Unpublished Papers

A New Philosophy For Financial Stability Regulation

Hilary J. Allen, Loyola University New Orleans College of Law

Abstract

The financial crisis of 2007-2008 showed up many inadequacies in the pre-crisis approach to financial stability regulation. The response from legislators and regulators has been to implement a broad new range of regulatory tools – individual solutions to individual regulatory failings highlighted by the crisis. But the prevailing cost-benefit philosophy that informed financial stability regulation in the United States prior to the crisis persists today - there has been no real effort to rethink the overarching philosophy behind financial stability regulation. Because a cost-benefit approach gives too much primacy to the short-term interests of the financial industry, this Article rejects cost-benefit analysis and develops a substitute precautionary philosophy for financial stability regulation, drawing analogies from the literature on the use of the precautionary principle in regulating complex environmental systems. A precautionary philosophy is more responsive than cost-benefit analysis to the complexity and fragility of the financial system, directing financial regulators to err on the side of caution and to prioritize the stability of the financial system over the short-term interests of the financial sector.

While this Article is primarily intended to advocate a change in the philosophy that underpins financial stability regulation (and thus provide a cogent theoretical framework for regulators implementing Dodd-Frank and future reforms), this Article also explores a more practical framework for precautionary review of innovative financial products. This operates as a concrete illustration of how the precautionary philosophy might be operationalized: the key practical implication of such an approach is that it will shift the regulatory burden to the financial industry to demonstrate why regulation of a new product is unnecessary. As this Article demonstrates, this burden-shifting entails many benefits, including mitigating issues of regulatory capture and collective action problems, and remediating limits on regulatory funding and expertise.

Suggested Citation

Hilary J. Allen. 2012. "A New Philosophy For Financial Stability Regulation" ExpressO
Available at: http://works.bepress.com/hilary_allen/1

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