Kathryn Judge

Columbia Law School

Regulation and Deregulation : The Baseline Challenge


A core challenge for financial regulation is how best to address the inherent dynamism of finance. The financial system is engineered to change. Periods of stability, evolving macroeconomic conditions, and regulation are among the forces driving the constant shape shifting of finance. As a result, rules established at Time A often have a different substantive effect at Time B. And because efforts to reduce the cost of complying with regulatory burdens, commonly known as regulatory arbitrage, are among the forces driving this change, a static regulatory regime will tend to be inherently deregulatory.


Currently, the processes through which the law is made are ill suited to accommodate this dynamism. Frictions built into legislative and regulatory processes make it difficult to update the law even when the substantive impact of a proposed change merely replicates the originally agreed upon balance. Complicating matters further, changing market structures may make it impossible to replicate the precise balance a law had been designed to achieve. Financial regulation often entails tradeoffs among competing values and new environments and innovations may enable but also necessitate different tradeoffs.


There is no easy way to reconcile the dynamism of finance with the lawmaking processes better suited for static environments. Proscribing innovation may be warranted in some domains, but has real costs and is unlikely to be feasible as applied to the system as a whole. Nonetheless, recognizing this tension is a critical to understand why regulation has failed to achieve desired aims and why it may well fail again. This tension also helps to explain the heated debate about the scope of deregulation prior to the 2007-2009 financial crisis and its role contributing to that crisis. Only by grappling with the myriad reasons for financial innovation and the mixed impact of that innovation can we develop the common ground needed to forge a better approach.


What does it mean to deregulate? Is deregulation just about the repeal of existing rules? In a closed and static system, this definition seems apt.


But what if the bounds are porous? Or the internal workings of the system are dynamic? Once a system is structured to allow the option set to change, do the proscriptions embedded in law at Time A remain the appropriate baseline? Or should the baseline evolve, recreating the balance struck at Time A given the option set that exists at Time B?


What if the reasons for the balance struck at Time A are myriad, and drawing a line at Time B requires some values to be sacrificed to protect others? What if jurisdictional or other logistical challenges preclude replicating Time A’s line at Time B? Is the expectation of such challenges a reason to limit dynamism? Should it matter whether the innovations underlying the dynamism enhance welfare in ways unrelated to the regulatory regime?

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