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PrintPublicationDate: Sep2010 Subject: BusinessandManagement,GovernmentandLaw,FinanceandEconomics

OnlinePublicationDate: Sep2010

DOI: 10.1093/oxfordhb/9780199560219.003.0018

FinancialServicesandMarkets NiamhMoloneyTheOxfordHandbookofRegulationEditedbyRobertBaldwin,MartinCave,andMartinLodge

OxfordHandbooksOnline

AbstractandKeywords

Thisarticlefocusesontheparticularchallengesandrisksraisedbytheregulationoffinancialservicesandmarkets.Itreviewsthetraditionalrationalesforregulationandhowregulationhasexperiencedrepeatedreformswhicharebecomingincreasinglytransformativeintheirambition.Itsuggeststhatwhatmarksoutthisregulatoryareaisthesignificantlevelofriskinvolvedintheregulatoryproject.Italsoconsidershowregulatorytoolscanbefine-tunedtomitigatetheevolvingrisksofintervention.Itconsiderstheexpandingdomainofregulationasdomesticmarketshavebecomecloselyinter-connected,therelatedrisks,andthenatureoftheregulatoryresponse.Thetraditionalrationaleforfinancialservicesandmarketsregulationisthecorrectionofmarketfailuresrelatedtoasymmetricinformationandtoexternalities,notablysystemicrisks,inordertosupportmarketefficiencyandefficientresourceallocation.Keywords:financialservices,markets,regulation,marketfailures,systemicrisks

18.1IntroductionThischapterfocusesontheparticularchallengesandrisksraisedbytheregulationoffinancialservicesandmarkets. Thisfirstsectionreviewsthetraditionalrationalesforregulationandhowregulationhasexperiencedrepeatedreformswhicharebecomingincreasinglytransformativeintheirambition.Section18.2suggeststhatwhatmarksoutthisregulatoryareaisthesignificantlevelofriskinvolvedintheregulatoryproject.Section18.3considershowregulatorytoolscanbefinetunedtomitigatetheevolvingrisksofintervention.Section18.4considerstheexpandingdomainofregulationasdomesticmarketshavebecomecloselyinterconnected,therelatedrisks,andthenatureoftheregulatoryresponse.Section18.5concludes,withreferencetotheEnronandcreditcrunchcrises.

Thetraditionalrationaleforfinancialservicesandmarketsregulationisthecorrectionofmarketfailuresrelatedtoasymmetricinformationandtoexternalities,notablysystemicrisks,inordertosupportmarketefficiencyandefficientresourceallocation.Informationasymmetries,forexample,canlead,onthesupplyside,toincreasesinthecostofcapital(reflectingthefamouslemonshypothesis;Akerlof,1970)and,onthedemandside,cancompoundthedifficultiesretailinvestorsfaceinassessingcomplexproductsandinmonitoringinvestmentfirms.(p.438) Marketfailureshaveevolved,however,andhavebecomeexposedtonewscrutinyinthefaceofmarketdevelopments.Thelastthreedecadeshave,forexample,seenaverysignificantdeepeningofsystemicriskasglobalisationandfinancialinnovation,particularlywithrespecttoderivatives(exemplifiedbythe1998rescueofLongTermCapitalManagement)andwithrespecttotherepackagingofrisksandtheirtransmissionfromthebankingintothesecuritiesmarkets(exemplifiedbythecreditcrunchandthefinancialcrisis),havesharplyincreasedthepotentialforrisktransmissionacrossmarkets(Schwarcz,2008andFSA,2009).Inpractice,regulatorsadoptmorelooselycastrationalesconcerningtheneedtoprotectinvestors,toensurethatmarketsare

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fair,efficient,andtransparent,andtoreducesystemicrisk(IOSCO,2008).Thesharpermarketfailureanalysisis,however,increasinglyprevalentinregulators'discourse(e.g.FSA,2006aandEuropeanCommission,2008a),reflectingtheBetterRegulationmovementaswellasaconcerntoobtaincompetitiveadvantagethroughefficientregulation(CommitteeonCapitalMarketsRegulation,2006).

Reformandinnovation,withrespecttothesubstanceofregulationanditsinstitutionalstructures,havebeenpersistentfeaturesofregulationoverthelastthirtyyears.Themajorreformmovementshavetypicallybeenepisodicandreactivetoperiodsofmarketexpansionandsubsequentturbulence(Ribstein,2003),inparticularwheretheseperiodsimpactonhouseholdswhoareotherwiseusuallypoliticallyquiescentonfinancialmarketmatters(BebchuckandNeeman,2007).TheshiftintheUKregulatoryregimefromself-regulation,to,intheory,self-regulationwithinastatutoryframeworkundertheFinancialServicesAct1986,and,moreradically,totheFinancialServicesandMarketsAct2000(FSMA),whichestablishedtheFinancialServicesAuthority(FSA)andanextensivestatutoryframework,haditsrootsinscandal(e.g.BlackandNobles,1998).ThewiderangingsubstantiveandinstitutionalreformsofthepostEnronUSSarbanesOxleyAct2002(SOX),whichhadsignificantinternationalimplications,reflectedwidespreadpublicangerconcerningdeepandpoorlymanagedconflictofinterestriskinthesecuritiesmarkets.Butthefinancialcrisislookssettodelivertheparadigmaticexampleofradicalandcrosssectorregulatoryreforminresponsetocrisisconditions(e.g.FSA,2009).

Butitisnotalwaysthecasethatmajorreformshavebeenforgedintheheatofdramaticmarketupheavals.TheEUreformmovement,whichisnoteworthyastheEUhas,inthelastfifteenyearsorso,emergedasoneoftheworld'smajorfinancialmarketregulators,isstrikingforitsproactiveconcerntoconstructanefficientandintegratedfinancialmarketandtopromoteretailinvestorengagementwiththemarkets.Fromthelate1990s,theEU'sFinancialServicesActionPlan(theFSAP)(EuropeanCommission,1999)begantoimposeaharmonisedregulatoryregimeacrosstheEUMemberStatesofunparalleledcomplexityandbreadthandofconsiderabletransformativeambition.ThebehemothMarketsinFinancialInstrumentsDirective2004(MiFID) anditssupportingrules,forexample,notonly(p.439) pursuestheambitiousobjectivesofsupportingcrossborderactivitybyinvestmentfirmsandofrestructuringtheEuropeantradingenvironmentbysupportingcompetitionbetweenstockexchangesandotherexecutionvenues.ItalsoseekstodevelopastrongerretailinvestmentcultureacrosstheEU.AsimilartrendcanbeobservedintheUKwheredetailedandoftenreactiveFSAregulation,particularlywithrespecttoretailmarketmisselling,adoptedinthewakeofFSMA2000,canbecontrastedwiththeFSA'srecentRetailDistributionReview(FSA,2007a),whichisnotrelatedtoaparticularretailmarketscandalbutisdesignedtomoveawayfromreactiveinterventionandtodrilldownintotheworkingsoftheretailmarketanditsflawedincentivestructure.ItcanalsobeseenintheUS,wheretheSecuritiesandExchangeCommission(SEC)isgrapplingwithanewsubstitutecompliancemodelforengagementwithcrossborderactorswhichreflectsaconcerntosupporteasierinvestoraccesstotheinternationalmarkets(Jackson,2007a),althoughitsfateremainsunclearinthewakeofthecreditcrunchupheavals.

Theinternationalregulatoryreformmovementrelatedtothefinancialcrisisaccordinglyisastarktestamenttothereactivequalityofregulatoryreformwhichhascharacterisedthelastthirtyyears.Butreformsoverthelastthirtyyearshavealsoreflectedproactiveambitionstoshapethemarketplace,domestically,regionally,andinternationally.Theseambitionsrequireregulationtocarryoutsomeveryheavylifting.Theyalsoinjectconsiderableriskintoaregulatoryprojectwhichisalreadystrugglingwiththerisksofinterventionandoverreaction.

18.2TheRisksofFinancialMarketInterventionInthefinancialservicesandmarketsspherethecontrolofrisksisanimperativebuttherisksofinterventionareconsiderable.Ontheimportanceofriskcontrol,thewidereconomicimpactofthefinancialcrisishasprovidedgraphicevidencethatapublicpolicycommitmenttostrongfinancialmarkets,expressedthroughregulatoryintervention,isreasonable.Buttheintuitionthatastrongandefficientfinancialsectoris,insomeway,relatedtowidereconomicgrowthhas,forsometime,beensupportedbyanextensivebodyofresearch(e.g.LevineandZervos,1998).Thelastthirtyyearshaveseenfinancialmarketsbecomeofcentralimportancetolongtermhouseholdsavingsasgovernmentswithdrawfromwelfareprovisionanddemandmoreoffinancialmarketsandofhouseholds(e.g.BaselCommittee,IOSCO,andIASC,2008andZingales,2009).Householdmarketparticipationvariesacrosscountriesforahostofreasonsexploredbythegrowinghouseholdfinanceliterature(Campbell,

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2006).Butthegreaterexposure,directand(p.440) indirect,ofhouseholdstothefinancialmarketsoverthelastthirtyyearscanbeseenintheincreasedproportionofinstitutionalisedsavings(relatedtopensions,insurancefirms,andmutualfunds)inhouseholdportfoliosin,forexample,France,theUK,andtheUS(from6%,23%,and17%respectively,in1970to39%,54%,and38%in2003)andinthedecreaseintheproportionofhouseholdassetsheldasbankdeposits(G10,2005).Regulationhasfollowedsuitasaraftofdisclosureandfinancialcapabilityreforms,intheUK,theEU,andinternationally,haveseentheretailinvestortransformedfromthevulnerablewidowandorphan(e.g.Gower,1984)tothemoreAmazonian,empowered,capitalsupplyingandselfsupportinginvestor,capableofexercisinginformedchoiceandofactingasaresponsibilisedandriskregulatingactor(e.g.GrayandHamilton,2006;Ramsay,2006;andWilliams,2007).

Thecentralimportanceofthefinancialmarketsandtheambitionofrecentregulatoryreformssituneasily,however,withtherapidpaceoffinancialmarketgrowth,innovation,andcomplexityoverthelastthirtyyearsorso.Asmallsampleofnewchallengesmightincludethefollowing.Thescaleofthefinancialmarketsisnowimmense;recoursetothefinancialmarketshasincreasedexponentially,with,takingtheEUexample,bondissuancedoublingandequitymarketcapitalisationtriplingbetween1996and2006(CaseyandLannoo,2006).Thepotentialforincentivemisalignmentandconflictofinteresthasexplodedwiththeriseofmultifunctioninvestmentfirms(theLondonStockExchange's1986BigBangrepresentsanimportantstagingpost )andwiththeburgeoningofcompetitionbetweentraditionalstockmarketsandotheralternativetradingvenuesoverthelasttwentyyearsorso.Thenatureofrisktransferhaschanged.Thisisclearfromtherepackagingofcreditrisksintomarketrisksassociatedwiththecreditcrunchandfromthegrowthofhedgefunds:althoughthefinancialcrisishasdamagedthehedgefundindustry,thenumberofhedgefundsgrewfrom400to6,000between1993and2003intheUSalone(SEC,2003).Investmentproductshavebecomeevermorecomplexandareplacingpressureonsilobasedregulationwhichhastraditionallybeensegmentedintoinsurance,banking,andinvestmentsegments(Claessens,2006).Financialmarketsalsoappeartobepoorlyequippedtodealwithchangingmacroeconomicimbalancesand,inparticular,higherlevelsofleveragefollowingfromlowinterestrates(FSA,2009).

Itisnotatallclearthat,despitetheirimportance,rapidlyevolvingfinancialmarketsandtheirriskscanbeeasilycorralledbyregulation.Aseriesofrisksattachtoregulatoryinterventionandtheregulatorydesignchoicesarecomplex.Thesetensionshavebecomecleareroverthelastthirtyyears,particularlyasrichdatasetsforexaminingtheimpactoflaw/regulationinactionhavebeenprovidedbytheregulatorychoicesmade,sincetheearly1980s,bytheEUforitsintegratingmarketand,fromthe1990s,bythepostCommuniststatesinadoptingmarketeconomymodels(e.g.Glaeser,Johnson,andShleifer,2001).Itisnowclearthatitisdifficulttodesigngoodruleswhichsupportstrongmarketsoreven,andlessambitiously,(p.441) ruleswhichdonothaveunintendedmaligneffects(B.Black,2001),ashasbeentheexperiencewiththeEU'sProspectusDirective whichappearstohavegeneratedperverseincentivestocontracttheretaildebtmarket(CESR,2007).AnextensiveSOXliterature probesthedifficultiesindesigningrulesintheteethofpoliticalattentionandmarketturbulence(e.g.Romano,2005).Thecostsoffinancialmarketregulation(Zingales,2004),includingwithrespecttopublicchoiceeffects(Macey,1994andCoates,2001),arenowwelldocumented.

Therichscholarshipwhichhasdevelopedonpathdependenciesinthecognatefieldofcorporateevolution(e.g.BebchukandRoe,1999)alsocontainsthelessonthatpathdependenciescanprejudiceefficientregulatorydesign(e.g.AnandandKlein,2005).Behaviouralfinancehasalsothrownasharplightontherisksofintervention;recentresearchontheUSSEC,forexample,suggeststhatregulatorsarevulnerabletosystematicbiases(Paredes,2006)andthatinstitutionalculturecandistortrulemaking(Langevoort,2006).Regulatorychoicesarealsoincreasinglycomplex.Themechanismswhichcandelivermarketdisciplinearemanyandextendfromtraditionalcommandandcontrolregulation,whichhasdominateduntilrecently,toincludeamultiplicityofinstitutions,domestic,regional,andinternational,andmarketactorswhichcanbeenrolledintheregulatoryprocess(J.Black,2002).Wheremarketfailuresaresafelyidentified,experiencewith,forexample,theretailmarketnowsuggeststhattheyareoftenintractable,forexamplewithrespecttoproductdisclosure(e.g.FSA,2005),orrequirecomplexandsymbioticregulatoryandsupervisorystrategies,forexamplewithrespecttoproductdistribution(FSA,2007aandDelmas-Marsalet,2005).

Thestakesarealsobecominghigher,notonlybecauseoftheincreasingcentralityoffinancialmarketstotherealeconomyandhouseholds,butalsobecauseofeverincreasinginternationalisation(Section18.4below)andtherelatedriskstocompetitivenessfrompoorregulation.ThepositionoftheUSastheinternationalmarketofchoiceappears(althoughthisiscontested)tobeunderthreatinthewakeofthedemandsofSOXcomplianceandthe

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burdensimposedbytheUScivilliabilityregime(CommitteeonCapitalMarketsRegulation,2006).Althoughthecreditcrunchhasledtoasharperfocusinternationallyonstabilityandsafetythanonaccessandliberalisationasregulatorsandpoliticiansretrench,theseconcernsremain(CommitteeonCapitalMarketsRegulation,2008).InternationalcompetitivenesshasbeenafeatureoftheUKregimeforsometime(e.g.Gower,1984andFSMA2000 )buttargetedUKinterventionhasnowtakenplaceintheshapeoftheInvestmentExchangesandClearingHousesAct2006which,reflectingconcernsduringNASDAQ's2006failedbidfortheLondonStockExchange,givestheFSAavetooveranyregulationproposedbyaUKexchangewhichisexcessive;itisdesignedtoallowtheFSAtorejectrulechangeswhicharerequiredbyaforeignregulatorofaforeignownedUKexchangeandtomitigatetherisksthatUKmarketscouldbecomelessattractive.(p.442)

Copycatdynamicsarealsoatroublesomeconsequenceofinternationalisation(McVea,2004).ManyofthestructuralmarketconditionswhichledtotheEnronerafailuresandwhichwereassociatedwiththerisksofdispersedownershipandgatekeeperfailure(Gordon,2002)werenotreplicatedintheEUmarket(FerrariniandGuidici,2005).ThustheriskstoretailinvestorsfromflawedinvestmentresearchwhicharoseintheUSwerenotreplicatedintheembryonicEUretailmarket,particularlygiventheabsenceofastaranalystculture(FSA,2002).TherisksofimportingtheUSresponseintotheEUmarketwerethereforeconsiderable.TheEU'streatmentofinvestmentanalystconflictofinterestrisksdidnot,however,tracktheUSresponse(which,throughregulatoryreformsandthe2002GlobalSettlementwiththeindustry,focusedontheseveringoflinksbetweenresearchandinvestmentbankingandthesupportofindependentresearch)buthasbeenprinciplesbasedandflexible.Inparticular,thenewMiFIDbasedregimedoesnot,unliketheUSregime,mandateparticulararrangementsfortheseparationofinvestmentbusinessandresearch;firmsremainfreetodesigntheirconflictsofinterestpolicyastheyseefit,aslongasanalystobjectivityandindependenceisnotthreatened.

Whetherornottheregimeiseffectiveremainstobeseen;muchdependsonwhetheraprinciplesbased,outcomesdrivenapproachcanbeembeddedwithinfirmsandeffectivelysupervised.Butthefirsthurdlehasbeenpassedinthatthetemptationtoborrowamoreprescriptiveapproachwasavoidedandcarewastakentoalignregulatorydesignwithlocalmarketconditions,includingthelackofindependentinvestmentresearchhousesintheEUandtherelatedriskthatoverprescriptioncouldreducethevolumeofresearch.Exporteffectsremaintroubling,however,asisclearfromtheEU'srapidadoptionofaprinciplesbasedmodelforinvestment-servicesregulationgenerallyinparallelwiththeFSA'sstrategicinitiativeinthisarea(Section18.3below),largelywithoutconsiderationofwhatthisentailsinpractice.

Therisksofregulatoryinterventionareallthegreatergiventhatitisnowclearthatregulatorsoperateinanuncertainenvironmentandareoftenhamperedbypoorinformationandbylongheldassumptions:thefinancialcrisis,forexample,hasexposedtheexpertiseasymmetrybetweenregulatorsandthewholesalemarketandthefailureoftheassumptionthatcertainmarketsegmentsoperatebestunderaself-regulationmodel.Theextensivedebateondisclosure,whichhasgrappledwiththeimplicationsoftheinvestorrationalityassumptionandofpoorempiricalassessmentsbyregulatorsofdisclosurerules,providesanotherusefulexample.Oneofthemostvibrantstrandsoffinancialmarketscholarshipoverthelastthirtyyearsorsohasprobedtherelationshipbetweeninvestordecisionmakinganddisclosurerequirements.Disclosure,whetherbyissuers,investmentintermediaries,orintheformoftheexecutiondataissuedbytradingvenues,haslongbeen(e.g.Loss,1951),andremainsacentralpillaroffinancialmarketregulation.Itcarriesthebenefitsofgenerallyminimalintervention,althoughthecostsof,andappropriatedesignfor,mandatorydisclosurehavelongbeendebated.(p.443)

Recentregulatoryreformsalsosuggest,insomequarters,adegreeofscepticismastotheabilityofdisclosuretoaddressentrenchedmarketfailures:the2002SOXreforms,forexample,arebasedonmoreinterventionistcorporategovernancereforms,whileintheEUthe2004MiFIDregimefavoursconductshaping,firmfacingrequirementstoinvestorfacingdisclosurerules.Butissuerdisclosure,inparticular,remainsattheverycoreofcapitalmarketregulation;itspreeminencereflectstheEfficientCapitalMarketsHypothesis(ECMH)(Fama,1970),whichteachesthatmarketpricesreflectallpubliclyavailableinformationandthat,whereirrationalitiesdistortthepricingmechanism,theyarecorrectedbyarbitragemechanisms(Shleifer,2000)andtheroleofmandatorydisclosureinsupportingthemarketefficiencymechanismswhichdrivetheECMH(GilsonandKraakmann,1984andCoffee,1984).

Despite,orperhapsbecauseof,theprevalenceofissuerdisclosurerequirementsinpractice,thepredominantlyUSdebateastotheirappropriatenesshasbeenmultifacetedandvigorousoverthelastthirtyyears.Asimilar

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dynamichasoccurredwithrespecttoinsiderdealing,whichhasbeenthesubjectofalivelyscholarshiponwhetherinsiderdealingshouldbepermittedonefficiencygrounds,reflectingManne'searlyandprovocativeargumentthatinsiderdealingimprovespricingandpenalisesspeculation(Manne,1966).Aswiththeissuerdisclosuredebate,thisscholarshipissomewhatatoddswiththeprevalenceofinsiderdealingprohibitionsworldwide(BhattacharyaandDaouk,2002).Thecycleofdisclosureanalysishasincludedcostdrivenattacksinthe1960sand1970s(Benston,1973andStigler,1963),efficiencydrivensupportinthe1980s(Coffee,1984;andGilsonandKraakman,1984)and,mostrecently,lawandfinanceassessmentsoftheimpactofdisclosureonmarketdevelopment,thelinkbetweenenforcementandeffectivedisclosure,andthedynamicsofregulatorycompetition(e.g.Choi,2002).

Therichdisclosuredebatehasthrownupatleastoneprofoundlyimportantissuewithrelevancefortherisksofregulatorydesignandfortheflawedassumptionswhichregulatorscanmake.Disclosurerequirementsassumesomedegree,atleast,ofinvestorrationalityandcompetence;theECMHisbasedonthecollectiverationaljudgementofthemarketplaceastothevalueofanissuer'ssecurities.Thisrationalityassumptionnowappearstobesignificantlyflawed.Thefindingsofbehaviouralfinance,andthestrongsuggestionthatinvestorsdonotbehaverationallywhenmakinginvestmentdecisionsorwhenassessingdisclosure,havebeenenthusiastically,althoughsometimessceptically,embracedbyanextensiveliterature,particularlyinthelastfifteenyearsorso(e.g.Bainbridge,2000;Langevoort,2002;andStout,2003).TheECMHhassimilarlycomeunderattackbasedontheevidenceofapparentlysystemicirrationalitywhichisnotremovedbyarbitrageandwhichcandriveinefficientpricingandresourceallocation(e.g.F.Black,1986andShleifer,2000).WeaknessesintheECMHhavebeenunderlinedbythemarketfailuresexposedbythedotcomcollapseandtherelatedseriesofissuerfrauds(e.g.Gordon,2002)andbythefinancialcrisis(FSA,2009).Nonetheless,(p.444) despiteitsflaws,theECMHappearstobeareasonablyrobustexplanationforpricingdynamicsandajustifiablesupportformandatorydisclosure(GilsonandKraakman,2003).

Thereisnodoubtthatthebehaviouralfinanceanalysisisenormouslyengaging.Butgiventheresilienceofissuerdisclosure,itswidermarketefficiencysignificance,andsome,atleast,consensus,thattheECMHretainsadegreeofdescriptivepower,thewiderlessonsfromthebehaviouralfinancemovement,perhaps,arethosewhichrelatetoindividualinvestordecisionmakingand,inparticular,toretailmarketpolicy.Foritisclearthatwhileitmaybesafetoassumethatrationalityisnotwidespread,regulators,despitetheincreasingresponsibilityplacedonretailinvestors,stillhaveverylittleunderstandingofwhyhouseholdsinvest(Campbell,2006)andhowinvestorsmakedecisions.Reflectingtheoriginalandkeyinsightastoboundedrationality(Simon,1955),investorsappeartooperateunderafogofmisapprehensions,confusion,andbiasesandhaveverylittleunderstandingofhowmarketswork(e.g.LaBlancandRachlinksi,2005).Thetemptationtoripuptheconventionalrulebookmustbeconsiderabletothebeleagueredregulator,particularlygiventhecurrentpolicyfocusonsupportingstrongerhouseholdmarketsaving.Buttherisks,costs,anduncertaintiesofregulatoryinterventionallsuggestthatwellmeaningadventuresinregulatorydesignwhichassumewidespreadirrationality(suchasgreaterpaternalismintheformofexclusionaryorrestrainingstrategies)wouldberiskladen,particularlygiventhedifficultiesbehaviouralfinancefacesinbuildingarobustmodelfordecisionmaking(Arlen,1998).Thesheerrangeofbiases,uncertaintyastotheextenttowhichbiasesimpactonthemarket,thedynamicsofdecisionmakingbydifferentgroupsofinvestorsandconcerningdifferentassetclasses,theimportanceofcontext,thequestionableabilityofregulationtorespondgivenbiasinlawmaking,andtheevidencethatpoorincentivealignment,ratherthanbias,maydriveseeminglyirrationaldecisions(Mahoney,1995)allsuggestcaution.Investorirrationalitymayalsoprovideunwarrantedsupportforregulatoryinterventionatatimeofclosepoliticalattentiontotheretailmarkets,andseeanincreaseintherisksofregulatoryintervention.

Buttherearesomelessons.Attheveryleast,thebehaviouralfinanceassumptionthatinvestorsarevulnerableendowsinvestorprotectionargumentswithanoverduedegreeofscholarlyrespectabilitygiventheincreasingpolicyconcerntopromotehouseholdsavingsandtheneedforasharperfocusonintermediation/advicerisksissuerdisclosure,thecapitalraisingprocess,andtherelatedefficiency,andissuerfacing,schoolofanalysishavelongbeenthemainconcernsoffinancialmarketregulationscholarship.Retailinvestorshavebeenvariouslyexaminedasbeneficiariesofthemarketefficiencybenefitsofissuerfacingrules(EasterbrookandFischel,1984),apotentiallydisruptiveforce(Bradley,2000),orasfitonlytobeherdedintopassivetrackerfunds(Choi,2000).Theriseofthebehaviouralfinanceschool,however,hasoccurredintandemwithaconcerntorehabilitateboththe(p.445) retailinvestorandretailinvestorprotectionobjectivesforregulatoryintervention(e.g.Stout,2002).

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Inpractice,thepolicyimplicationsare,initiallyatleast,ratherhumdrum,althoughnonethelessimportantforthat.Itisclearthatconsiderablymoreresourcesneedtobeexpendedonmasstestsondecisionmakingandonhowregulationcansupporteffectivedecisionmaking,iftherisksandcostsofinterventionarenottobeincreased(Mitchell,2005).Sometrendsaugurwell.AlthoughtheUSSEChasfacedrepeatedcriticismforfailingtotesttheassumptionsthatunderpinitsrules(e.g.Paredes,2003),theFSArecentlyengagedinoneofthelargesteverstudiesoffinancialliteracy(FSA,2006b),whileCanada'swiderangingreviewofsecuritiesregulationhasbeenunderpinnedbyareviewintoinvestordecisionmaking(Deaves,Dine,andHorton,2006).

EvenatEUlevel,whereempiricalanalysishaslongbeenaweakpoint,concernisemergingtounderpinregulatorydesignwithevidenceoninvestorbehaviour(BME,2007).Attheveryleast,greaterregulatoryengagementwithbehaviouralfinanceandsharperawarenessofthedecisionmakingprocessesofmarketactorsmayadvertregulators,andparticularlythoseoperatinginaprinciplesbasedenvironment,tocompliancerisks,tohowincentiveriskscanbeexacerbated,andtothoseemergingriskswhicharenotcapturedbyregulation.Whilehindsightprovidesclearvision,greaterengagementwithbehaviouralfinancemighthaveadvertedregulatorsmorequicklytotheincentiverisksposedbycompensationstructures,whetherwithinbanksorcreditratingagencies,andtotherisksofoverrelianceoninternalriskmodels,bestexemplifiedbytheBaselIIcapitalaccord(BaselCommitteeonBankingSupervision,2006),exposedbythefinancialcrisis.Morebroadly,thebehaviouralfinanceschoolprovidesanecessarycounterbalancetothelawandeconomicsmovement.Thelawandeconomicsschool,whichhasbeenstronglyassociatedwithfinancialmarketregulationoverthelastthirtyyears,providespowerfulanalyticaltoolsandhaseffectivelyprobedtherisksoffinancialmarkets,inparticularprincipalagentincentiverisks(e.g.Mahoney,2004),andwhenincentivesmayobviateregulatoryintervention(e.g.EasterbrookandFischel,1984andRomano,1998).Butthewideranalyticalframeworkhasbenefitedfromitsextensionbeyondtheassumptionsoflawandeconomicsastorationalcontractingandutilitymaximisationandfromitsengagementwiththemessierobservationsofbehaviouralfinance.

Finally,theregulatoryprojectisariskyonegiventheuncertaintiesconcerningtheextenttowhichlawcandrivestrongmarkets.Untanglingtherelationshipbetweenlaw/regulationandfinancialdevelopmenthasbecomeoneofthecentralpreoccupationsoffinancialmarketregulationscholarshipoverthelastdecadeorsoasscholarshiphasattemptedtoidentifytherulesandinstitutionswhichdrivestrongsecuritiesmarkets.Therootsofthisinnovativeandprovocativescholarshiplieinthelate1990sandintheseriesofgroundbreakingstudiesbyfinancialeconomistsLaPorta,Lopez-de-Silanes,Shleifer,andVishny(LLSV)whichconsideredtherelationshipbetweencapitalmarketrulesandlegalorigins/familiesandindicatorsof(p.446) economicdevelopmentandfinancialsectorgrowth(e.g.LaPortaetal.,1997).Theirworksuggestedapositiverelationshipbetweenlawandfinancialmarketdevelopment(e.g.LaPortaetal.,1998).Inparticular,strongsecuritiesmarketsandlowercostsofcapitalappeartoberelatedtostronginvestorprotectionlaws(associatedwithcommonlawsystemsinparticular),particularlythosewhichprotectminorityshareholders.

Ifregulationisamagicbulletinthatitcandrivestrongfinancialmarketdevelopmentandhastransformativeeffects,thenthecaseforintervention,despitetherisks,receivesapowerfulfillip:thelinkagebetweenlawandfinancialmarketdevelopmenthas,forexample,beenreliedonbytheWorldBank(WorldBank,2006).ThefortunesoftheEU'smassiveregulatoryregime,whichisdesignedtohavetransformativeeffects,inoneexample,lookconsiderablybrighter.Butmuchremainstobedone.Itremainsunclearhowmarketsandlaws/regulationarerelated,whetherpublicorprivatelawmatters,andwhichpubliclaws/rulesmatter.TheLLSVmethodandtheproxiesusedtoquantifytheeffectivenessoflegalregimeshavebeenquestioned(e.g.Partnoy,2000),ashasthecausalrelationshipbetweenlawandstrongmarkets(e.g.Cheffins,2001andCoffee,2001).Acomplexinterplayofdifferentfactorsappears,unsurprisingly,todrivefinancialmarketdevelopmentincludingmonitoringbymarketactors,demandforcapital,theabsenceofoppressivegovernmentintervention,theinfluenceofthepoliticalmajority,theorganisationofrentseekinginterestgroups,culturalfactors,andtheprevalenceofinvestortrust(e.g.Coffee,2007).

Perhapstheclearestlessonfromthelawandfinancescholarshipisthateffortsexpendedinregulatorydesignmustbealliedtoeffectivesupervisoryandenforcementstrategies,bearingouttheintuitionthatlaws/regulationinactionhavestrongereffectsthanlaws/regulationonthebooks.Recentresearchhasdrilledbelowtheimpactoflawsonthebooksandemphasisestheimportanceofenforcementandsolawsinactionindrivingstrongmarkets(Coffee,2007;JacksonandRoe,2008).Buttheoptimumdesignforenforcement,and,inparticular,therelativemeritsofprivateandpublicenforcement,isstronglycontested(Jackson,2007b).Recentstudiessuggestthat

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privateenforcementmechanismsarerelatedtostrongfinancialmarketdevelopment(LaPorta,Lopez-de-Silanes,andShleifer,2006andCoffee,2007),butaggressiveprivateenforcementhasalsobeenassociated,albeitthatthisiscontested,withtherecentweakeningintheinternationalpositionoftheUScapitalmarket(e.g.Zingales,2007).Thefactorswhichdriveeffectivepublicenforcement,however,aremanyandintricateasenforcementoutcomessitatopasuperstructurebuiltonarangeoffactors,includingsupervisorystrategiesandresources,deterrenteffects,andthestyleofthesupervisor.

TheUKFSA,whichiscertainlyunderweightbycomparisontotheUSSECbyreferencetonumberofenforcementactionsundertakenorsizeofmonetarypenaltiesimposed, hasnottraditionallybeenanenforcementledsupervisor(FSA,2007c).TheUK'senforcementmatrix,whichisbuiltonariskbasedapproachtoregulationandsupervision(J.Black,2005;GrayandHamilton,2006),includesmarketdisciplineandisdeeplyrootedinthefeaturesoftheUK(p.447)marketplace(FerranandCearns,2008).Butconsiderablymoreresearchisneededintothedynamicsofthesupervisionandenforcementprocessandintohowlawinactioncanbemosteffectivelyachievedbeforewiderconclusionscanbedrawn.Carefulassessmentofthedeterminantsofeffectivesupervisionandenforcementisessentialto,forexample,theredesignoftheEU'snetworkedsupervisoryandenforcementregimewhichiscurrentlyunderwayinresponsetothefinancialcrisis(HighLevelGroup,2009),thedesignoftheSEC'sdevelopingmutualrecognitionregime,whichdependsheavilyontheeffectivenessofforeignsupervisionandenforcement,andtothesuccessoftheFSA'srecentembraceofamoreaggressiveapproachtosupervisionandenforcementthroughcredibledeterrenceandanIntensiveSupervisoryModel(Sants,2009andFSA,2009).

18.3AMoreFinelyTunedToolbox?Theuncertaintiesattendantonfinancialmarketinterventionarethereforeconsiderable.Butregulatorytechnologyhasbecomemoreinnovativeovertheyearsandisnowprovidingnewsolutionsforoldproblemsaswellasnewsolutionsfornewproblems(J.Black,2005).Itis,inparticular,increasinglyreflectingadecentredapproachtoregulationandsoembracingarangeofdiscipliningtechniquesbeyondregulation,engagingmultiplenonstateactors(ofdomestic,regional,andinternationalcharacter,andwithindustryandpublicsectorroots)inestablishingfinancialmarketdisciplines,andallowingforgreaterflexibilityandefficiency(J.Black,2001).Giventheuncertaintiesattendantontraditionalcommandandcontrolintervention,recoursetoawiderarrayoftoolsbeyondtraditionalcommandandcontroldevicesmaymitigatetherisksofintervention.

Principlesbasedregulation,givenitsrecentubiquityandpopularity,precreditcrunchinanyevent,providesausefulexample.AlmostinparallelwiththeUKFSA'shighprofileandrenewedfocusonmoreprinciplesbasedregulation(FSA,2007b),andtheFSA'scommitmenttothinningbacktheextensiverulebookwhichhasdeveloped,indifferentincarnations,sincethe1980s,theEUembracedaprinciplesbasedmodelforoperationalinvestmentfirmregulationunderthe2004MiFIDregime.Thisreflectsaninternationalmovement(Ford,2008andCunningham,2007)whichhasseenprinciplesbasedregulationadoptedby,forexample,theDutchandJapaneseregulators(AFM,2007andFSAofJapan,2008).PriortotheNorthernRockcollapseintheUK,andparticularlyfollowingtheUSattentiongiventotheFSA'sarticulationofprinciplesbasedregulation(CommitteeonCapitalMarketsRegulation,2006),principlesbasedregulationlookedsettobecomeaninstrumentofinternationalregulatorycompetition.(p.448)

Themeritsofprinciplesbasedregulationarepotentiallysignificantandincludeareductionintherisksofprescriptivestandards,supportofregulatoryflexibilityinrapidlyinnovatingfinancialmarkets,strongerseniormanagementengagementwithregulation,andbetterregulatoryresponsiveness(FSA,2007c;Black,Hopper,andBand,2007;andJ.Black,2008).Itmaydilutethecorerisksofinterventionandprovideanewwayforaddressingriskswhichappearintractable:theFSAhasassumed,forexample,thatoutcomesdriven,principlesbasedregulationmaybreakthecycleofscandalandregulatoryreactionwhichhascharacterisedrepeatedmissellingepisodes(FSA,2006c).IthasparticularbenefitsintheEUcontextwherethemonopolyrisksofcentralisedregulation,followingthe1999adoptionoftheFSAP,exacerbatetherisksofintervention.Itmayalsorespondwelltothechallengeofrapidlyevolvingmarketrisks.TheFSA'sversionofprinciplesbasedregulation,inparticular,chimeswellwiththeneedtodelivereffectivelawinaction.TheFSA'sTreatingCustomersFairly(TCF)initiative,whichformspartofitsprinciplesbasedstrategy,forexample,representsapragmaticattempttopromotestrongerfirmengagementwithretailinvestorneedsandwiththeoutcomessoughtbyregulation:itemploysarangeofnonregulatorytoolsincludingbestpracticeguides,casestudies,managementinformationrequirements,andaTCF

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cultureframework.

Buteffectiveprinciplesbasedregulationdemandssomeconsiderablenuanceofregulators.Itoperatesonacontinuumfromtheruledesignprocess,andtheenrolmentoftheregulatedcommunitythrough,forexample,industryguidance,totheadoptionofoutcomebased(andnotsimplythinnerorlighter)rules,andontosophisticatedsupervisionandenforcement.Therisksaremanyandwelldocumented,includingtheriskofregulatorsreverseengineeringintofirmpracticesthroughguidanceand,conversely,ofanoutsourcingofruledesigntothemarkets,inatimeofincreasedpressureonrulesandregulators,withoutadequateconsiderationoftherisksandthisisasidealtogetherfromthekeyuncertaintyastowhetherornotprinciplesbasedregulationcansupportstrongmarkets.ThepostEnrondebatecertainlyhighlighted,althoughdidnotseeaconsensuson,perceivedweaknessinprinciplesbasedaccounting(e.g.Bratton,2003;Cox,2003;andPartnoy,2003),whilethefailureofNorthernRockintheUKraisedquestionsastotherobustnessoftheFSA'sapproach(HouseofCommons,2008),althoughtheFSAremainedcommittedtoitsoutcomesdriven,principlesbasedapproach,despiteitsstrugglesundertheTCFinitiative(FSA,2007b).

Thefinancialcrisisreformprocesshasseenprinciplesbasedregulationrecedefromtheregulatorysceneamidstconcernsthatitledtoaprejudiciallylighttouchsupervisorystyle.The2009TurnerReview(FSA,2009)hascommittedtheFSAtomoreinterventioninthewholesalesecuritiesandbankingmarkets,significantlylessrelianceonmarketdiscipline,andmoreintrusivesupervision.Althoughitdoesnotfocusdirectlyonprinciplesbasedregulation,theReviewisassociatedwithawithdrawalfromprinciplesbasedregulation.ButtheFSAdoesnotappeartohave(p.449) rejectedprinciplesbasedregulation.Whileithasacknowledgeditslimitations,theFSAappearscommittedtomovingfromprescriptiverulestoahigherlevelofarticulationofwhattheFSAexpectsoffirmsandtodeterringboxticking(Sants,2009).TheFSAappearsconcerned,however,torecharacteriseprinciplesbasedregulation,withitsconnotationsoflightertouchsupervision,asoutcomesbasedregulationandtoemphasisethatregulationcannotoperateonprinciplesalone.Butthebasiccommitment,intermsofregulatorydesign,toregulatoryprinciplesappearstoremaininplace(e.g.FSA,2008a).Indeedawholesalerejectionoftheprinciplesbasedmodelwouldbetroublesomegiventhatprinciplesmayprovideawayforcapturingtheseverecomplexityriskwhichthefinancialcrisishasexposed.

Principlesbasedregulation,andinparticularitsassociationswithfirmjudgementandwithindustryguidance,hasstrongresonanceswiththeself-regulationtechniqueswhichenrolmarketactorsintheregulatoryprocessandwhicharealongstandingbutdisputedfeatureoftheregulatorylandscape:largesectionsofthewholesalemarketshavelongbeensubjecttolighterornoregulation.Insomerespects,however,financialmarketregulationinrecentyearshasseenamoveawayfromself-regulationandtowardsgreatercentralisation.Theregulatorygriponstockexchanges,whichweretraditionallylargelyselfgoverning,hastightenedinthewakeofthedemutualisationmovementwhichtookrootinthe1990sandthearrivalofcompetitionbetweenexchangesandotherexecutionvenues,generatingavibrantscholarshiponwhetherexchangesshouldretainaregulatoryrolegiventhesystemicriskofincentivemisalignmentbetweenexchangeandinvestor/marketinterests(e.g.Mahoney,1997andPritchard,1999).

Thefinancialcrisishasexposedtheriskswhichself-regulationandrelianceoninternalrisksmodelsinthewholesalemarketscanpose(FSA,2009).Butself-regulationremainsakeytechniqueforgoverningthefinancialmarkets,andanecessaryonegiventheregulator/marketinformationasymmetrywhichwillonlydeepenasmarketsbecomeevermorecomplexandastheweaknessesofstaticrulesbecomeclear;self-regulationhasnot,notably,beenentirelyrejectedbytheEU'sfinancialcrisisreforms(HighLevelGroup,2009).Thewaysinwhichregulatorsenrolmarketactors,institutions,andtradeassociationsandtheirexpertiseare,however,evolving.TheexpressionofselfregulationthroughtheFSA'scurrentlawinactionbased,principlesbasedstrategyissomelightyearsawayfromtheearlierdetailedandcomplexself-regulatoryrulesoftheFinancialServicesAct1986era,forexample.Thethreatofinterventionhasalsobeenemployedtodriveindustryresponses.IntheEU,thecontroversial20062008debateontheextensionofMiFID'sequitymarkettransparencyregimetothedebtmarkets,forexample,generatedanunusualdegreeofindustryengagementwiththeretailinterestinresponsetotheCommission'simplicitthreattointervenetocorrectmarketfailuresintheretailbondmarkets,andled,inlieuofregulation,totheadoptionbytheInternationalCapitalMarketAssociation(ICMA)ofastandardonretailbondmarkettransparency(ICMA,2007;EuropeanCommission,2008a).(p.450)

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18.4InternationalisationandInnovationThejurisdictionalcontextoffinancialmarketregulationhaschangedoverthelastthirtyyears.Securitiesmarketsbegantointernationalisefromthe1960swiththedevelopmentoftheoffshoreEuromarkets,the1971breakdownoftheBrettonWoodsexchangeratesystemandreflectinganarrayofotherfactorsincludingderegulation,anexpansionininternationaltrade,developmentsinportfoliotheory,theriseofemergingmarketsandprivatisations(duringthe1980sand1990sinparticular),andtechnologicaladvances(Ferran,2004).Amassiveincreaseinthevolumeofcrossborderbusinesshasfollowed(between1967and1996,forexample,thevalueofbondsissuedbynonsovereignissuersoninternationalmarketsgrewfromUS$5.2billiontoUS$708.8billion,andby2005bondissuancehadincreasedtoUS$13,995billionScott,2006).Internationalisationhasbroughtwithittherelatedpotentialforrisktransmission,butalsothepotentialforregulatoryfrictions,competitiveadvantageinregulation,andareorientationofdomesticallyfocusedregulationtoaddresstherisksandopportunitiesofinternationalisation.

Differentmodelshavedevelopedforinternationalengagement.Theyincludedomesticeffortstoseekcompetitiveadvantageandtodeepenlocalmarketsinapplyingdomesticregulationtoforeignactors,althoughtheeffectsofregulationcanchange.Forexample,apremiumhasbeenassociatedwithUScapitalraisingbyforeignissuersandwithcompliancewithitsstringentregulatoryregime(e.g.Coffee,2002a)whichhas,traditionally,madelimited(althoughsome)concessionstoforeignissuers.ButthispremiumappearstohavediminishedwiththecostsofSOXcompliance(Litvak,2007)andasissuershavelefttheUScapitalmarket,althoughcausationandtheextentofregulation'simpactonissuerwithdrawalfromtheUSremainsunclear.TheapparentrelationshipbetweenUSregulationandtheinternationalcompetitivenessofitsfinancialmarketreflectstherelatedrich,oftenfiercelycontested,andstillevolvingtheoryonregulatorycompetitioninfinancialmarkets(e.g.Jackson,2001),which,althoughithasdeeprootsinthelongstandingdebateonthedynamicsandmeritsofcompetitionbetweenthestatesinUScorporatelaw(e.g.Cary,1974;Romano,1993;andRoe,2003),hasburgeonedalongwithinternationalisation.Ithas,forexample,consideredhowchoicecanbeexercisedinaregulatorycompetition(e.g.Fox,1997;ChoiandGuzman,1998;andRomano,1998),testedtheracetothebottom/racetothetopconundrum(JacksonandPan,2001),grappledwiththegradualintensificationofEUharmonisationandwiththerelatedlimitationofMemberStatecompetenceintheEUoverthelastthirtyyears(e.g.BuxbaumandHopt,1988;Enriques,2006),andreflectedthelawinactiondynamicandtheimpactofenforcementoncompetition(Coffee,2007).

Internationalengagementisalsoassociatedwithharmonisationorconvergencestrategies.Internationalstandardscanreduceinternationalregulatoryfrictionsandcancapturecrossborderrisks.Theyarenowlongstandingandincreasingly(p.451) influentialondomesticandtransnationalregulatorypolicytotheextentthatadegreeofoutsourcingofregulatorydesignappearstobeunderwayasthebodieswhichproducestandardsareincreasinglyenrolledininternationalbutalsodomesticregulatoryframeworks.IOSCO(theInternationalOrganisationofSecuritiesCommissions),composedofdomesticfinancialmarketregulators,isoneoftheleadingactors,establishedin1983asinternationalisationintensifiedandformedfromanearlierbodyestablishedin1974asinternationalisationbegantotakeroot.Itsinitiativeshavetraditionallytakentheformofnonbindinginternationalbenchmarks(suchasitsObjectivesandPrinciplesofSecuritiesRegulation(originallyadoptedin1998,currentversion2008)),althoughitsstandardscanhardenintolocalrules,aswasthecasewithits2004CodeofConductforRatingAgencies,whichwasincorporated,somewhatproblematically,intotheEUregime.TheIASB(theInternationalAccountingStandardsBoard,aprivatestandardsettingbody)wasestablished(inadifferentform)in1973,againatanearlystageoftheinternationalisationmovement,andissuestheIAS(InternationalAccountingStandards)/IFRS(InternationalFinancialReportingStandards)accountingstandardswhicharenowinwidespreaduseworldwide;theywereadoptedbytheEUasamandatoryreportingstandardin2002.Buthoweverhelpfultheyareineasingregulatoryfrictionsandaddressingcrossborderrisks,thelegitimacyofstandardsettersremainstroublesome(UnderhillandZhang,2003)andisbecomingincreasinglysoasstandardsareinjecteddirectlyintodomesticregulatoryregimes.

Conversely,regulatorydiversityandcrossborderactivitycanbeaccommodatedbymutualrecognitiontechniquesunderwhichlocalregimes,inwhatmightberegardedasthezenithofinternationalcooperation,accepttheregulationand/orsupervisionoftheforeignactor'shomestate,oftenwherestandardshavepreviouslybeenharmonised,reflectingthesymbiosisbetweenharmonisationandmutualrecognition.ThecomplexitiesandrisksofmutualrecognitionhavereachedtheirapotheosisintheEU'sfinancialmarketregulationregime.Itisbasedona

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highlysophisticatedmutualrecognitionmodelwhichhasbecomeprogressivelymoreadvancedsincethe1970sasfinancialmarketsandmarketfinancehavebecomemorecentraltoeconomicgrowthandhouseholds,ensuringtheinternationalcompetitivenessoftheEUfinancialmarkethasbecomemorepressing,marketactorshavesupportedintegration,politicalsupporthasintensified,andtheEU'sregulatorytechnologyhasbecomemoresophisticated(Moloney,2008).TheEUproject,whichisbasedonhomeMemberStatecontrolofactors'panEUfinancialmarketactivitiesinaccordancewithanextensiveharmonisedregulatoryregime,hasseeninnovationininternationalcooperationacrossanumberofdimensions.Thecooperationprojectevolvedfromequivalence-basedharmonisationinthe1970stominimumharmonisationinthe1980stofullblowncentralisedregulationasthe19992004FSAPreformstookplace,bringingwiththemconcernsastomonopolyandcentralisationrisks.Institutionalreforms,reflectingintensifyingpoliticalandmarketpressuretocompletetheintegratedmarketoverthe1990s,havealsobeendramatic.(p.452)

The2001Lamfalussyprocessisbasedonarecastingoftheharmonisationprocessbasedontheinsightthatfinancialmarketrulesaretypicallycomposedofhighlevelprinciplesandtechnicalrules;undertheLamfalussyprocess,theEUCommissionisempoweredtoadopttechnicalrules,advisedbyanewactor,theCommitteeofEuropeanSecuritiesRegulators(CESR),composedofnationalregulators.Withoutaformallegalbasisformany,ifnotmost,ofitsactivities,andonthebasisofamakeshiftaccountabilitymodel(Moloney,2007),CESRhasemployedtheLamfalussyprocesstostunningeffect.Throughitsowninitiativeguidance,operational,andinternationalnetworkingactivitiesithasacquiredfarreachinginfluenceoverEuropeanfinancialmarkets.ItisalsoattemptingtobuildapanEUsupervisoryculturebyfosteringsupervisoryconvergenceinhowregulatorssuperviseandenforcerulesinpractice(e.g.FSAandHMTreasury,2007).Supervisoryconvergencemovesinternationalengagementfromlawsonthebooks,thelongstandingconcernofmutualrecognitionandharmonisation,tolawsinaction.Butdespiteitssophistication,theEUprojecthasconsiderableweaknesseswhichserveasawarningforwiderinternationalengagement.TheEUregimeisbasedonadecentralisedsupervisorymodelunderwhichregulatorsapplythesamerulesbutwielddifferentenforcementandsupervisorytoolsandoperateinverydifferentenforcementandsupervisioncontexts(e.g.Wymeersch,2007).Ontheonehand,thisdiversityallowsforadegreeofcompetitionandthegenerationofefficiencieswithrespecttolawsinaction.Ontheother,asthefinancialcrisishasmadeclear,itmaythreatentheeffectivenessofcrossbordersupervisionandriskmanagement(HighLevelGroup,2009).

18.5ConclusionThefinancialmarketregulationuniversenowencompassesactorsandproductswhichwerenotmajorconcernsofregulationsomethirtyyearsago,includinghedgefunds,alternativetradingsystems,andcomplexderivatives.Longstandingactors,includingauditorsandinvestmentanalysts,haveposednewrisksasincentiveshavechangedandmarketconditionshaveevolved.Traditionalregulatoryboundariesbetweeninsurance,banking,andsecuritiesactivitieshaveblurredasriskhasbeenunbundledandrepackagedintohighlycomplexstructures,regulatoryarbitrageriskhasintensified,andsegmented/functionalregulationhasstruggledtorespond(e.g.Claessens,2006).Whileregulatorytechnologyisbecomingmoresophisticateddomestically,regionally,andinternationally,financialmarketrisksareincreasingasaretherisksofintervention,astheEnroneraandthefinancialcrisis,whichisstillunfoldinganddeepeningatthetimeofwriting,makeclear.(p.453)

Bothcrisesareverydifferent.TheEnroneraisassociatedwiththeUSequitymarketsandcapitalraising,failuresinfinancialdisclosure,managerialopportunismandtheagencyrisksofdispersedownership,andfailuresinthemechanismsofmarketefficiency,notablyinvestmentanalysts.Thefinancialcrisisandtherelatedcreditcrunch,whilenowtouchingalmostallaspectsofthefinancialmarkets,isprimarilyassociatedwithcredit,liquidity,andtheinteractionbetweenthebankingsystemandthefinancialmarkets.Macroimbalancesinlevelsoffundinggloballyandlowinterestratesledtoarapidgrowthinthesupplyofleverageandtoanaggressivesearchforyieldbyinvestors.Inresponse,rapidfinancialmarketinnovationledtocreditriskfromleveragebeingtransmittedintothesecuritiesmarketsandbeingheldbyawiderangeofactorsthroughcomplexandinnovativesecuritieswhichrepackagedcreditrisksandweredesignedtosatisfyinvestordemandforhigheryields(FSA,2009).Butthemarketsprovedunabletorecyclecreditriskefficiently.

Amassivemispricingoftheinstrumentsusedtorepackagecreditrisk(notablystructured,highlycomplexassetbackedsecuritieswhichsecuritisedorrepackagedsubprimemortgagecreditrisks),linkedtoincentivefailures

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andfailuresofinternalriskmodels,ultimatelyled,inpartbecauseofthecomplexinterconnectionswhichboundtogetherthedifferentactorsinthesecuritisedcreditmarketandthescaleofthismarket,tothesubsequentseizureofworldcreditmarketsassystemicrisksescalated.Ratingagencies,hedgefunds,banks,investmentfirms,andauditors,aswellasregulatorsandcentralbanks,areamongtheactorsimplicatedinthecrisis.Theextenttowhichregulatoryfailureisdirectlyimplicated,particularlywithrespecttoliquidity,capitaladequacy,riskmanagement,andtransparencyisnotyetclear.Itappears,however,thatregulationhascontributedtothemassivevolatilityandsystemicinstabilityexperiencedbyglobalfinancialmarketsbyreinforcingprocyclicalityandfailingtoaddressthemacroprudentialriskstooverallsystemicstabilitywhicharisewhenmajorfinancialinstitutionsactinasimilarmannerinresponsetowidereconomicconditions(e.g.Brunnermeieretal.,2009;HighLevelGroup,2009;andFSA,2009).

Bywayofconclusion,someverytentativeobservationsmightbemadeconcerningthecreditcrunch,theEnronera,recenttheoryandpractice,andfinancialmarketintervention.Conflictofinterestandincentivemisalignmentriskispersistentandappearstomutatealongwithmarketdevelopmentsandtooutpaceregulation.Conflictofinterestriskandrelatedgatekeeperfailure,particularlywithrespecttoauditorsandanalysts,wasacentralfeatureoftheEnronera(Coffee,2002band2004).Conflictofinterestriskhasnowbeenassociatedwithexcessiverisktakingbybanksandwithflawedbankremunerationstructuresaswellaswithanothergatekeepingfailurethistimethefailureofratingagenciestoassessstructuredcreditriskscorrectly.Disclosurehas,asitwasintheEnronera,beenshowntobeatroublesometechniquewithinvestorsfailingtoassesscomplexproductsandcreditriskaccurately.Marketdisciplinehassimilarlybeenshown,as(p.454) itwasintheEnronera,tobeunreliable(Schwarcz,2007).Themarket'sfailuretopricecomplexcreditriskaccuratelyunderlinesthebehaviouraldifficultiesunderwhichthemostsophisticatedofmarketactorslabourandinrespectofwhichregulation,alreadystrugglingwithintensifyingcomplexityandinnovation,candolittle.

Thefinancialcrisis,inparticular,hasexposedtherisksrelatedtotheoutsourcingofregulationintheformofwidespreadrelianceoninternalriskmanagementmodelsandprocesses(bestexemplifiedbytheBaselIIregime)andonselfregulation,whetherofparticularactorsorofcomplexmarkets(notablytheoverthecounter(OTC)derivativesmarkets).TheEU'sinnovativeselfregulatorymodelforratingagencyrisk,basedonindustrycompliancewiththe2004IOSCOCodeofConductandcomplyorexplainoversightbyCESR,hasbeenanearlycasualty.Despiteinitialprotestationsastotheimportanceofalighttouch,principlesbasedapproachtoreform(McCreevy,2007),theCommissionhasproposedthatratingagenciesberegulated(EuropeanCommission,2008b).Internationalstandardsettinghasappearedshakyinthewakeofthefinancialcrisis,withtheBaselIIregimeandaccountingstandardsassociatedwiththecrisisandwithexacerbatingprocyclicality.Theempoweredretailinvestormodelseemsdeeplyproblematicinthefaceofthevolatilityunleashedbythecrisis,asitdidovertheEnroneraasequitymarketsplunged.Thesystemicnatureofthecreditcrunch,incombinationwiththeexperienceoftheUSmarketpostSOX,alsowarnsagainstdomesticallyfocusedresponses.

Butthepictureisnotentirelybleak.Thecurrentreformdiscussionsarebeingframedinaninternationalcontextandaregrapplingwiththerealitiesofsupervisorycooperationinaction(e.g.FinancialStabilityForum,2008andOECD,2008).Theneedforfinancialmarketregulationtoengagewithmacroeconomicpolicyandwithmacroprudential,sectorwideriskshasbeenaccepted(FSA,2009).Theburgeoningcomplexityoffinancialmarketrisk,thepaceofinnovation,theblurringoffinancialsectorsandregulatoryboundaries,andtheneedformultilayeredregulatorystrategiesallreinforcetheweaknessesofdetailedstaticregulationandcautionagainstadetailed,rulebasedresponse.Thesefactorsalsounderlinethepotentialof,andnecessityfor,effectiveenrolmentstrategiesandflexible,outcomesdriven,principlesbasedregulation,whichhavereceivedcloserattentioninrecentyears.But,inasignificantcaveat,thesestrategiesmustbealliedtoarobustandinformedlawinaction/supervisorystrategies;thishas,however,beenacknowledgedbytheFSA(FSA,2008band2009).Whetherinterventionbasedontheembeddingofoutcomescanovercometheprofoundincentivemisalignmentsandintensifyingcomplexityriskstowhichthefinancialmarketsarevulnerableisuncertain.Butbehaviouralfinanceandthestrengtheningemphasisonempiricismmayprovidesomeanswers.

Thechallengefacingregulationisimmense.Thelastthirtyyearshaveshownthatthecomplexitiesandrisksofdesigninggood,oratleastnotmalign,lawsonthe(p.455) booksareconsiderable.Thenextthirtyyearsandbeyondwillexposethemuchgreaterchallengesposedbylawinactionandbythedeliveryofsoundoutcomesinarapidlyevolving,increasinglyinterconnected,andcomplexitypronefinancialsystemthatisbearingevermorecloselyonhouseholds.

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Notes:(1.)Thischapteraddressestheregulationofissuerswhoseektoraisecapital,investors,investmentservices,andfinancialmarketrisk.Itdoesnotaddresstheparticularsystemic,liquidity,riskmanagement,andsolvencyrisksraisedbytherelatedbankingandcreditsystemwhichhavebeenthesubjectofdiscreteregulationandwhichbecamegraphicallyclearduringthecreditcrunch(consideredinoutlineinSection18.5).Thecreditcrunchhasalsoshownhowcloselyconnectedbankingandfinancialmarketregulationhavebecome.Bankingregulationsharesmanyoftherisksassociatedwithfinancialmarketintervention,althoughthesystemicimplicationsofmarketandregulatoryfailurearesignificantlyheightened.

(2.)Directive2004/39/EC[2004]OJL145/1.

(3.)London'sBigBangisassociatedwiththeremovaloftheseparationbetweenbrokersactingasagentsanddealersactingasprincipals.Itledtoawaveofconsolidation,thearrivalofinternational(particularly,US)banks,andthegrowthofthemultiserviceinvestmentfirmanditsinherentconflictsofinterestrisk.

(4.)Directive2003/71/EC[2003]OJL345/64.

(5.)Foranexampleseethecollectionofarticlesin(2007)105MichiganLawReview,Vol.8.

(6.)FSMArequirestheFSAtotakeintoaccounttheinternationalcharacteroffinancialservicesandmarketsandcompetitiveness:s.2(3)(e).

(7.)Thestatisticsarestark,evenwhennormalisedtoreflectthedifferentsizeofthetwomarkets.Between2002and2004therewere25publicenforcementactionsbytheFSA,comparedto224bypublicauthoritiesintheUS.Monetarypenaltiesdivergedsimilarlysharplybetween$326millionintheUSand$9millionintheUK(Jackson,2007b).

NiamhMoloneyNiamhMoloneyisProfessorofFinancialMarketsLawattheLondonSchoolofEconomicsandPoliticalScience.