Jeffrey N. Gordon
Professor of Law, Columbia University
‘Dynamic Precaution’ in Maintaining Financial Stability : The Importance of FSOC
The Financial Crisis of 2007-09 has shown that financial stability is the ultimate public good: all benefit from it, it is costly to maintain, and its undersupply results in catastrophe. The threat to financial stability comes along four different avenues: first, the effort by institutions within the financial stability regime to find loopholes and other sorts of regulatory arbitrage to avoid the regime’s costs; second, the effort by institutions outside of the regime to produce financial intermediation services that are the functional equivalent of within-the-regime firms; third, “innovation,” which includes the unexpected consequence of existing rules in new application; and fourth, macroeconomic forces that magnify the threat of financial instability. The forces, separately and in combination, can reshape the financial system; these forces can move a formerly stable system into one that is systemically susceptible to either an internal or external shock.
One very important lesson of the Financial Crisis is that the maintenance of financial stability is an on-going project that requires an approach of “Dynamic Precaution.” This requires an institution such as the Financial Stability Oversight Council to monitor the financial system as it evolves, to call attention to emerging risks to financial stability, and to catalyze the necessary regulatory intervention. In developing a case for Dynamic Precaution, this chapter explains first, why financial institutions need to remain as the focus of the FSOC regime even while observation and regulation aimed at activities is also important; second, how FSOC can serve Dynamic Precaution by using its designation authority to negotiate “off ramps” from enhanced oversight for firms whose instability or failure would otherwise have systemic implications; and third, if the maintenance of financial stability is the apex goal, why cost-benefit analysis can play only a limited role in financial regulation.
This chapter is addressed to the problem of maintaining financial stability after the immediate shock of the Financial Crisis of 2007-09 has subsided. Financial stability is the ultimate public good; in particular, it’s “non-excludible,” meaning that every institution, financial and nonfinancial, and every person benefits from financial stability. Yet, maintaining financial stability is costly: Institutions face onerous-seeming constraints on their plans and activities and we have set up a complicated administrative and supervisory apparatus in the name of maintaining financial stability.
I encounter this problem, the problem of memory and belief, with every fall’s teaching in a course called “Financial Crises and Regulatory Responses” (co-taught with the economist Patrick Bolton, for law and business students). The course, which focuses on the recurrent nature of financial crises rather than their singularity, nevertheless devotes particular energy to the financial crisis that began to unfold in 2007. Unlike the Savings and Loan crisis of the 1980s, the crisis of 2007 to 2009 upended the entire U.S. financial sector and spread globally. The economic impact is measured in the $trillions, a massive regulatory project is still underway, and the political consequences still ramify in the United States and its global partners. And this is in the aftermath of a “good” crisis outcome.