Gerding law, bubbles, and financial regulation (2014)

Law, Bubbles, and Financial Regulation Financial regulation can fail when it is needed the most The dynamics of asset price bubbles weaken financial regulation just as financial markets begin to overheat and the risk of crisis spikes At the same time, the failure of financial regulations adds further fuel to a bubble This book examines the interaction of bubbles and financial regulation It explores the ways in which bubbles lead to the failure of financial regulation by outlining five dynamics, which it collectively labels the “Regulatory Instability Hypothesis.” These five dynamics include: The regulatory stimulus cycle As bubbles form and markets boom, policymakers face increasing pressure to provide regulatory stimulus for financial markets Policymakers provide this stimulus not only by deregulating financial markets and repealing statutes and regulations, but also by lowering enforcement, providing exemptions to legal rules, and choosing not to apply legal rules to new contexts In many cases, governments intervene in markets by providing legal preferences, monopolies, and other subsidies to select market participants Compliance rot Bubbles undermine the compliance by market participants with antifraud and other financial rules Regulatory arbitrage frenzies Bubbles foster increased gamesmanship of financial regulations by market participants Bubbles sharpen the creativity of these parties and their appetite for legal risk Procyclical regulation Certain regulations exacerbate boom and bust cycles in financial markets, without policymakers changing legal rules or market parti­ cipants varying their level of compliance Promoting of investment herding Other legal rules encourage investors and financial institutions to engage in dangerous herding into particular investments The book concludes by outlining approaches to make financial regulation more resilient to these dynamics that undermine law Erik F Gerding is Associate Professor at the University of Colorado Law School The Economics of Legal Relationships Sponsored by Michigan State University College of Law Series Editors: Nicholas Mercuro Michigan State University College of Law and Michael D Kaplowitz Michigan State University Compensation for Regulatory Takings Thomas J Miceli and Kathleen Segerson Dispute Resolution Bridging the settlement gap Edited by David A Anderson The Law and Economics of Development Edited by Edgardo Buscaglia, William Ratliff and Robert Cooter Fundamental Interrelationships between Government and Property Edited by Nicholas Mercuro and Warren J Samuels Property Rights, Economics, and the Environment Edited by Michael Kaplowitz Law and Economics in Civil Law Countries Edited by Thierry Kirat and Bruno Deffains The End of Natural Monopoly Deregulation and competition in the electric power industry Edited by Peter Z Grossman and Daniel H Cole Just Exchange A theory of contract F H Buckley Network Access, Regulation and Antitrust Edited by Diana L Moss *The first three volumes listed above are published by and available from Elsevier 10 Property Rights Dynamics A law and economics perspective Edited by Donatella Porrini and Giovanni Ramello 11 The Firm as an Entity Implications for economics, accounting and the law Edited by Yuri Biondi, Arnaldo Canziani and Thierry Kirat 12 The Legal–Economic Nexus Warren J Samuels 13 Economics, Law and Individual Rights Edited by Hugo M Mialon and Paul H Rubin 14 Alternative Institutional Structures Evolution and impact Edited by Sandra S Batie and Nicholas Mercuro 15 Patent Policy Effects in a national and international framework Pia Weiss 16 The Applied Law and Economics of Public Procurement Edited by Gustavo Piga and Steen Treumer 17 Economics and Regulation in China Edited by Michael Faure and Guangdong Xu 18 Law, Bubbles, and Financial Regulation Erik F Gerding This page intentionally left blank Law, Bubbles, and Financial Regulation Erik F Gerding First published 2014 by Routledge Park Square, Milton Park, Abingdon, Oxon OX14 4RN and by Routledge 711 Third Avenue, New York, NY 10017 Routledge is an imprint of the Taylor & Francis Group, an informa business © 2014 Erik F Gerding The right of Erik F Gerding to be identified as author of this work has been asserted by him in accordance with the Copyright, Designs and Patents Act 1988 All rights reserved No part of this book may be reprinted or reproduced or utilized in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers Trademark notice: Product or corporate names may be trademarks or registered trademarks, and are used only for identification and explanation without intent to infringe British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging in Publication Data Gerding, Erik F., 1973– Law, bubbles and financial regulation / Erik F Gerding pages cm ISBN 978­0­415­77939­5 (hbk) – ISBN 978­1­315­88504­9 (ebk) Finance–Government policy Finance–Law and legislation Capital markets–Government policy Stocks–Prices Financial crises Financial institutions–Law and legislation I Title HG173.G44 2013 332–dc23 2013014203 ISBN: 978­0­415­77939­5 (hbk) ISBN: 978­1­315­88504­9 (ebk) Typeset in Times New Roman by Wearset Ltd, Boldon, Tyne and Wear For Andrea This page intentionally left blank Contents List of figures List of tables Acknowledgments Introduction: the Regulatory Instability Hypothesis PART I The economics and legal history of bubbles xi xiii xiv 31 The economics of bubbles 33 A legal history of bubbles 62 PART II The Regulatory Instability Hypothesis 137 Boom, bust, and the regulatory stimulus cycle in financial markets 139 Epidemics of fraud and compliance rot 196 Regulatory arbitrage frenzies and the hydraulics of investor demand 236 Deregulation and regulatory arbitrage spirals: a dance for two 276 Procyclical regulation and herd­promoting regulation 311 Conclusion 145 146 147 148 149 150 151 152 153 154 155 156 157 529 For a sampling of academic commentary on the SEC’s struggles in the D.C Circuit, see, e.g., Troy A Paredes, On the Decision to Regulate Hedge Funds: The SEC’s Regulatory Philosophy, Style, and Mission, 2006 University of Illinois Law Review 975 (2006); Donald C Langevoort, The SEC as a Lawmaker: Choices about Investor Protection in the Face of Uncertainty, 84 Washington University Law Review 1591 (2006) (discussing case in which D.C Circuit struck down SEC rule on mutual funds for failure to perform cost–benefit analysis); Edward Sherwin, The Cost-Benefit Analysis of Financial Regulation: Lessons from the SEC’s Stalled Mutual Fund Reform Effort, 12 Stanford Journal of Law, Business and Finance (2006) (arguing financial regulators need to justify regulation according to federal rules requiring cost–benefit analysis) For a detailed analysis of the ways in which cost–benefit analysis has been misused in environmental regulation, see Richard L Revesz and Michael A Livermore, Retaking Rationality: How Cost–Benefit Analysis Can Better Protect the Environment and Our Health (2008, Oxford University Press) For a sketch proposal of how to conduct cost–benefit analysis in the realm of financial regulation, see Eric Posner and E Glen Weyl, Benefit–Cost Analysis for Financial Regulation, 103 American Economic Review 393 (2013) For one critical examination during this period of calls for a single financial regulator, see Joseph J Norton, Global Financial Sector Reform: The Single Financial Regulator Model Based on the United Kingdom FSA Experiences – A Critical Reevaluation, 39 International Law 15 (2005) Cf Eilís Ferran, The Break-up of the Financial Services Authority, 31 Oxford Journal of Legal Studies 455 (2011) (criticizing breakup of the FSA and analyzing its consequences) Supra note 47 Klaus C Engelen, Germany’s Fight over BaFin: The Ramifications of a Bundesbank Takeover, International Economy 54 (Winter 2010) The FSOC enjoys a broad mandate to identify risks to financial stability, monitor financial regulatory developments, and make recommendations to various federal regulators Dodd-Frank § 112(a), 124 Stat 1393 (codified at 12 U.S.C § 5322(a)) The Dodd-Frank Act makes liberal use of Inspector Generals to police the behavior of financial regulatory agencies See e.g., Dodd-Frank § 211(d), 124 Stat 1514 (codified at 12 U.S.C §5391(d)) (requiring review of FDIC by Inspector General of that agency) Eric Fielding, Andrew W Lo, and Jian Helen Yang, The National Transportation Safety Board: A Model for Systemic Risk Management, Journal of Investment Management 17 (2011) McDonnell and Schwarcz, supra note 31 Committee to Establish the National Institute of Finance, www.ce-nif.org/ (last visited June 1, 2012); S 3005, 111th Congress (2010) The Dodd-Frank Act reflects these concerns It gives one agency, the FSOC, the power to designate which non-bank financial companies are systemically significant, while other agencies take the lead in developing and enforcing the regulations that would apply to those designated companies Dodd-Frank § 113, 124 Stat 1398 (codified at 12 U.S.C § 5323) Of course any division of labor and the creation of checks and balance create coordination problems Ed deHaan, Kevin Koh, Simi Kedia, and Shivaram Rajgopal, Does the Revolving Door Affect the SEC’s Enforcement Outcomes? American Accounting Association, Annual Meeting Presentation (July 2012) available at http://aaahq.org/newsroom/ RajgopalDeHaanKediaKoh.pdf (last visited July 31, 2013); Edward Wyatt, Study Questions Risk of S.E.C Revolving Door, New York Times, August 5, 2012, at B2 530 Lessons and solutions 158 Duncan Alford, Supervisory Colleges: The Global Financial Crisis and Improving International Supervisory Coordination, 24 Emory International Law Review 57 (2010) 159 Basel Committee on Banking Supervision, Basel III Regulatory Consistency Assessment Programme 5–7 (April 2012) available at www.bis.org/publ/bcbs216.pdf (last visited July 27, 2013) 160 Chris Brummer, How International Financial Law Works (and How It Doesn’t), 99 Georgetown Law Journal 257, 280–1 (2011) 161 This is analogous to provisions in the Dodd-Frank Act that give certain financial regulators “back-up” authority to examine institutions subject to primary regulation by another agency E.g., Dodd-Frank Act § 172, 124 Stat 1438 (codified at 12 U.S.C §1820(b)(3)) (giving FDIC back-up authority to examine certain non-bank financial companies supervised by Federal Reserve Board in connection with power of FDIC to take non-bank financial companies into receivership) 162 For a summary of dispute settlement mechanisms under the WTO and other important international regimes such as NAFTA, see Michael Trebilcock, Robert Howse, and Antonia Eliason, The Regulation of International Trade, 49–90 (5th ed 2012, Routledge) 163 For a scholarly analysis of soft law in international financial regulation, see Chris Brummer, Soft Law and the Global Financial System: Rule Making in the 21st Century (2012) 164 See generally Stephen Clarkson, Integration and Disintegration in North America: The Rise and Fall of International Economic Law in One Region, European Yearbook of International Economic Law 327 (2011) 165 Policymakers and scholars have considered various proposals to give private firms standing in WTO dispute settlement mechanisms as well E.g., Thomas J Schoenbaum, WTO Dispute Settlement: Praise and Suggestions for Reform, 47 International and Comparative Law Quarterly 647 (1998) 166 Jason Webb Yackee, Pacta Sunt Servanda and State Promises to Foreign Investors Before Bilateral Investment Treaties: Myth and Reality, 32 Fordham International Law Journal 1550 (2008) 167 Federal Financial Institutions Examination Council Central Data Repository (CDR) Public Data Distribution (PDD) Frequently Asked Questions, available at https://cdr ffiec.gov/public/HelpFileContainers/FAQ.aspx (last visited July 15, 2012) 168 Gerding, supra note 46 169 Ibid 170 Ibid at 151 citing Kenneth C Kettering, Securitization and Its Discontents: The Dynamics of Financial Product Development, 29 Cardozo Law Review 1553, 1674–6 (describing rating agencies as “de facto lawmakers”) 171 Gerding, supra note 46, at 153 172 Frank Partnoy, The Siskel and Ebert of Financial Markets? Two Thumbs Down for the Credit Rating Agencies, 77 Washington University Law Quarterly 619, 681 (1999) 173 Gerding, supra note 46, at 154–7 174 Gerding, supra note 46, at 158–9 Alternative Net Capital Requirements for BrokerDealers That Are Part of Consolidated Supervised Entities, Exchange Act Release No 34–49, 830, 69 Federal Register 34,428 (June 21, 2004) (codified at 17 C.F.R pts 200 and 240) 175 Gerding, supra note 46, at 158–9 176 Office of Inspector General, SEC’s Oversight of Bear Stearns and Related Entities: The Consolidated Supervised Entity Program (2008), Report No 446-B (September 25, 2008) available at www.sec-oig.gov/Reports/AuditsInspections/2008/446-a.pdf (last visited July 31, 2013) 177 Conrad de Aenlle, When Crisis Hit, a Global Framework for Limiting Risk Proved Ineffective, New York Times, October 19, 2008, available at www.nytimes Conclusion 178 179 180 181 182 183 184 185 186 187 188 189 190 191 192 193 531 com/2008/11/20/business/worldbusiness/20iht-rriskbis.1.17962169.html?pagewanted= all (last visited July 31, 2013); Jack Ewing, A Fight to Make Banks More Prudent, New York Times, December 21, 2011, at B1; Sins of the Few, World Finance (December 12, 2008) (online edition) available at www.worldfinance.com/home/final-bell/sins-of-thefew (last visited July 31, 2013) Gerding, supra note 46, at 185, 188 Partnoy, supra note 172 Gerding, supra note 46, at 129–34 (analogizing the delegation of regulatory responsibility to models as creating a “new financial code”), 190–1 (outlining benefits of “open source” risk models) Schooner, supra note 10 Gretchen Morgenson and Louise Story, Rating Agency Data Aided Wall Street in Deals, New York Times, April 24, 2010, at A1 Chapter 1, “Rigor and pragmatism in identifying bubbles.” Chapter 1, “Rigor and pragmatism in identifying bubbles.” Chapter 1, “Rigor and pragmatism in identifying bubbles.” Chapter 1, “Rigor and pragmatism in identifying bubbles.” This review is required by statute 10 U.S.C § 118 (2009) Dodd-Frank § 112(b)(1), 124 Stat 1396 (codified at 12 U.S.C § 5322(b)(1)) Dodd-Frank § 112(b)(2) 124 Stat 1396 (codified at 12 U.S.C § 5322(b)(2)) For a somewhat dated but still insightful analysis of the theory and practice of the National Environmental Policy Act, see Serge Taylor, Making Bureaucracies Think: The Environmental Impact Statement Strategy of Administrative Reform (1985, Stanford University Press) This chapter uses the term “adaptive” to mean flexible regulations that policymakers adjust to economic or political conditions Other legal scholars have used the term “adaptive regulations” to describe regulations formulated together by public and private sector actors For a small sample of the literature in this vein, see Lawrence G Baxter, Adaptive Regulation in the Amoral Bazaar, 128 South African Law Journal 253–72 (2011) (arguing that this type of regulation must be grounded in morality); Philip J Weiser, The Future of Internet Regulation, 43 UC Davis Law Review 529 (2009); Gideon Parchomovsky and Philip J Weiser, Beyond Fair Use, 96 Cornell Law Review 91 (2010) For a cultural study of the securities regulation created in the wake of certain English bubbles that examines the role of morality in passing these new rules, see Stuart Banner, Anglo-American Securities Regulation (1998, Cambridge University Press) Tulips were used for their symbolic value as memento mori and vanitas devices Ann Goldgar, Tulipmania: Money, Honor, and Knowledge in the Dutch Golden Age, 90–2 (2007, University of Chicago Press) Art historians have noted that painters and patrons valued this flower for a number of reasons, not least because of their exotic beauty and their role as status symbol in seventeenth century Holland For histories of the tulip motif in Dutch and European painting, see Celia Fisher, Flowers of the Renaissance, 79–86 (2011, J Paul Getty Museum) See also Simon Schama, The Embarrassment of Riches: An Interpretation of Dutch Culture in the Golden Age, 162 (1991, Harper Perennial) (discussing vanitas and memento mori paintings in the Netherlands, including in responses French Mississippi bubble); ibid at 359–71 (analyzing other Dutch art motifs that responded to Tulipomania) Examples of the tulip in vanitas paintings also date to before the 1637 Tulipomania Cf Benjamin R Bennett-Carpenter, Moving Memento Mori Pictures: Documentary, Mortality, and Transformation in Three Films, 63 n 14 (2008, ProQuest) (describing 1603 painting) But see Fred G Meijer, Dutch and Flemish Still-life Paintings, 25–6 (2003, Ashmolean Museum) (rejecting claims that tulips in paintings after Tulipomania referenced that financial crisis and arguing these flowers were inherently popular painting subjects because of their beauty) Index Page numbers in italics denote tables, those in bold denote figures accountability 476, 510 Adams, Charles Francis 78, 216 Adams, Henry 216 administrative law 149–50, 504–5 Adrian, Tobias 45, 326, 375, 383–4, 446–7, 448, 449 agency costs 152, 206, 220, 245 AIG 441 Akerlof, George 205 Allen, Franklin 44, 319–20 amakudari 157 American Depository Receipts (ADRs) 237 anchoring 40, 208 Anthony Jr., James R 88–9 anti-bubble laws: arbitrage, removing barriers to 343, 354; categories 340–1; circuit breakers 339, 342, 343, 353; disclosure 340, 348–9, 356n13; effectiveness 339–40; examples of 339; experiencing a bubble and a crash 351–2; experimental asset market use 343–7, 348; futures markets 350; improving information to investors and information processing of investors 341, 348, 349; investor education 350–1; positive feedback investment loops 342–3, 352–4; resale of assets 354; restricting access of unsophisticated investors and tiering 352; transaction and capital gains taxes 353 antitrust laws 85–6 arbitrage 355n3; as an anti-bubble policy 339; bias arbitrage 144, 170–1; removal of barriers to 343, 354; risks 40–1; see also regulatory arbitrage Argentina 103 Aspinwall, Richard 401–2, 419–20n25 asset-backed commercial paper (ABCP) 255, 257–8, 406–7, 412, 422n70, 441 asset-backed securities 16, 202, 256–7, 377–9, 378, 404–5, 412, 449 asset liquidity 320 asset price bubbles 41; behavioural finance models 38–9, 41, 54n75; bounded rationality and noise traders 39–40; causal factors and regulatory failure 22; conflation of risk and uncertainty 36; correlation and causation 67–8; credit, role of 34, 44–6; criticism of behavioural finance 42; definition 4, 25n12, 35–8; discounting the costs of a bubble 150–1; disputes on historical bubbles 37–8; divergence in legal, political and biological outcomes 174–5; effects of 4, 15; experimental evidence of bubbles 38; fraud and law-breaking 66–7; and fundamental information 36–7; fundamental values 4; herding and positive feedback investment loops 40; historical link with deregulation 139–41; historical patterns, reliance on 35–6; ideology, role of 173–6; interventions 48; legal responses to 6–8, 64–6; limited arbitrage 40–1; long term asset holding 37; microeconomic models of bubbles 38–47; moralistic responses 474; and political campaign expenditure 154–6, 154, 155, 156; price deviation from fundamental value 35–6; pricing anomalies 41–2; rational bubbles 42–3; real estate bubbles 3–4, 46–7, 59–60n140; regulatory stimulus 64–6; research on 4–6; warning signs 47–8; see also anti-bubble laws Index 533 Austria, Panic of 1873 80–4, 103, 165 availability bias 39, 168, 172, 200, 221 Aviram, Amitai 144, 170–1 bailouts 13, 148–9, 151, 252–3, 324–6, 334n91, 454, 477–8 balance sheet leverage 410 Bank of England 68, 73, 74, 77 Banking Act 1935 (US) 92 bankruptcy 95, 315–16, 323–4, 367, 382, 431 banks: 1920s boom 161; Austria 82; bank runs 16, 43, 312, 319–21, 402–3; capital requirements and provision of bank credit 379–80; central banks 98, 198, 287, 368–70, 370, 372–3, 445–6, 446; disclosure requirements 88; failures 76–7, 248; financial institution regulation 148–9, 151; Florida 88–9; fractional reserve banking 369–70, 370; Germany 81–2, 242–3; herding 319; incremental deregulation 163–4; investment banks 414–15, 424n109; Japan 93–4, 130n311, 238, 248, 289–93, 319; legal changes after Panic of 1825 74; lending 45; loan loss reserves 12, 314, 374; participation in derivatives markets 433–4; participation in securitization 432–3; and real estate lending and securities activities 86–8; regulations, US 92; reserve requirements 369, 374; restricting investment in securities and real estate 483–4; securitization 16–17; Spain 492; Sweden 159–60, 238, 247–8, 287–9; transaction fees and taxes 495–6; unregulated banks 73; use of monetary policy to curb inflation 20; see also regulatory capital arbitrage; shadow banking Banner, Stuart 210, 211 Banque Générale (later Banque Royale) 69–70 Bartlett, Bob 201 Basel Accords 238, 253–4, 256, 258–9, 261, 270–1n138, 315, 440, 447, 491, 509, 511 Bear Stearns 453, 455, 511 behavioral finance 5; bounded rationality and noise traders 39–40; criticism of 42; fraud and behavioral biases 207–9; models 38–9, 41, 54n75; pricing anomalies 41–2 behavioral model of regulation 479–80; agents’ responsibility to superiors 169; behaviourally biased regulators 167–8; bias arbitrage, limits of 170–1; crises that not develop 168–9; disaster myopia 168; evaluation of and integration with other models 177–8; explanation of model 166; interest groups and behavioral biases 170; predicting regulatory backlash 171–2; use in explaining post WWII financial stability 178–9 belief perseverance 40, 208 Bernanke, Ben 20, 21, 370–1 Bernie Madoff fraud 204 Bhidé, Amar 478 bias arbitrage 144, 170–1 Bismarck, Otto von 81, 83, 174, 175 Blair, Margaret 444, 451 blame hedging 164–5 Blazing Saddles (film) 325 bonds 73, 93, 238, 287–8, 399–400; government bonds 291; mortgage bonds 89, 90; warrant bonds 239, 291 Bonfire of the Vanities, The (Wolfe) 214 Borio, Claudio 312–13, 315 Born, Brooksley 171, 434 bounded rationality 36, 39–40 Bressman, Lisa Schultz 481 bribes 153–4 Britain: 1830s railway boom to the Panic of 1837 74–5, 101, 173; 1840s railway mania to the crisis of 1847 75–6, 101, 211; 1850s boom to the crisis of 1857 76–7, 102; 1860s boom and crisis of 1866 77; Argentina boom 103; English stock market boom 1690s 68–9, 165; nineteenth century corporate law and crises 110–11; Panic of 1825 72–4, 101, 173, 297; South Seas bubble 71–2, 100, 174, 186–7n67, 210, 211, 482 Brunnermeier, Markus 169, 326 Bubble Act 1720 (UK) 72, 73, 117n55, 140, 165, 172, 222 ‘Bubble Thy Neighbour’ (study) 249 bubbles see asset price bubbles Buffet, Warren 204 building and loan associations 89, 90 California 96–7 cash flows 4, 35, 37, 44, 51n25 caveat emptor 209–10 Chancellor, Edward 210, 211–12, 214, 216, 239 China 339, 343, 374 Choi, Stephen 167 534 Index circuit breakers 339, 342, 343, 353 Citigroup 221–2, 436 Coffee, John 165–6, 180n1, 197–8, 223n7 collateral requirements 380–1, 411 collateralized debt obligation (CDO) 243, 405, 417, 443 collective action 145, 151, 162, 165–6, 282, 384 Commodity Futures Modernization Act 2000 (US) 298, 434 Commodity Futures Trading Commission (CTFC) 298, 434, 490 Compagnie d’Occident (later Compagnie des Indes) 69–70, 482 Companies Act 1862 (UK) 77 compensation 220, 246, 444, 466–7n128, 497–8 complex adaptive systems 261–2 compliance rot 2, 10–11, 197; behavioral biases, influence of 220–1; legal legitimacy, deterioration of 215–18; promotion of compliance 19; prudential regulations 218–22; rational calculus 219–20; shadow banking 443–4; social norms, influence of 221–2 conduits 406 conglomerate stock boom 1960s 129–30n305 Consolidated Supervised Entity Program 440, 511 constitutions 79–80 corporate law 65–6, 151; and crises in nineteenth century Britain 74–7, 110–11, 173; France 71; Germany 81 Corrigan, Gerald 401, 450 corruption: banks in Florida 88–9; bribes 153–4; judicial system 78; political corruption 216–17; South Seas bubble 72; see also fraud countercyclical regulations 314, 327, 477, 485, 491–4 court rulings: Central Bank of Denver v First Interstate Bank of Denver 98, 134–5n379, 198; Citizen’s United 480; Lampf, Pleva, Lipkind, Prupis & Petigrow v.Gilbertson 98, 198; Public Utilities Commission of Rhode Island v Attleborough Steam & Electric Co 86; US v Winstar 503–4 CoVar 326 credit 5–6, 12, 445; credit booms 300; credit crunches 319; credit derivatives 16, 157, 244, 258, 298, 375–7, 376, 390–2n76, 391, 392n78, 392, 407–8, 407, 408, 410, 411, 412, 431, 434–5, 490; credit enhancements 258; credit transfers 390–2n76, 391, 392; default swaps 1, 375, 376, 376, 439, 440; fuelling bubble growth 34, 44–6; intermediation 399, 407; macroeconomic research 365–6; rating agencies 436–7; regulations 14, 21; restrictions in experimental markets 365; risk 253–4, 256–7, 264n34, 378, 407–8, 408, 410, 416, 418, 447; securitization 16–17; transformation 400, 405, 414 credit-rating agencies 259, 511–12 crony capitalism 84, 142, 144, 175, 196–7, 216–17 Davidoff, Steven 455 debt fuelled bubbles 34, 44–6 Defoe, Daniel 214, 216 demand-determined theories 202–3 deposit insurance 92, 165, 219, 284, 285, 287, 322, 323, 382, 416, 455, 485 Depository Institutions Deregulation and Monetary Control Act 1980 (US) 430 deregulation 2, 7, 8, 22, 64, 114n4; big bang style 178–9; blame hedging 164–5; demand for 145; destabilizing deregulation 277–8, 280; double key deregulation 503–4; energy industry 96–7; feedback loops 130n311; historical link with bubbles 139–41; implicit guarantees 299–300; incremental approaches to 163–4; influence on fraud 197–200, 198, 199; Japan’s spiral of deregulation and regulatory arbitrage 93, 289–93; model explaining deregulation/regulatory arbitrage spirals 278–87; regulatory distortion and displacement 298–9; role of regulatory arbitrage 159–66; securities 97–8; sunset provisions 501–2; supply of 151–2; Swedish spiral of deregulation and regulatory arbitrage 287–9; technology stock bubble 1990s 94–5; telecommunications 95; as a trigger for regulatory arbitrage 276–7; US subprime mortgage securitization crisis 293–7, 297; see also regulatory stimulus Dewey, John 48 Diamond, Douglas 319 disaster myopia 10, 22, 39, 47, 168, 177, 221, 479, 501 Index 535 Disraeli, Benjamin 74, 213, 242 Dodd-Frank Act 2010 (US) 6, 27n32, 27n34, 243, 378, 478, 489, 490, 491–2, 503, 514 Downs, Anthony 166 Dump Your Bank movement 484 Dybvig, Philip 319 Ebbers, Bernie 96 economic leverage 410, 411 economic liberalism 73, 81 economic shocks 146–7 Efficient Markets Hypothesis (EMH) 5, 35, 37, 39, 208–9; real estate markets 47 embedded leverage 410, 411 Emergency Economic Stability Act 2008 (US) 455 energy deregulation 96–7 Energy Power Act 1992 (US) 96 English stock market boom 1690s 68–9, 100, 165 Enron 95, 96–7, 98, 134–5n379, 198 environmental law 149, 487, 515 experimental asset markets 340; design 345; effects on bubbles 345–6; explanation of use 343; external validities and limitations of basic design 345–6; validity of experimental economics 344–5 experimental economics 38, 344–5 Fannie Mae 17, 294–7, 415, 431–2, 443, 468n154, 482 Farhi, Emmanuel 325 Federal Credit Union Act 1934 (US) 92 Federal Deposit Insurance Corporation (FDIC) 498 Federal Energy Regulatory Commission (US) 96 Federal Reserve Act 1913 (US) 87, 127n260 Federal Reserve Act 1917 (US) 88, 127n260, 435–6, 455, 456, 458 Federal Reserve (US) 18, 90, 164, 367, 372, 379, 387n24, 451, 455–7, 456, 458, 481–2 feedback loops 2, 6; compliance rot 11; deregulation 130n311; herding and positive feedback investment loops 40; higher asset prices 286; loan loss reserves 314; positive feedback investment loops 342–3, 352–4; potential for destructive loops 383; between procyclical credit and boom and bust cycles 45–6; procyclical regulations 12; regulatory arbitrage frenzies 12; regulatory problems of 19–20; regulatory stimulus cycle 10; tokkin accounts, Japan 239 finance companies, Sweden 287–9 financial conglomerates 416, 430, 435, 439, 440 financial/legal innovations and instruments 107–9 financial liberalization 178–9 financial regulation 312; accountability 476, 510; administrative law 149–50, 504–5; agency independence 481–2; budgets 495–6; civil society as a counterbalance to interest groups 483–4; contingent capital 494; contribution to growth of bubbles 2; countercyclical regulations 314, 327, 477, 485, 491–4; cultivating regulator norms and developing intellectual capital 498–500; decoupling political cycles from financial cycles 480; decoupling stock market, real estate and banking cycles 484–5; diluted enforcement 160–2, 161, 219–20; disequilibrium in financial markets 486–7; double key deregulation 503–4; enforcement, transparency of 510; financial institution regulation 148–9, 151; financial instrument licensing 500–1; future challenges 473–5; government investment in financial institutions 482–3; human variables 496–7; incompleteness 236, 262n1; industry segmentation and interest group competition 483; information gathering 490; international trade law 509; Japan 93; judgement, importance of 478–9; lawyers and legal scholars, contribution of 488–9; legitimacy 196–7, 215–18, 473; loopholes 236; and macroeconomic policy 487–90; memento mori devices 513–15, 516; as monetary tools 380–1; money supply and regulatory preferences 381–2; outsourcing regulatory responsibility 510–12; peer review of regulators 508; policies to make regulation more robust 19; prophylactic rules 150, 169, 505; prudential regulations 218–22, 248, 312–13, 381, 382, 487; radical disequilibrium 179; regulator compensation, promotion and retention 536 Index financial regulation continued 497–8; regulatory agency competition 505–6; regulatory agency staff recruitment 508; regulatory arbitrage and the need for networked regulations 492–3; regulatory institution design 475–80, 489; reliance on technology 494–5; separation of social security and capital markets 485–6; shell companies 500–1; as substitutes for monetary policy 373; sunset provisions 501–2; transparency 476, 505, 509–10, 512; watchdogs 505–7 financial restatements by corporations 198–200, 198, 199 Financial Services Authority (UK) 506 Financial Stability Oversight Council (US) 27n32, 489, 506, 514 Fleischer, Victor 240, 245, 246, 247, 250, 262n3, 263n4 Florida 88–9, 161 Foreign Exchange Law Reform 1980 (Japan) 291 fractional reserve banking 369–70, 370 framing 40 Fraser, Steve 85, 90, 216 fraud 66–7, 430; 1850s boom 76–7; banks in Florida 88–9; behavioral biases, influence of 207–9; behavioral explanations 200–1; causes of 196–7; CDO deceptions 443; corporate fraud 198; damages 205, 207; demand for 200–2; deregulation, influence of 197–200, 198, 199; detection 204; and deteriorating legal legitimacy 215–18; deterioration of deterrence 202–7; deterrence model, effects of bubbles on 204; deterrence model, explanation 203–4; enforcement probability of antifraud rules 205; English stock market boom 1690s 68; final period problems of booms 206–7; financial restatements by corporations 198–200, 198, 199; information and agency costs 206; Japan 93–4; mortgage deceptions 442–3; norm asymmetries 212–13; Panic of 1825 73–4; Panic of 1873, Germany and Austria 82–3; and political corruption 216–17; railway companies 76; and rational risk taking 202; reciprocity 210–11, 212; reputation 204, 205–6; securities 97–8; social minorities 214–15; social norms, influence of 209–10; South Seas bubble 72; stock market and real estate booms of the 1920s 90; stock market crash 1836 74–5; summary table 100–6; technology stock bubble 1990s 95, 98, 197–200; telecommunications deregulation 96; trust 201; United States scandals 78–9; young people 213–14 Freddie Mac 17, 294–7, 415, 431–2, 443, 468n154, 482 fundamental values 4, 25n13; price deviation from asset price bubbles 35–6; and the Regulatory Instability Hypothesis 20–2 futures markets 47, 341, 350 gains trading 254, 317 Gale, Douglas 44, 319–20 gatekeepers 197–8, 205, 206, 223n7, 227n49 Geanakoplos, John 45, 383–4, 446 Germany: bank investment in US assetbacked securities 242–3; Panic of 1873 80–4, 103, 165, 173–4; state intervention in economy after 1873 175 Gilson, Ronald 217–18, 237 Gladstone, William 75, 173 Glass-Steagall Act 1933 (US) 92, 98, 147–8, 165, 169, 221–2, 297, 433, 435, 439, 502 Goldman Sachs 212–13, 259, 414–15 Gorton, Gary 324, 382, 405, 409, 431, 453 government-sponsored entities (GSEs) 17, 294–7, 297, 415, 431–2, 443, 482–3 Grange movement 80, 166, 175 Great Barbecue 216 Great Depression 1, 84, 91, 104, 178 Greenspan, Alan 372, 434, 440, 476–7, 482 Guttentag, Jack 168, 221 haircuts 375, 409, 453 Hanson, Samuel 314 hedge funds 44, 53n63, 212–13, 415, 453 Henderson, Todd 497 herd behaviour 5, 311–12; and positive feedback investment loops 40; rationality of 43 herd-promoting regulations 3, 13, 19; bailouts 324–6, 334n91; bank runs and reverse runs 319–21; capital requirements and investment herding 322–3; failure to detect herding 326–7; financial institution herding and homogeneity 318–19; investment and Index 537 liquidity herding intertwined 321–2; investment herding, influence of financial regulation 322; legal preferences for financial instruments and trading liquidity 323–4; risks 318 Herring, Richard 168, 221 heuristics 39, 46, 166, 209, 479, 496 historical cost accounting 316, 317 hyperbolic discounting 167, 208 ideological and normative model of regulation 172–7; evaluation of and integration with other models 177–8; liberalism 173–6; norms and the purchase of regulatory stimulus 176–7; use in explaining post WWII financial stability 178–9 inflation 20, 45, 283, 365, 370, 371, 430 information: asymmetries 152, 156–7, 202, 245; cascades 43, 226n35; costs 202, 206, 220, 242 initial public offering (IPO) carve out 42 insider trading 76, 78, 91, 94 Insull, Samuel 85, 86 intellectual capital 498–500 intellectual property rights 245 interest rates 21, 45, 351, 369, 371, 372, 430 International Monetary Fund (IMF) 441 international trade law 509 internet-name anomalies 42, 54n80 investment: anchoring 40; availability bias 39; belief perseverance 40; collective investment 13; framing 40; investment structuring 11, 237, 238, 243–6, 249, 286, 492; investment switching 11, 236–7, 238, 241–3, 249, 286, 492; investor sentiment 42; linkages 300; overconfidence 39; overoptimism 39; risk and uncertainty 36; see also herdpromoting regulations Investment Advisers Act 1940 (US) 91 investment banks 414–15, 424n109 Investment Company Act 1940 (US) 91, 342 investors 208–9; classes and backgrounds 211–12; education 350–1; newcomers 210–11; tiering 342–3, 352; women 211, 212 irrational decision-making 5, 10, 34, 41 issue attention cycle 166 Japan: bank deregulation 238, 248; crony capitalism 217; deregulation and regulatory arbitrage spirals 277, 289–93; deregulation of bond markets and securities 160; economic shocks 146–7; feedback loops 130n311; jusen 93, 157, 289–90, 293; neoliberalism 176; real estate bubble 93–4, 140, 159, 289–93, 319; revolving door theory of regulator behavior 157; tokkin accounts 238–9; warrant bonds 239; zaitech 238–9 Jews 165 joint-stock companies: Austria 83; Britain 73, 74–5, 76, 77, 102, 173; Germany 81 Joint Stock Companies Act 1844 (UK) 75, 173 Joint Stock Companies Act 1856 (UK) 76 Jones, David 256 jusen (Japanese financial institution) 93, 157, 289–90, 293 Kane, Edward 253 Kashyap, Anil 314 Kelly, Claire 149, 484 Keynes, John Maynard 171 Keynesianism 19 Kindleberger, Charles 5, 35, 196, 200, 486 Kiyotaki-Moore model 384, 446 Knight, Frank 36 Knott, Michael 237 Kostal, Rande 211, 217 Krawiec, Kim 220 Krozner, Randall 341 Krugman, Paul 372 Law and Society movement 9, 66 Law, John 69–70, 71, 140 legal profession 217–18; decline of general partnerships and lockstep compensation 246; lateral mobility 246; opinion shopping 246; role in regulatory arbitrage 246–7 Legal Realism movement 9, 66 legislation: Banking Act 1935 (US) 92; Britain, nineteenth century corporate law and crises 110–11; Bubble Act 1720 (UK) 72, 73, 117n55, 140, 165, 172, 222; Commodity Futures Modernization Act 2000 (US) 298, 434; Companies Act 1862 (UK) 77; Depository Institutions Deregulation and Monetary Control Act 1980 (US) 430; DoddFrank Act 2010 (US) 6, 27n32, 27n34, 243, 378, 478, 489, 490, 491–2, 503, 514; Emergency Economic Stability Act 2008 (US) 455; Energy Power Act 1992 538 Index legislation: Banking Act 1935 continued (US) 96; Federal Credit Union Act 1934 (US) 92; Federal Reserve Act 1913 (US) 87, 127n260; Federal Reserve Act 1917 (US) 88, 127n260, 435–6, 455; GlassSteagall Act 1933 (US) 92, 98, 147–8, 165, 169, 221–2, 297, 433, 435, 439, 502; Investment Advisers Act 1940 (US) 91; Investment Company Act 1940 (US) 91, 342; Joint Stock Companies Act 1844 (UK) 75, 173; Joint Stock Companies Act 1856 (UK) 76; Limited Liability Act 1855 (UK) 76; McFadden Act 1927 (US) 87; National Housing Act 1934 (US) 92; Private Securities Litigation Reform Act 1995 (US) 97, 198; Public Utility Holding Company Act 1935 (US) 86, 92, 96; Resumption of Specie Act 1875 (US) 79; Sarbanes Oxley Act (US) 98–9; Secondary Mortgage Market Enhancement Act 1984 (US) 432–3; Securities Act 1933 (US) 91, 165, 166; Securities Exchange Act 1934 (US) 91, 166, 205, 379; Securities Litigation Uniform Standards Act 1998 (US) 97, 198; Sir John Barnard’s Act 1734 (UK) 72; Trust Indenture Act 1939 (US) 91 Lehman Brothers 17, 438–9, 441–2 leverage 5–6, 26n23, 45–6, 85, 253; balance sheet leverage 410; collective changes and information problems 384; credit derivatives 375–6; cycles 383–4, 446–7; economic leverage 410, 411; embedded leverage 410, 411; expansion through increased financial institution leverage 366; increased leverage 11–12, 17, 219, 325; Minsky’s theories 44; shadow banking 445–7; US primary dealers 446–7, 448 Levitt, Arthur 98 liberalism 173–6 Limited Liability Act 1855 (UK) 76 limited liability companies 77, 102, 245 liquidity 13, 14, 26n24, 257–8, 264–5n35, 318, 386n8; herding 319–22; legal preferences 323–4; transformation 399–400 Livermore, Michael 504–5 loan loss reserves 12, 314, 374 lockstep compensation 246 loss spirals 320 M3 451, 451 Macey, Jonathan 165 macroprudential regulation 312–13, 327 Mahoney, Paul 165 Manias, Panics and Crashes (Kindleberger) 196 margin/haircut spirals 320–1 margin rules 377, 379, 380–1 mark-to-market accounting rules 316–17 Marx, Karl 77 materiality 208–9 maturity transformation 325, 399–400, 414 McDonnell, Brett 507 McFadden Act 1927 (US) 87 memento mori devices 513–15, 516 Metrick, Andrew 324, 409, 431, 453 Milhaupt, Curtis 93 Miller, Geoffrey 93 Miller, Merton 237 Miller-Modigliani theorem 252, 380 Minsky, Hyman 5, 24n1, 34, 44, 486 Mississippi bubble 67, 69–71, 100, 140, 174, 482 Missouri Constitution 1875 79–80 monetary payoffs 344 monetary policy 20–1, 45, 46, 65, 77, 369–70, 451; bank reserve requirements 369, 374; as a cause of bubbles 367–8; central bank loans to private sector banks 369–70, 370, 372–3; expansion through creation of money-like instruments 366; expansion through increased financial institution leverage 366; financial regulations as substitutes for monetary policy 373; ‘Greenspan Put’ 372; ‘leaning into the wind’ policy 371–2; money supply and regulatory preferences 381–2; open market operations 368–9; prudential regulations as instruments of monetary policy 382; spillover effects of 371, 373; use of monetary policy to address bubbles 370–3; using regulation as monetary tools, advantages and disadvantages 380–1 money creation 381–2, 400, 414, 431, 445–6, 446 money illusion 45 money market mutual funds 408, 413, 430–1, 453 moral hazard 151, 252–3, 280, 281, 326, 372, 457, 459 moralism 474, 516 Morley, John 165 mortgages: building and loan associations 89, 90; deceptions 442–3; mortgagebacked securities 89–90, 147–8, 415, Index 539 432–3, 442–3, 483; norm asymmetries 212; regulation 92; shadow banking 17; subprime mortgages 6, 17, 213, 293–7, 297, 415, 441, 453; US real estate bubble Murphy, Antoin 70–1 Nagel, Stefan 169 National Housing Act 1934 (US) 92 neoliberalism 175–6 New Deal 165, 166; regulatory backlash 91–2 noise traders 39–40, 40–1, 42, 205–6, 341, 342, 352 North American Free Trade Agreement 509 Office of Comptroller of the Currency (OCC) 87, 88, 161, 163–4, 183n39, 189n103, 219, 433–4 Office of Financial Research (US) 499 Olson, Mancur 166, 180n1 Omarova, Saule 163–4, 191n110, 433, 435–6 opacity 243, 250, 317, 400, 403, 452 opinion shopping 246 overconfidence 39, 52n46, 167, 200, 221 Overend, Gurney Crisis 1866 77 overoptimism 39, 52n46, 167, 200, 208, 221 Panic of 1825 72–4, 101, 173, 297 Panic of 1847 76 Panic of 1873, Germany and Austria 80–4, 165, 173–4 Panic of 2007–2008 1, 3–4, 6–7, 171, 201, 212, 385; causes of 398; displacement 297–8; regulatory capital arbitrage, effects of 259–60, 315; shadow banking 16–18, 427–9 Panics of 1869 and 1873 77–80, 102–3 Pierce, Richard 96 political campaign expenditure 154–6, 154, 155, 156 political economy 139 ponzi finance 44, 73, 204 pooling 399, 400, 404, 407, 414 pricing anomalies 41–2 Pritchard, Adam 167 Private Securities Litigation Reform Act 1995 (US) 97, 198 process switching 45 procyclical regulations 3, 12, 17, 19, 311, 312, 313–18, 491; bankruptcy fire sales 315–16; capital buffers 317–18; capital requirements 314–15; mark-to-market accounting rules 316–17 prophylactic rules 150, 169, 505 prudential regulations 218–22, 248, 381; macroprudential regulation 312–13, 487; monetary effects 382 public choice theory 10, 145–6, 150, 165, 170 Public Private Investment Program for Legacy Assets 455 Public Utility Holding Company Act 1935 (US) 86, 92, 96 railways 75–6, 140, 146; Austria 82; Britain 74–6, 101, 211, 217; United States (US) 78 rational actor/public choice model of regulation 142, 143; administrative law structure 149; altering the cost-benefit analysis of regulators 152–3; blame hedging 164–5; bribes 153–4; causal complexity and collective action 159; consumers and retail investors 148; corporate form and the political marketplace 147; cost of opposing regulatory stimulus 158; demand for deregulation and regulatory stimulus 145; diluted enforcement of financial regulations 160–2, 161; discounting risk of being blamed for a crisis 158–9; discounting the costs of a bubble 150–1; evaluation of and integration with other models 177–8; explanation 144; financial booms 150; financial industry consolidation and liberalization 147–8; financial institution regulation 148–9; incremental approaches to deregulation 163–4; information asymmetries 152, 156–7; interest group purchasing power 153–6; political campaign expenditure, connection with bubbles 154–6, 154, 155, 156; precedent and public choice 163; prophylactic rules and cost-benefit analysis 150; public choice theory 165; public choice theory, role of 145–6, 150; regulatory arbitrage and deregulation 159–66; regulatory backlash 165–6; regulatory capture 157–8; revolving door theory of regulator behavior 157; shocks and the interest group equilibrium 146–7; tradeoff between depth and breadth of regulatory change 162; use in explaining post WWII financial stability 178–9 540 Index rationality: decision making 5, 10, 19, 34; herding 43; rational bubbles 42–3; rational calculus 219–20 real estate bubbles 3–4, 46–7, 82; Japan 93–4, 140, 159, 289–93, 319; relationship to banking crises 483–4, 519–20n59; Sweden 287–9; United States (US) 84–92 Regulation Q 430 regulatory arbitrage 3, 11–12, 19; crossborder regulatory arbitrage 301; destabilizing regulatory arbitrage 278, 280; financing costs 245–6; hydraulics of investor demand 240–7; inconsistency 263n4; information asymmetries and agency costs 245; investment linkages 300; investment structuring 11, 237, 238, 243–6, 249, 286, 492; investment switching 11, 236–7, 238, 241–3, 249, 286, 492; Japan’s spiral of deregulation and regulatory arbitrage 289–93; legal implications 248–50; legal profession, role of 218; legal risk 243–4; model explaining deregulation/regulatory arbitrage spirals 278–87; and networked regulations 492–3; Panic of 1825 72–4; political implications 247–8; professional norms 246–7; regulatory capital arbitrage 11–12, 249, 251–60; regulatory distortion and displacement 298–9; regulatory work-arounds 237; role in encouraging deregulation 159–66; similarities with financial arbitrage 237; Swedish spiral of deregulation and regulatory arbitrage 287–9; third party and internal structuring costs 244–5; tokkin accounts, Japan 238–9; as a trigger for deregulation 276; US subprime mortgage securitization crisis 293–7, 297; warrant bonds 239 regulatory backlash 6–8, 64–6, 94; blaming social minorities 165; collective action problems 165–6; competition, restriction of 165; English stock market boom 1690s 69; French Mississippi bubble 70–1; Japan 94; Panic of 1847 76; Panic of 1873, Germany and Austria 83–4; Panics of 1869 and 1873 79–80; predicting regulatory backlash 171–2; rational actor/public choice model of regulation 165–6; securities 98–9; South Seas bubble 72; stock market and real estate booms of the 1920s 91–2; summary table 100–6 regulatory capital arbitrage 11–12, 249, 260; aims of case study 251; Basel Accords 253–4, 256, 258–9, 261, 270–1n138, 315; capital requirements as regulatory tax 251–2; cheap debt 252–3, 260–1; compound arbitrage 259; credit risk concentration 256–7; effect on Panic of 2007–2008 259–60, 427; indirect credit enhancements and creative guarantees 257–8; moving assets from banking book to trading book 258; operational aspects 254–6; remote origination 257; shadow banking 436, 441; third party guarantees 258 regulatory cartels 93, 147 regulatory cycle, 1920s -1990s and beyond 112–13 Regulatory Instability Hypothesis 34, 44, 459, 475, 486; compliance rot 2, 10–11; consequences of regulatory instability 14–15; fundamental value 20–2; herdpromoting regulations 3, 13; procyclical regulations 3, 12; regulatory arbitrage 3, 11–12; regulatory stimulus cycle 2, 8–10; and shadow banking 452 regulatory stimulus 2–3, 8–10, 64–5, 139; behavioral explanations 166; as a cause of bubbles 139–41; compliance rot 2, 10–11, 19, 220; consequences of regulatory instability 14–15; cost of opposing 158; definition 8–9; demand for 145; differences between the regulated and regulators 141–2; English stock market boom 1690s 68; French Mississippi bubble 69–70; and fundamental value 20–2, 25n13; government investment in financial institutions 482–3; herd-promoting regulations 3, 13, 19; and ideological shifts 173–6; interest groups and behavioral biases 170; norms and the purchase of regulatory stimulus 176–7; Panic of 1825 73; Panic of 1873, Germany and Austria 81–2; procyclical regulations 3, 12, 17, 19; regulatory arbitrage frenzies 3, 11–12, 19, 72–4; regulatory stimulus cycle 2, 8–10, 139, 140; shadow banking system 429–30; South Seas bubble 71–2; stock market and real estate booms of the 1920s 84–5; summary table 100–6; supply of 151–2 Index 541 Reinhart, Carmen 383 rent-seeking behavior 217–18 repurchase agreements (repos) 323–4, 367, 374–5, 409, 413, 431, 453 reputation 153, 198, 203, 204, 205–6, 218, 246, 258 Resumption of Specie Act 1875 (US) 79 Revesz, Richard 504–5 Ribstein, Larry 246 Ricks, Morgan 382, 448 risk 170–1; credit risk 253–4, 256–7, 264n34, 378, 407, 408, 410, 416, 418; disclosure of risk models 512; effects of regulatory arbitrage 250; and fraud 202; fundamental risk 40; legal risk in investment structuring 243–4; liquidity risk 402; masking risk 384; noise trader risk 40; proprietary risk models 315; rates of return adjustment 241; solvency risk 402–3; spreading 405; systemic risk 14, 148–9, 150, 241, 248–9, 252–3, 269n107, 280, 313, 326, 329n17; and uncertainty 36 Roe, Mark 431 Rogoff, Kenneth 383 rogue traders 220 Romano, Roberta 323 Roosevelt, Franklin 91 Rowe, Frederick 85 Ruhl, J.B 261–2 sample size neglect 168 Sarbanes Oxley Act (US) 98–9 Schiller, Robert 199 Schwarcz, Daniel 507 Secondary Mortgage Market Enhancement Act 1984 (US) 432–3 securities 86–8; asset-backed securities 16, 202, 256–7, 377–9, 378; deregulation 97–8; gatekeepers 197–8; mortgagebacked securities 89–90, 147–8; regulation 91–2; securities law 342; trust in markets 201; trust preferred securities 255 Securities Act 1933 (US) 91, 165, 166 Securities and Exchange Commission (US) 91, 92, 150, 160–2, 161, 189–90n105; behavioral biases 167; Consolidated Supervised Entity Program 440, 511; and Goldman Sachs 212–13, 259, 414–15; repeal of uptick test 343, 358n36 Securities Exchange Act 1934 (US) 91, 166, 205, 379 Securities Litigation Uniform Standards Act 1998 (US) 97, 198 securitization 16, 255–6, 260; bank participation 432–3; shadow banking 403–5, 404; US subprime mortgage securitization crisis 293–7, 297 shadow banking 16–18, 260, 321, 367, 488; accounting for derivatives 434–5; asset-backed commercial paper (ABCP) 406–7, 412, 422n70, 441; asset-backed securities 404–5, 413; bailouts 454; balance sheet leverage 410; bank participation in derivatives markets 433–4; bank participation in securitization 432–3; bank runs 453–4; banks and regulated entities 416; CDO deceptions 443; comparison with depository banking 400–2; compliance rot 443–4; credit derivatives 407–8, 407, 408, 410, 411, 412, 431, 434–5; credit intermediation 399, 407; credit provision 410, 414; credit provision and risk transfer 416, 418, 447; credit transformation 400, 405, 414; economic features of shadow banking instruments 411–14, 412–13; economic leverage 410, 411; embedded leverage 410; features of shadow banking 399–400; Federal Reserve interventions 455–7, 456, 458; financial conglomerates 416, 430, 435, 439, 440; future priorities for regulation 459–60; governmentsponsored entities (GSEs) 415, 431–2; growth and development 397–8, 418, 427–8, 439–41; hedge funds 415; intermediation 414; investment banks 414–15, 424n109; legal origins and regulatory stimulus 429–30; less regulated entities 415–16; leverage 445–7; maturity transformation 399–400, 414; money creation 400, 414, 431, 445–6, 446; money instruments 447–50, 449; money market mutual funds 408, 413, 430–1, 453; mortgage deceptions 442–3; opacity 400; pooling 399, 404, 407, 414; regulatory capital arbitrage 436, 441; and the Regulatory Instability Hypothesis 452; repurchase agreements (repos) 409, 413, 431, 453; risks 402–3; securitization 16–17, 403–5, 404; shadow banking instruments form a web 416–17, 417; structuring 399, 405, 407, 414; timing of transactions 438–9; as a transmission 542 Index shadow banking continued belt for monetary policy 450–2, 450, 451; Treasury Department support for non-depository institutions 454–5; US primary dealers, main leverage 446–7, 448; valuing of residual interests 438; variable interest entities 437–8 shareholder capital 147 shareholder wealth maximization 215, 218 shell companies 500–1 Shin, Hyun Song 45, 375, 383–4, 446–7, 448, 449 short sales 354, 364n147 Sir John Barnard’s Act 1734 (UK) 72 Sissoko, Carolyn 504 smart money 41, 170, 219, 352 Smith, Adam 73 Smith, Vernon 345 Sobel, Robert 79 social minorities 165 social norms 209–10; compliance rot 221–2; norm asymmetries 212–13; reciprocity 210–11, 212; sell side norms 213–15 social security 485–6 South Seas bubble 71–2, 100, 174, 186–7n67, 210, 211, 482 Spain 491, 492, 524n92 speculative finance 44 spirals of deregulation and regulatory arbitrage: collapse of asset prices 286–7; cross-border regulatory arbitrage 301; deregulation/regulatory arbitrage/ deregulation feedback mechanism 282–3; elements of model 280–1; exogenous shock, effects of 281; financial institution categories 280–1; increased lending 286; Japan 289–93; regulatory arbitrage/deregulation/ regulatory arbitrage feedback mechanisms 283–4; regulatory distortion and displacement 298–9; subsidy games 284–6, 299–300; Sweden 287–9; US subprime mortgage securitization crisis 293–7, 297 Stein, Jeremy 314 stickiness 46–7 stock manipulation schemes 94 stock market and real estate booms of the 1920s 84–92, 104; antitrust law enforcement and rise of utility holding companies 85–6; banking law changes and real estate lending and securities activities 86–8; building and loan associations 89; legal responses to 91–2; margin loans and manipulation of the stock market 90–1; mortgage-backed securities 89–90; regulatory stimulus 84–5 stock markets 43, 68–9; 1920s stock market and real estate boom 84–92, 104; Austria 82; English stock market boom 1690s 68–9, 100; Germany 82; price to earnings ratios 199–200, 199; regulation 83; South Seas bubble 71–2 Stone, Oliver 214 Stout, Lynn 201 structuring 399, 405, 407, 414 subprime mortgages 6, 17, 213, 293–7, 297, 415, 441, 453 subsidies 8, 64, 141, 277–8; implicit guarantees 299–300; market distortions and displacement 285–6, 298–9; regulatory subsidies 280, 284; transfers and leakage 284–5 sunset provisions 501–2 Sweden 63; bank deregulation 159–60, 247–8; deregulation and regulatory arbitrage spirals 277, 287–9; investment switching 238 Swift, Jonathan 200 systemic risk 14, 148–9, 150, 241, 248–9, 252–3, 269n107, 280, 313, 326, 329n17 taxation 66, 342, 343, 353 Teapot Dome scandal 84, 175 technology stock bubble 1990s 94–5, 98, 106, 197–200 telecommunications deregulation 95, 140–1 Texas Constitution 1876 80 Thiessen, Jan 83 This Time is Different (Reinhart and Rogoff) 383 Thompson, Robert 481 tiering 342–3, 352 Tiger Fund 41 Tirole, Jean 325 tokkin accounts (Japan) 238–9 trading liquidity 320, 323–4 transparency 476, 505, 509–10, 512 Treasury Department (US) 454–5 Troubled-Asset-Relief Program (TARP) 455 Truman, David 166 trust 201 Trust Indenture Act 1939 (US) 91 trust preferred securities 1, 255 Index 543 Tung, Fred 497 twin-share anomalies 42 Tyler, Tom 196–7, 215 uncertainty 36 United States (US): administrative law 149–50; asset statistics 450; bank regulation 86–9; conglomerate stock boom 1960s 105, 129–30n305; corruption 78; energy deregulation 96–7; federal margin regulations 379; Grange movement 166, 175; legal profession 246–7; Panics of 1869 and 1873 77–80, 102–3; political campaign expenditure 154–6, 154, 155, 156; political liberalism of 1920s 175; real estate bubble 3, 17; repurchase agreements market 409; securities deregulation 97–8; stock market and real estate booms of the 1920s 84–92, 104; subprime mortgage securitization crisis 293–7, 297; technology stock bubble 1990s 94–5, 98, 106; telecommunications deregulation 95, 140–1 uptick test 343, 358n36 utility holding companies 85–6, 92, 126–7n239 variable interest entities 437–8 Volcker Rule 476 Wachter, Susan 221 Wall Street (film) 214 warrant bonds 239, 291 watchdogs 505–7 White, Brent 212 White, Eugene 88, 161 Williams, Geoffrey 76 Wilmarth, Arthur 86, 87, 435, 439 Wolfe, Tom 214 women 211, 212 Woo, Sarah 315–16, 489 World Trade Organization 509 WorldCom scandal 95, 96 young people 213–14 zaitech 238–9 Zaring, David 455 Zingales, Luigi 483 ... Piga and Steen Treumer 17 Economics and Regulation in China Edited by Michael Faure and Guangdong Xu 18 Law, Bubbles, and Financial Regulation Erik F Gerding This page intentionally left blank Law,. . .Law, Bubbles, and Financial Regulation Financial regulation can fail when it is needed the most The dynamics of asset price bubbles weaken financial regulation just as financial markets... to bubbles and financial crises Legal thought can help policymakers and the public understand how regulation, deregulation, and legal change more generally can take different forms and be measured