detail, the everyday business of securities broker-dealers and other market intermediaries. (20) Under this concept of industry self-regulation, rooted deeply in the regulatory paradigm of the post-Great Depression era, securities SROs function effectively as quasi-governmental entities performing resource-intensive tasks "outsourced" to them by the SEC. (21)

   By contrast, the dynamics of the twenty-first-century global financial market demand a new approach to industry self-regulation, which has the potential to be much more comprehensive and systemic in its scope and operation. The most recent financial crisis clearly demonstrated that the most fundamental challenges facing financial regulators and policymakers stem from the increasing complexity of financial products and activities and the globalization of financial markets and institutions. Industry self-regulation could serve as the key link allowing us to tackle two issues central to regulatory reform in the aftermath of the crisis: the critical role of timely access to market information, on the one hand, and the need to monitor and manage risk across jurisdictional...