Private Enforcement of Systemic Risk Regulation

• Publication year: 2022

43 Creighton L. Rev. 993. PRIVATE ENFORCEMENT OF SYSTEMIC RISK REGULATION

PRIVATE ENFORCEMENT OF SYSTEMIC RISK REGULATION

Heidi Mandanis Schooner(fn*)

I. INTRODUCTION

The list of causes of the 2008 Financial Crisis is long, varied, and the subject of debate. Just as we continue to debate the causes of the Great Depression, we will likely continue to debate the causes of the 2008 Financial Crisis for many years to come. A common list of failures contributing to the Financial Crisis includes: global imbalances (excess savings in some countries and excess borrowing in others), erroneous monetary policy (sustained ultra-low interest rates), financial innovation (for example, the reliance on securitization of mortgages), risk management and internal control failure, market discipline failure, and regulatory failure.(fn1)

This Article does not attempt to decide the relative importance of any of these or other factors. This Article does assume, as discussed below, that regulatory failure is an important cause. The United States Congress directed the Financial Crisis Inquiry Commission ("FCIC")(fn2) to examine, inter alia, the role of "[f]ederal and State financial regulators, including the extent to which they enforced, or failed to enforce statutory, regulatory, or supervisory requirements."(fn3) The FCIC must submit its report to Congress later this year. Still, it appears fairly evident that our regulatory system failed to prevent a costly crisis. Of course, some might argue that the regulatory system failed because of its overactive role in financial markets. Others would claim that the regulatory system underestimated and under-regulated risk. Either way, the regulatory system failed to protect the economy from a significant systemic meltdown.

Wise commentators note that reform is premature when the exact nature and causes of the financial crisis are yet to be determined.(fn4)Yet, proposals for regulatory reform hit the streets before anyone knew the extent of the crisis. The United States Department of the Treasury ("Treasury") released its Blueprint for a Modernized Financial Regulatory Structure ("Blueprint")(fn5) while President Bush was still in office and while the depth of the crisis remained unrealized. Soon after the election of President Obama, Treasury outlined a proposal that accounted for the full measure of the crisis.(fn6) On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act(fn7) (hereinafter the "Dodd-Frank Act"). The Dodd-Frank Act will have far-reaching impact on the financial services industry. The exact impact of the Dodd-Frank Act will not be known for some time because many of the implementation details have been left to rulemaking by the various regulatory agencies. This Article will focus on the key provisions of the Dodd-Frank Act that are most directly linked to regulating systemic risk.

The Dodd-Frank Act does not sufficiently address the problem of agency discretion generally, or the problem of an agency's discretion to forebear, in particular. This seems a striking omission given the findings of the Congressional Oversight Panel ("COP") and other research concluding that the regulatory failure in the 2008 Financial Crisis was not caused by agencies' lack of regulatory authority (although the lack of statutory authority may have played a limited role).(fn8) Rather, the agencies exercised their considerable discretion in favor of not regulating. As discussed below, an agency might choose to refrain from enforcing existing laws or writing new regulations for many reasons. The public interest may justify some of those reasons but may not justify others. Nevertheless, it seems that agencies will always have considerable discretion and that an effective regulatory regime should include some check on that discretion. This Article focuses specifically on the issue of agency enforcement and considers whether private monitoring could enhance the current public enforcement regime. Part II discusses the nature of systemic risk and the realization in the wake of the 2008 Financial Crisis that existing forms of prudential regulation did not adequately address systemic risk. Part iii briefly overviews the provisions of the Dodd-Frank Act that seek better regulation of systemic risk. Part IV discusses the preliminary findings regarding the causes of the 2008 Financial Crisis which conclude that regulatory failure was an important element. Part V discusses the current mechanism for public enforcement of prudential regulation. Part Vi considers whether private enforcement might serve as a valuable enhancement to the public enforcement regime. Part Vii proposes a hybrid public/private qui tam model of enforcement as a potentially valuable enhancement to systemic risk reform.

II. systemic risk

The 2008 Financial Crisis spawned a cottage industry in the business of defining systemic risk.(fn9) Systemic risk may serve as a strange reminder of the only thing that many lawyers know about the law of obscenity-you can't define it but you know it when you see it.(fn10) Systemic risk seems to suffer from the opposite limitation. While systemic risk can be defined as a general matter, identifying the emergence of such risk is a significant challenge.(fn11) The nature of a systemic crisis may not be adequately captured or understood without years of retrospective analysis. Moreover, government action to stave off systemic crisis may prevent a crisis from occurring. Thus, we may never know whether there would have been a systemic event in the absence of such intervention.

In a recent report to the G20 by the International Monetary Fund, Bank for International Settlements, and Financial Stability Board, systemic risk is defined as "the disruption to the flow of financial services that is (i) caused by an impairment of all or parts of the financial system; and (ii) has the potential to have serious negative consequences for the real economy."(fn12) The reforms addressed in this Article are an attempt to mitigate such risk.

Of course, governments have long attempted to prevent systemic crisis. The primary mechanism for traditional systemic risk regulation has been the prudential regulation of banks. Prudential, or sometimes called "safety and soundness," regulation traditionally sought to prevent systemic crisis by protecting banks from failure.(fn13) The 2008 Financial Crisis, however, challenged the assumption that systemic risk could be addressed by attempting to protect the solvency of individual banks (what is now called a "micro-prudential" approach to regulation). Markus Brunnermeier et al. wrote:

The current approach to systemic regulation implicitly assumes that we can make the system as a whole safe by simply trying to make sure that individual banks are safe. This sounds like a truism, but in practice it represents a fallacy of composition. In trying to make themselves safer, banks, and often highly leveraged financial intermediaries, can behave in a way that collectively undermines the system. Selling an asset when the price of risk increases, is a prudent response from the perspective of an individual bank. But if many banks act in this way, the asset price will collapse, forcing institutions to take yet further steps to rectify the situation. It is, in part, the responses of the banks themselves to such pressures that leads to generalised declines in asset prices, and enhanced correlations and volatility in asset markets.(fn14)

This observation regarding the nature of systemic risk highlights two general deficiencies in our current system of regulation. First, banks are not the only systemically important financial institutions. other financial institutions, such as investment banks and hedge funds, can also contribute to systemic crisis. Second, protecting the solvency of a financial institution does not always prevent systemic risk since a firm may take steps to protect its own solvency (for example, by selling assets), and that action, if repeated by other firms, may be what triggers the systemic crisis. Therefore, many reform proposals highlight the importance of adding a macro-prudential focus to the traditional micro-prudential regimes. Stated another way, such new regulatory regimes would not only focus on the solvency of commercial banks (micro-prudential) but would also consider the impact of the activities of all financial institutions on the financial system and real economy (macro-prudential).(fn15)

The purpose of this Article is not, however, to make the case for reform or expansion of systemic risk regulation.(fn16) The challenges to developing such a system are great especially given the potential for increasing moral hazard once systemic firms or activities are identified. As discussed in Part III, the Dodd-Frank Act adopts a macroprudential approach, and this Article does not attempt to decide whether the substance of that approach is ideal. Rather, this Article focuses on the question of whether reforms like those in the Dodd-Frank Act can be enhanced by including enforcement mechanisms outside of the existing public enforcement system.

iii. systemic risk reform proposals

Lawmakers and scholars continue to develop and refine their proposals for regulatory reform. Many of the proposals would have far-reaching impact on the financial services industry. Below is a very brief overview of...