Rethinking the Law and Economics of Post-Crisis Micro-prudential Regulation: The Need to Invert the Relationship of Law to Economics?

In the decade after the global financial crisis 2007–09, financial regulation reforms have been extensive, led at the international level by the Basel Committee of the Bank for International Settlements and the Financial Stability Board. The European Union has implemented most if not all of the international standards, in addition to overhauling regulatory architecture such as introducing the direct micro-prudential supervision of key euro-area banks by the European Central Bank (Banking Union) and instituting pan-European architecture to ensure implementation of regulatory reforms to a robust and faithful standard (the European System of Financial Supervision, notably the role of the European Banking Authority).

Banks being the perpetrators of the last crisis, they have been in the spotlight and few would opine that the regulatory framework has made little impact. Capital requirements imposed upon them  have risen markedly, as have other micro-prudential regulatory rules on leverage and liquidity. Banks are also experiencing much more intense supervisory scrutiny through significantly increased obligations in transparency and stress-testing. These micro-prudential regulatory reforms are targeted at changing banks’ strategic behaviours so that their essential financial risk-taking can be calibrated at a level that is appropriate for the bank but also for the wider financial system and economy in which the bank is nested.

My article focuses on the development of micro-prudential regulation since the time of the crisis, although it is acknowledged that many other regulatory tools have developed to deal with the problems that surfaced. Micro-prudential regulation remains a key feature in ‘preventing failure’ and it is important to question how far the reforms have moved closer to the objective. The essence of micro-prudential regulation is that it is aimed at preventing financial institution failure by introducing behavioural levers through the setting of regulatory price for different types of financial risk-taking. Pre-crisis it may be argued that the regulatory price was set too low and unrealistic, and after 2006, regulatory pricing became manipulable and of little significance in shaping risk-taking behaviour. Post-crisis, the reforms have reset regulatory prices to much higher levels and closed off gaps for manipulating and undermining such regulatory prices. The underlying methodology remains the same and continues to rely on a fundamentally micro-economic framework for shaping behaviour.

Micro-prudential regulation is quintessentially ‘law and economics’ at work in regulatory design, as regulation gives expression to micro-economic tools in shaping the regulated entity’s behaviour. The weaknesses of law and economics in pre-crisis micro-prudential regulation have been criticised, and post-crisis, the reforms are arguably founded upon ‘new and improved’ law and economics which takes into account flawed assumptions of earlier micro-economic models and incorporates insights from macro-economics. It seems that the economic foundations for the law and economics of micro-prudential regulation have been made more comprehensive and robust. However, commentators continue to point out the shortcomings of the law and economics’ foundations, and are also concerned about the increasing complex prescriptions in micro-prudential regulation. In other words, ‘new and improved’ law and economics has supported a new regime for micro-prudential regulation that is increasingly unwieldy, complex and burdensome without clearly connecting to the wider benefits in public interest that were articulated as necessary in the wake of the crisis- such as the need for finance to serve socially useful needs and in a long-termist and inter-generational manner, and for financial markets and economies to be sufficiently stable, competitive and not to be highly susceptible to boom and bust.

The regulatory adoption of a methodology to govern behaviour formation in financial institutions is necessary as financial institutions suffer from perverse incentives in managing ‘other people’s money’ and from behavioural heuristics in the face of market pressures. The regulatory price for risk-taking is however largely set in micro-economic and quantitative terms, in the vein of the law and economics tradition. I argue that such an approach does not address certain shortfalls which are better addressed by qualitative regulatory methodologies, such as regulatory standards of conduct and duties that have both ex ante and ex post effects on behaviour formation. The rebalancing of law’s role can introduce qualitative duties and obligations that re-embed regulatory objectives of public interest in the formation financial institution behaviour, as quantitative methods tend to compel focus on ‘numbers as boundaries’, dis-embedding the behaviour formation process from the wider context of regulatory objectives and public interest. Hence, a rebalancing of the ‘law’s’ role in law and economics has the potential to assist in constructing a more enduring regulatory design with both quantitative and qualitative aspects.

My article proposes that the substantive public interest and social goods that we desire finance to serve can better be framed in relation to qualitative legal duties for financial institutions, namely to justify their attainment of systemically important profiles and to take extra prudential care if they become systemically important, to desist from purely speculative activities that do not serve a genuine or proportionate purpose to their financial intermediation business, and to be subject to a public interest purpose in their corporate charters. Although legal duties are qualitative in nature and require interpretation in order to become refined and more certain, they can better foster a consciousness for regulatory compliance that is embedded in regulatory goals and social expectations. The article discusses the contours of the legal duties we have sketched and the promise they hold in transforming the efficacy of prudential regulation for financial institutions, while acknowledging the challenges for implementing these.

Iris H-Y Chiu is Professor of Corporate Law and Financial Regulation at the Faculty of Laws, University College London.