Since the financial crisis began, former SEC chairman Christopher Cox has had a target on his back. Many hold him accountable for not cracking down on financial institutions to prevent the industry's near collapse. So when he appeared before the Financial Crisis Inquiry Commission (FCIC), you might have thought there would be fireworks. You'd be wrong. There weren't even many interesting exchanges between him and the commissioners; there were still fewer revelations. But there was one good question he was asked: should we be concerned that some firms are not just too big to fail, but too big to regulate?
The inquiry came from commissioner and former Commodity Futures Trading Commission Chair Brooksley Born. Cox loved the question and said more people should be asking it. So let's give it a little thought.
First, the question is actually misstated. Size alone isn't a significant barrier to regulation. If you have a simple bank that deals in deposits and lending, then whether it has $50 million or $50 billion in assets doesn't much matter. You can craft rules that easily govern its business, though you likely need to put more examination hours into the larger institution.
Instead the question should be rephrased: are some firms too complex to regulate? That was the problem that the financial crisis poses which Cox actually addressed in his response. He asserted that as the market rapidly evolves, regulation cannot remain a step behind. Firms develop new products, innovative ways for facilitating transactions, quick shifts in strategy to respond to market shocks, etc. One-size-fits-all regulation can't govern dynamic changes like these.
So how does regulation keep up with a quickly evolving market? It probably doesn't, or at least it doesn't without somehow harming the economy. For example, higher capital requirements will help to cushion unexpected losses. But the higher the capital required, the lower a firm's return on capital. A new rule could force all new financial products to be approved before sold to investors, but that would slow down the market and might jeopardize economic efficiency, since supply couldn't quickly meet demand. You could forbid some institutions from dealing in some kinds of securities to reduce interconnectedness, but that would hurt liquidity.
Regulation necessarily causes some harm to the market. But as history has shown, no regulation results in a market that is susceptible to complete failure. That's why regulators must carefully choose new rules that minimize the cost to the economy, while enhancing stability. Generally, the best way to accomplish that end is through new regulation that helps the market to function better. One way is better disclosure, so investors can have additional information to make more fully rational decisions about the securities they buy. Enhanced disclosure also allows regulators to better under the institutions they oversee.
The "too complex to fail" problem is a real challenge for regulators. Frankly, they can't expect to be able to always keep up with the market, so mechanisms need to be put in place that allow prudent financial industry participants to help bring dangerous new paradigms to light, before a cancer grows that threatens the entire economy.
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