Against Regulatory Displacement: An Institutional Analysis of Financial Crises

Abstract

This Article analyzes institutional choice in preventing and managing financial crises. “Institutional choice” means that different institutions— here, markets, courts and regulators—have different capacities to achieve similar goals. While none is perfect, some may be better than others, so the institutions we choose to prevent or resolve failure will influence the likelihood and severity of future financial crises. I use the analysis of institutional choice to make three claims about current (and foreseeable) approaches to preventing and resolving financial crises. First, because regulators are vulnerable to capture by large financial services firms, they cannot address the pathologies that create crises: market concentration and complexity. Indeed, regulators may aggravate these conditions through tactics that consolidate firms, and the volume and complexity of regulation, resulting in “regulatory displacement” of markets and courts as institutional choices to prevent or resolve financial distress. Second, in the context of financial distress, institutions tend to interact (“braid,” in the language of contract theory literature). Markets and courts can do so to create incentives to renegotiate financial distress, thus reducing the likelihood of crises. Regulators and markets braid, too. But, large financial firms may dominate the interactions to increase concentration and complexity, and thus create social costs without compensating benefits. Large financial firms may protest, but they benefit from the subsidies and protections of regulatory displacement, and thus ultimately choose it. Third, courts are an underappreciated institution that may ameliorate the pathologies of concentration and complexity by rethinking the so-called “duty to be informed” on the part of directors of systemically important financial firms. Taking this duty more seriously here might lead directors to simplify and/or reduce the size of those firms, thereby creating conditions and incentives that would support market-oriented re-structuring rather than regulatory displacement if—perhaps when—crisis next strikes.