Striking Regulatory Irons While Hot

Hersh Shefrin and Meir Statman

Volume 7, Number 4, Fourth Quarter 2009

We are in the midst of what might end up as the most significant change to financial regulations since the Great Depression. This is because the financial and economic crisis that continues to engulf us is the most severe crisis since the Great Depression. The markets for houses, mortgages, and derivatives linked to them have played critical roles in the crisis, and debates about the shape of future financial regulation have led to intense focus on these markets. In this paper we place the current debate about regulatory changes within a larger frame. We present a framework based on capture theory and fairness where regulatory irons are heated by changes in financial markets such as a plunge from exuberant booms to frightening crashes, changes in the economy such as a fall from heady job creation to dispiriting unemployment, changes in technology such as an innovation in information technology which enables banks to substitute the Internet for tellers, changes in politics, such as one party displacing another, or new rulings by the Supreme Court, such as the one that opened the door to interstate banking. We discuss the fires that heat regulatory irons, the craftsmen standing ready to strike them, and the process by which they are struck, in credit card and bank regulations, insider trading regulations, Regulation FD, trading halts, the Global Settlement, and the Sarbanes-Oxley Act. We conclude with our prescriptions.