The enactment of financial legislation in the wake of a financial crisis exhibits a number of shortcomings. First, information is scarce regarding causes of the crisis, let alone what would be an appropriate response. Despite that difficulty, legislators feel compelled to legislate given media and public demands for governmental action. This suggests that it will be at best fortuitous if the legislative fixes are adequate to the task of mitigating future crises.
Second and compounding the lack of information, crisis-driven legislation is sticky: U.S. political institutions were deliberately designed to make enactment of legislation (including repeal of existing legislation) slow and effortful, through a system of checks and balances that imposes numerous veto-gates. Third, financial regulators are not predisposed to reevaluate rules, given well-known cognitive biases favoring the status quo and risk aversion. Reenforcing that proclivity, financial regulation’s technical nature tends to result in the public and legislature ceding regulatory matters to experts: the public loses interest as the salience of a crisis recedes, legislation has been enacted, and complex issues delegated to agencies for implementation.
These features of the post-crisis legislative process are particularly troublesome, given two key characteristics of financial institutions and the markets in which they operate. financial institutions and markets are subject to substantial uncertainty and are dynamically innovative, characteristics that can undermine the efficacy of regulation. Financial markets are subject to two forms of uncertainty – what former Bank of England Governor Mervyn King refers to as radical uncertainty – unknowable risks that institutions and regulators cannot be expected to anticipate and thereby cannot manage; and dynamic uncertainty that regulated financial institutions will respond to regulation so as to reduce their compliance costs in ways that regulators cannot predict. These forms of uncertainty, thus undermine regulation’s effectiveness.
In addition, innovation in financial products and the technology of finance has been an ever-present force for economic growth and prosperity since the dawn of civilization; the essence of finance—converting future value into present value— — was a prerequisite for the development of cities, as it provided a tool to arrange the adequate provision of food for an urban population from distant agricultural centers., But financial innovations that are beneficial over the course of time can also prove to be profoundly destabilizing. Overabundant enthusiasm and imprudent use can lead to asset bubbles that burst with devastating economic consequences. The dynamic innovation in financial technology, which on occasion may be a function of efforts to circumvent regulation, suggests that we can expect that among the future risks confounding financial regulation due to radical uncertainty there will be risks created by novel financial products. Moreover, financial innovations can render financial firms’ and regulators’ state-of-the-art knowledge regarding the management of risks rapidly obsolete. As a result, it is foreseeable that crisis-driven legislation and implementing regulations will contain at least some provisions that are inapt or inadequate or, more often, have consequences that are not well understood or even knowable.
In devising a legislative strategy to address the shortcomings of crisis-driven financial legislation, we can draw upon insights from evolutionary biology, where, homologous to the key problems besetting financial regulation, a central issue is the ability to adapt to changing environments. The interaction between financial innovation and regulation has antecedents in evolutionary theory. Whereas naïve views of the workings of evolution through natural selection hypothesize a notion of optimization, more sophisticated perspectives distinguish the process of adaptation from the attainment of multiple optima. Viral or bacterial evolution triggers responses on ecological and evolutionary time scales in host species, which in turn cause further evolution in the pathogen species. Just as the virus continually evolves to escape host immune responses, so too will regulated financial institutions continually evolve in response to regulation. If that regulation is not sufficiently adaptive, it is doomed to fail.
We advocate sunsetting crisis-driven financial legislation and its implementing regulations as a mechanism to mitigate the shortcomings of crisis-driven financial regulation and its implementing regulation. Sunsetting requires that after a fixed time span, legislation and its implementing regulation be reenacted to remain in force. It is a legislative strategy that has been used by Congress and state legislatures in the United States since the nation’s founding in a variety of circumstances, including in the financial regulatory context. For instance, the Commodity Futures Trading Commission (CFTC), established by Congress in 1974 as the regulator of derivative securities, is a sunset agency, in that it must be reauthorized on a periodic basis to continue as an agency, rather than simply being subject to the appropriations process as are other agencies.
Sunsetting is particularly well-suited to address the shortcomings of crisis-driven financial legislation. It sets into motion a process by which post-enactment information can be incorporated into regulation, thereby mitigating the disadvantages of devising policy solutions based on a paucity of information at the time of enactment, and lessening the stickiness of such solutions by altering the legislative status quo. Further, reevaluation at a later date fosters adaptation to new developments in financial technology and corollary risks that have emerged in the interim. But to be effective, the sunsetting process needs to be properly crafted. In our article, we make a number of recommendations for how the process should be structured to ensure that the outcome of a sunset review is neither a mere rubber stamp reenactment of a statute nor a statute’s termination by a legislative minority blocking reconsideration. We also contend that the dynamic innovation in financial markets implies that sunsetting needs to occur on a periodic basis, rather than as a one-time post-enactment event, consistent with Congress’s approach to the CFTC.
There are parallels in evolutionary biology to the sunsetting approach to crisis-driven financial legislation. In evolutionary biology, plasticity is the first response to a changing environment. Plasticity however has its limits, and there are costs to retaining the capacity for change. Thus natural selection found reproduction, a fresh start in which offspring replace parents, with genotypes modified from the parental types through mutation or various forms of recombination. Even in the development of a single organism, apoptosis, the death of cells, is a natural part of growth and development. Apoptosis and organism death are of course forms of sunsetting, allowing for new types to arise. Sunsetting does not mean that legislation must necessarily disappear – only that it must be reenacted: perhaps with modification, discarding (or reenacting) existing regulations, but revisiting them and improving them, much as can potentially be achieved via mutation and recombination in the evolutionary process.
In evolutionary modification, mutational changes would leave most of the genome alone, and selectively replace some; recombination would use existing segments, but recombine them in ways that will be selected if they produce higher fitness.
Sunsetting similarly looks first to modify and adapt outdated parts of statutes. When that fails, the existing legislation must give way to new legislation (or no legislation), possibly mutated or recombined forms of existing legislation. For example, the Gramm-Leach-Bliley Act of 1999 overturned a provision separating commercial and investment banking of the Banking Act of 1933 (known as Glass-Steagall). A policy consensus had emerged a number of years earlier that the 1933 statute’s restrictions were inefficient, leading to a less resilient banking system, and within the legislative strictures, regulators had permitted exceptions for a few institutions before Congress acted. Under a legislative process requiring sunsetting, the policy reversal might have been accelerated by moving the issue up on the legislative agenda and thereby overcoming the stickiness of the status quo. Such an outcome would have been socially beneficial.
There are of course major differences in how evolution works and how regulations are constructed. Fitness differences drive evolutionary processes myopically, with no long-term vision. In the case of legislation and implementing regulations, we have the potential to take the longer-term view, with clear objectives. Still, if short-term processes in evolution fail to produce longer term robustness, the result is likely to be extinction of the lineage; hence, much can be learned in the construction of regulations meant to provide robustness and resilience in financial systems from the mechanisms that achieve this in biological systems.
Roberta Romano is Sterling Professor of Law at Yale Law School and Director of the Yale Law School Center for the Study of Corporate Law.
Simon Levin is the James S. McDonnell Distinguished University Professor in Ecology and Evolutionary Biology at Princeton University and the Director of the Center for BioComplexity in the Princeton Environmental Institute.
This post is adapted from their article “Sunsetting as an Adaptive Strategy,”published in PNAS
