Regulating Ex Post: How Law Can Address the Inevitability of Financial Failure

Unlike many other areas of regulation, financial regulation operates in the context of a complex interdependent system. The interconnections among firms, markets, and legal rules have implications for financial regulatory policy, especially the choice between ex ante regulation aimed at preventing financial failure and ex post regulation aimed at responding to that failure. Regulatory theory has paid relatively little attention to this distinction. Were regulation to consist solely of duty-imposing norms, such neglect might be defensible. In the context of a system, however, regulation can also take the form of interventions aimed at mitigating the potentially systemic consequences of a financial failure. We show that this dual role of financial regulation implies that ex ante regulation and ex post regulation should be balanced in setting financial regulatory policy, and we offer guidelines for achieving that balance.I. IntroductionThe financial system can be viewed as a complex network in which financial firms interact directly and indirectly (through markets) against the background of legal rules. Like any system, the financial system's behavior depends on its structure-the relationships among its elements. A key feature of the financial system's structure is that it possesses the characteristics of a high-risk system. High-risk systems are accident-prone. They tend to experience long periods of stability and occasional, catastrophic failures.This Article analyzes the implications of systems analysis for reducing financial systemic risk,1 a serious challenge for financial regulators. We begin in Part II by considering the nature of systems and the usefulness of systems analysis as a methodology for studying law. Law-related systems are systems in which the law is an integral element. In the financial system, as in any other law-related system, law can intervene at various junctures. In particular, it can operate ex ante, to prevent a financial failure from occurring, or ex post, to mitigate a financial crisis that has already been set in motion.We develop our distinction between ex ante and ex post regulation in Part III. While this distinction is frequently made in legal scholarship, it has distinct implications in the context of a law-related system in general and the financial system specifically. Ex ante versus ex post debates have traditionally been associated with the question whether the law should be given content before or after harmful conduct has occurred. This question-whether deterrence is best served by "bright-line rules" or "flexible standards"-is meaningful when deterrence is the law's primary aim. In a law-related system, however, regulation can operate not only to prevent harmful conduct, but also to mitigate the harmful consequences that flow from that conduct. As a result, law has a role to play even after harmful conduct has taken place.After developing our distinction between ex ante and ex post regulation in the financial system, we consider the limits of ex ante financial regulation. We argue that, while relying exclusively on ex ante regulation might at first appear to be a desirable policy objective, it will always have to be supplemented by ex post regulation. Ex ante regulation cannot prevent all financial crises. Furthermore, it is unrealistic to believe that complete ex ante regulation could survive the political opposition of the financial services industry. Finally, tight financial regulation will always confront the problems of chilling efficient risk taking and inducing regulatory arbitrage.In subpart IV(A), based on our study of the financial system's features, we offer two types of ex post regulatory strategies for mitigating systemic risk. The first, creating financial safety nets, operates on the elements of the financial system. Financial safety nets are designed to absorb losses of a financial firm or market that has begun failing. The second, disrupting the transmission of systemic risk, operates on the financial system's interconnections. …