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Document Type

Article

Publication Date

Fall 2017

Publication Citation

92 Indiana Law Journal 1559 (2017)

Abstract

Bank regulation failed in the run up to the financial crisis of2008, as it has numerous times in the course of U.S. history. This is despite the existence of traditional prudential regulation, such as capital adequacy mandates, reserve requirements, and bank examination, as well as more common legal remedies, such as tort and contract litigation. Unsurprisingly, in the wake of these failures, many reforms have been proposed, and some adopted, to try to reduce bank risk taking. These reforms include limiting bank size, requiring bank managers to be paid differently, restricting investment in high-risk financial products, and, of course, tightening up existing prudential regulation.

In this Article, we first categorize these proposals into traditional categories of regulation-ex ante and ex post forms-and point out the weaknesses of each. Ex post regulation-generally, liability after the fact for harm caused-fails almost by construction: given externalities of systemic risk and leverage, judgment-proofness is virtually guaranteed and is uninsurable. Ex ante regulation-which comprises the bulk ofcurrent prudential relation-is, as a starting point, inefficient because it fails to take into account both private information and subsequent public information. More vexingly, ex ante regulation encourages worse behavior: size limits and transactions taxes encourage higher-octane bets, and asset restrictions lead to the recreation of the same risk profiles in less efficient ways.

We then describe an intermediate form, what we call the "regulatory veto, " which allows regulators to intervene to reduce bank risk taking after banks have started their activities, but before the losses have occurred We show how the regulatory veto is, potentially, an elegant solution to the information problem presented by ex ante regulation and the judgment-proofness problem of ex post regulation of bank activities. However, the regulatory veto is subject to a structural flaw: banks get to move first in a form of the ultimatum game and choose supra-optimal levels of bank activities, which are not quite bad enough to cause regulators to shut them down. To mitigate this flaw, we propose reforms to enhance regulators' ability to credibly commit and to reduce banks' ability to game the system

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