Improving Crisis-driven Financial Regulation

It may come as no surprise that crisis-driven situations are prone to the adoption of ineffective rules.  Seeking to mitigate economic harm and ease public concern in the face of a crisis, legislators often feel compelled to pass new laws before they have collected adequate information about the true causes of the crisis.

In a new paper, “Regulating in the Dark,” Yale law professor Roberta Romano argues that a solution to the problems of crisis-driven legislation would be to increase the use of sunset provisions.  Such provisions would make it easier to review crisis-driven legislation after the heat of the moment passes, giving regulators a second chance to “get it right.”

According to Romano, a key problem with regulating during a financial crisis is the uncertainty of how new legislation will affect business behavior.  She examines this challenge through three recent crisis-driven financial laws:  the Sarbanes-Oxley Act, the Dodd-Frank Act and the Basel Accords.

In the case of Sarbanes-Oxley, introduced in response to the stock market decline in the early 2000s, Romano suggests that certain provisions, such as the governance mandates, were taken from pre-existing policy proposals that had received little support as effective in the academic literature.  However, given the media-frenzy surrounding the crisis and the pressure on regulators to do something quickly, the same policies, labeled as tailor-made solutions to the crisis at the time, were quickly implemented. Romano points out that this legislation is still law, despite imposing considerable cost and having no discernible  positive impact.

Romano also criticizes excessive administrative delegation as an equally ineffective mechanism for dealing with uncertainty in a crisis, using the Dodd-Frank Act as an example. Though some commentators might believe that institutional competence would make financial agencies best suited to determine successful solutions during an economic crisis, Romano contends that legislators often use delegation to create the appearance that they are taking action, while facilitating avoidance of criticism for the substance of any eventual regulation. Romano points to the numerous substantive rulemaking instructions in the Dodd-Frank Act with short deadlines that are impossible to meet as evidence supporting her contention that more informed decisionmaking was not the reason, noting that 104 rulemaking deadlines had already been missed at the statute’s 1-year anniversary.

She also views the Basel accords as an example of how global harmonization is an equally ineffective strategy for coping with crisis, arguing that a global top-down approach cannot adapt readily to change or foster the diversity necessary to be effective. Additionally, Romano maintains that the excessive political maneuvering required to reach consensus in the international system can make it difficult to weigh risks and determine the most appropriate regulatory response.

Given the limited availability of information in times of crisis and the need to act, the risk of unintended adverse consequences of regulatory action is substantial.  By revisiting statutes and implementing regulation after their enactment, Romano maintains that harmful outcomes can at least be mitigated later.

Sunsetting calls for legislation to have a dedicated expiration date unless it is affirmatively reenacted. Romano asserts that sunsetting could help remedy the issue of “stickiness” in Congress—the tendency not to quickly repeal legislation once it has been enacted, despite its being ineffective or even counterproductive.

Not only would having a dedicated termination date for a statute alleviate the risk of making a permanent error, but including a sunset provision would give legislators the opportunity to incorporate information that has become available after the statute’s enactment. But in order to be effective, she suggests that the sunset provisions would require much more than just an expiration date. Specific evaluative criteria related to the statute would need to be developed in order to avoid unfocused statutory reviews.

Romano recommends the establishment of a sunset review panel composed of independent experts in the relevant field of the statute who are given a designated timetable for reporting recommendations and congressional action in response.  Having such a system, or a similar system using agencies to perform the reviews, could alleviate the burden on legislators and enhance the quality of the reevaluation, she argues.

However, not everyone is in agreement that sunsetting crisis-driven provisions would have a positive impact. Romano notes two criticisms raised by John Coffee, a law professor at Columbia University, against sunsetting: that the administrative process would be susceptible to capture by financial institutions and therefore would be at odds with   the public interest;  and that the flaws in crisis legislation will be revised by  administrative agencies over time.

But according to Romano, Coffee’s reasoning is mistaken. Regarding the first criticism, she notes that provisions in crisis legislation do not always reflect the public interest, as Coffee maintains, and, of course, the interests of the public and business are not necessarily at odds. She further points out that financial institutions are not a monolithic interest group, but are often divided over regulatory policy, and there are opposing organized groups who participate actively in the regulatory process, with political clout, in the financial regulation area, such as public pension funds and unions.   Finally, she explains that if Coffee’s first criticism, that the administrative process is captured, were true, then he should support all the more sunsetting because that review process would make more transparent an agency’s decisions, by placing them under public scrutiny as Congress reconsiders the legislation and its implementation. Moreover, she points out that Coffee’s example from the Sarbanes-Oxley Act, to support his second contention, that regulatory flaws are self-resolving, is incorrect, as the revision to SOX was forced on the agency by Congress.  And she concludes by noting that even if Coffee’s second contention regarding ex-post agency revision were true, it would not be an argument against sunsetting, because sunsetting would simply accelerate that resolution.

Despite these compelling benefits, Romano herself highlights three reasons why sunsetting has not been widely used to remedy the inherent problems in crisis-driven financial regulation. First is a genuine policy concern, that the knowledge that a statute will expire may decrease regulatory certainty, imposing a cost on firms.  The other two reasons involve legi
slators’ incentives.  Legislators are not likely to want to cede  control over legislation to future Congresses of which they may not be a part.  In addition, legislators may take offense at  sunset provisions, as they may be perceived as suggesting that their work-product is flawed—a suggestion that can be tough to swallow, particularly when the statute in question bears a legislator’s name.

Can these issues ever be resolved? The policy concern is, in Romano’s judgment, not compelling in the context of financial regulation because the multi-year interval before a sunset is long enough for the completion of business planning surrounding regulated financial investments and instruments, given how rapidly the financial environment changes. The incentive issue is more difficult to overcome; Romano suggests that harnessing the influence of the media and commencing a public awareness campaign advocating for the importance of sunsetting provisions would be helpful.

In addition to sunsetting, Romano also argues that crisis-driven financial regulation could be improved if it were given a more flexible structure that would allow for experimentation. To allow for deviation from a statutory regime without negatively impacting an entire regulatory structure, Romano advocates instructing agencies to use exemptive authority to permit individual or classes of institutions to operate under different regulatory arrangements for an experimental period, which would be monitored and evaluated. Through experimentation an agency would obtain information regarding the impact of different approaches, leading to more effective regulation, and it would therefore work hand in glove with sunset reviews. She also sketches out how this approach could work to introduce diversity into the Basel regulations. However, she notes the difficulty in implementing such exemption policies in a context of politically influential financial institutions advocating for harmonization, and regulators’ innate conservatism to maintain the status quo they know well.

Although there are  challenges to inducing legislators and regulators to enhance diversity in statutory implementation and introduce sunsetting reviews, Romano maintains that adopting these proposed changes would lead to significantly improved decisionmaking by “facilitat[ing] timely updating of the legislative and regulatory architecture.”

Romano’s paper appears as a chapter in the recently published book, Regulatory Breakdown: The Crisis of Confidence in U.S. Regulation, edited by Cary Coglianese and published by the University of Pennsylvania Press.