{"id":6431,"date":"2009-08-02T20:53:54","date_gmt":"2009-08-03T01:53:54","guid":{"rendered":"http:\/\/law.marquette.edu\/facultyblog\/?p=6431"},"modified":"2009-08-02T20:53:54","modified_gmt":"2009-08-03T01:53:54","slug":"regulation-and-the-second-law-of-thermodynamics","status":"publish","type":"post","link":"https:\/\/law.marquette.edu\/facultyblog\/2009\/08\/regulation-and-the-second-law-of-thermodynamics\/","title":{"rendered":"Regulation and the Second Law of Thermodynamics"},"content":{"rendered":"

\"stephen_hawking\"At first blush, one would not think that Barney Frank and Stephen Hawking would have anything in common.\u00a0 The first is the Chairman of the House Financial Services Committee, and is currently conducting hearings on the regulatory reform of the financial markets.\u00a0 The second is the noted University of Cambridge professor of theoretical physics and the author of the best selling book A Brief History of Time<\/em>.<\/p>\n

\u00a0However, in my mind both men are associated with the Second Law of Thermodynamics.\u00a0 This law of physics states that the entropy of an isolated system always increases over time.\u00a0 Stephen Hawking described it\u00a0in more comprehensible terms in A Brief History of Time<\/em>:<\/p>\n

It is a common experience that disorder will increase if things are left to themselves.\u00a0 . . .\u00a0 In any closed system disorder, or entropy, always increases with time.<\/p><\/blockquote>\n

\u00a0Therefore, when I think of\u00a0Hawking, I think of someone who can explain the Second Law of Thermodynamics.\u00a0 When I think of\u00a0Barney Frank, I think of someone who is desperately trying to avoid its operation.<\/p>\n

I would contend that all forms of market regulation follow the Second Law of Thermodynamics.\u00a0 In each case, a comprehensive statutory scheme is enacted as law, it imposes a closed system of rules on market actors, and over time the scheme inexorably breaks down.\u00a0 Federal securities regulation, which began with the Securities Act of 1933 and the Securities Exchange Act of 1934, provides the perfect case history of this principle in action.<\/p>\n

The federal securities laws were designed to force companies selling their securities to the public to make certain basic disclosures about their finances and business prospects to the potential purchasers of these securities.\u00a0 The policy goal was to even the playing field so that the buyers of the securities had at least some of the information that the sellers possessed, and the buyers could then make an informed purchase decision.\u00a0 Federal law therefore created a system of regulation to ensure that specific documents were prepared, and disclosed to the public, before securities transactions were allowed to take place.<\/p>\n

This regulatory scheme was imposed on the world as it existed in 1933.\u00a0 This was a world where the fastest form of communication for a written text was the United States mail.\u00a0 It was also a world where all information was compiled and stored in a document-centric format: if you sought a particular piece of information you had to search for it by reading through an entire book or a report.\u00a0 This was also a world where the types of securities sold to the public were comprised mostly of the vanilla variety of stocks and bonds that buyers (and sellers) knew and understood.<\/p>\n

\u00a0We live today in a very different world.\u00a0 Technology has changed.\u00a0 A written text can be sent anywhere in the world instantaneously via the internet.\u00a0 In addition, information is stored very differently in the digital age.\u00a0 We enter search terms into Google and Lexis, thereby allowing us to extract specific nuggets of information directly, without having to read through an entire book or document to find them.<\/p>\n

\u00a0The markets where securities are bought and sold have also changed dramatically.\u00a0 Virtually anything can be \u201csecuritized\u201d and turned into a product that can be traded over the market \u2013 from the right to receive future mortgage payments to the risk that the same mortgage holders will default on those payments.\u00a0\u00a0 Financial institutions were initially forced to confine their trading to a single line of business: whether securities trading, banking, or insurance.\u00a0 Over time, however, these rules were relaxed and firms became \u201cfinancial supermarkets\u201d that were allowed to take on multiple market risks at the same time.\u00a0 The same company can now take the simultaneous risk that the securities it underwrites will not sell, that the loans it makes will not be repaid, and that its cash flow will not be sufficient to meet its obligations to policyholders.\u00a0 A single company can survive one bad bet; it cannot survive losing all three.<\/p>\n

\u00a0These changes in information technology and market behavior all occurred at the same time that economists were radically changing their theories about the way that prices for securities are determined by the market.\u00a0 The SEC has long embraced the Efficient Capital Markets Hypothesis, which holds that the price of a financial asset reflects all available information that is relevant to its value.\u00a0 If this theory holds true, then it is proper for regulators to focus their attention on ensuring that companies quickly and accurately disclose new information relevant to their future prospects.\u00a0 However, behavioral economists have come to the conclusion that investors are often swayed by irrational factors unconnected to objective data about the company, such as an unjustified optimism that a past price rise will continue into the future (the \u201cbubble\u201d effect).\u00a0 New theories of evolutionary economics posit that investors adopt trading practices in a process of trial and error, keeping strategies that work and dropping strategies that cease to create profit.\u00a0 The implication is that investment decisions are neither purely rational nor purely irrational, and that the SEC\u2019s single-minded pursuit of information disclosure can never foreclose the possibility of future market bubbles and meltdowns.<\/p>\n

It has become plain that the original regulatory scheme of 1933 is beyond the point where minor patching will work anymore, and is probably beyond the point where even serious repair can rescue the original model.\u00a0 Entropy has overtaken federal securities regulation.\u00a0 Some might argue that this fact demonstrates that any attempt to regulate the financial markets is ultimately futile.\u00a0 However, I believe that our experience with securities regulation merely proves that every regulatory scheme has a natural lifespan.<\/p>\n

\u00a0Our current model for the regulation of financial markets has reached the end of its useful life.\u00a0 The world we live in has changed to such an extent that the original model\u00a0should be discarded and a new regulatory scheme\u00a0embraced.\u00a0 While it may not be feasible to replace all of our current market regulators, at a minimum those regulatory bodies should be consolidated and given a new mission.<\/p>\n

\u00a0If financial institutions are going to be allowed to operate in multiple market sectors, then the focus of our financial regulation should be on systemic risk (the risk that conditions across several different market sectors will lead large financial institutions to fail).\u00a0 In addition, the content of financial regulation should be determined less by the characteristics of the financial product being sold (securities for the SEC, commodities futures for the CFTC, loans for the Treasury Department and the Federal Reserve) and more on the financial stability of companies that sell financial products.\u00a0 This would entail the enforcement of minimum capital requirements and prohibitions on excessive leverage so that the managers of large financial institutions do not bet the company\u2019s very existence on risky trading strategies.\u00a0 Finally, the mission of our financial regulators needs to shift away from policing whether sellers have disclosed information and focus on\u00a0the needs of the public as the consumers of a product.\u00a0 Are buyers being given a variety of choices?\u00a0 Does the information being made available allow consumers to make meaningful comparisons between products?\u00a0 A new Consumer Financial Protection Agency could be created to undertake this last task.<\/p>\n

\u00a0What I have described are the very premises that underlie the Obama Administration\u2019s proposals to reform financial regulation.\u00a0 Barney Frank and the House Financial Services Committee have been holding hearings on these ideas.\u00a0 You can read more about the Administration\u2019s proposals in this report <\/a>from the Brookings Institution.\u00a0\u00a0I agree with the report\u2019s author that these measures are sensible and overdue.<\/p>\n

However, politics always gets in the way.\u00a0 Each existing financial regulator is jealously guarding its own turf, to ensure that a new system of market regulation does not diminish its authority.\u00a0 Powerful congressmen, who possess their power due to their seniority on the committees that oversee different segments of the market, do not want to see the old system of regulation abolished.\u00a0 And financial institutions that have learned how to operate around and between the interstices of multiple regulatory bodies do not want a comprehensive reform that eliminates or even blurs these lines of demarcation.<\/p>\n

As a result, any legislation enacting these reform proposals will probably be significantly watered down and the original 1933 model of securities regulation is likely to persist.\u00a0 According to the Second Law of Thermodynamics, leaving the original model of regulation to itself\u00a0will result in increasing disorder in the financial markets.\u00a0 Someone once said that \u201cyou can\u2019t fight the laws of physics.\u201d\u00a0 I think it was either\u00a0Stephen Hawking or Barney Frank.<\/p>\n","protected":false},"excerpt":{"rendered":"

At first blush, one would not think that Barney Frank and Stephen Hawking would have anything in common.\u00a0 The first is the Chairman of the House Financial Services Committee, and is currently conducting hearings on the regulatory reform of the financial markets.\u00a0 The second is the noted University of Cambridge professor of theoretical physics and […]<\/p>\n","protected":false},"author":16,"featured_media":0,"comment_status":"open","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"ocean_post_layout":"","ocean_both_sidebars_style":"","ocean_both_sidebars_content_width":0,"ocean_both_sidebars_sidebars_width":0,"ocean_sidebar":"","ocean_second_sidebar":"","ocean_disable_margins":"enable","ocean_add_body_class":"","ocean_shortcode_before_top_bar":"","ocean_shortcode_after_top_bar":"","ocean_shortcode_before_header":"","ocean_shortcode_after_header":"","ocean_has_shortcode":"","ocean_shortcode_after_title":"","ocean_shortcode_before_footer_widgets":"","ocean_shortcode_after_footer_widgets":"","ocean_shortcode_before_footer_bottom":"","ocean_shortcode_after_footer_bottom":"","ocean_display_top_bar":"default","ocean_display_header":"default","ocean_header_style":"","ocean_center_header_left_menu":"","ocean_custom_header_template":"","ocean_custom_logo":0,"ocean_custom_retina_logo":0,"ocean_custom_logo_max_width":0,"ocean_custom_logo_tablet_max_width":0,"ocean_custom_logo_mobile_max_width":0,"ocean_custom_logo_max_height":0,"ocean_custom_logo_tablet_max_height":0,"ocean_custom_logo_mobile_max_height":0,"ocean_header_custom_menu":"","ocean_menu_typo_font_family":"","ocean_menu_typo_font_subset":"","ocean_menu_typo_font_size":0,"ocean_menu_typo_font_size_tablet":0,"ocean_menu_typo_font_size_mobile":0,"ocean_menu_typo_font_size_unit":"px","ocean_menu_typo_font_weight":"","ocean_menu_typo_font_weight_tablet":"","ocean_menu_typo_font_weight_mobile":"","ocean_menu_typo_transform":"","ocean_menu_typo_transform_tablet":"","ocean_menu_typo_transform_mobile":"","ocean_menu_typo_line_height":0,"ocean_menu_typo_line_height_tablet":0,"ocean_menu_typo_line_height_mobile":0,"ocean_menu_typo_line_height_unit":"","ocean_menu_typo_spacing":0,"ocean_menu_typo_spacing_tablet":0,"ocean_menu_typo_spacing_mobile":0,"ocean_menu_typo_spacing_unit":"","ocean_menu_link_color":"","ocean_menu_link_color_hover":"","ocean_menu_link_color_active":"","ocean_menu_link_background":"","ocean_menu_link_hover_background":"","ocean_menu_link_active_background":"","ocean_menu_social_links_bg":"","ocean_menu_social_hover_links_bg":"","ocean_menu_social_links_color":"","ocean_menu_social_hover_links_color":"","ocean_disable_title":"default","ocean_disable_heading":"default","ocean_post_title":"","ocean_post_subheading":"","ocean_post_title_style":"","ocean_post_title_background_color":"","ocean_post_title_background":0,"ocean_post_title_bg_image_position":"","ocean_post_title_bg_image_attachment":"","ocean_post_title_bg_image_repeat":"","ocean_post_title_bg_image_size":"","ocean_post_title_height":0,"ocean_post_title_bg_overlay":0.5,"ocean_post_title_bg_overlay_color":"","ocean_disable_breadcrumbs":"default","ocean_breadcrumbs_color":"","ocean_breadcrumbs_separator_color":"","ocean_breadcrumbs_links_color":"","ocean_breadcrumbs_links_hover_color":"","ocean_display_footer_widgets":"default","ocean_display_footer_bottom":"default","ocean_custom_footer_template":"","ocean_post_oembed":"","ocean_post_self_hosted_media":"","ocean_post_video_embed":"","ocean_link_format":"","ocean_link_format_target":"self","ocean_quote_format":"","ocean_quote_format_link":"post","ocean_gallery_link_images":"on","ocean_gallery_id":[],"footnotes":""},"categories":[70,41],"tags":[],"class_list":["post-6431","post","type-post","status-publish","format-standard","hentry","category-business-regulation","category-business-transactional-law-and-practice","entry"],"_links":{"self":[{"href":"https:\/\/law.marquette.edu\/facultyblog\/wp-json\/wp\/v2\/posts\/6431","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/law.marquette.edu\/facultyblog\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/law.marquette.edu\/facultyblog\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/law.marquette.edu\/facultyblog\/wp-json\/wp\/v2\/users\/16"}],"replies":[{"embeddable":true,"href":"https:\/\/law.marquette.edu\/facultyblog\/wp-json\/wp\/v2\/comments?post=6431"}],"version-history":[{"count":0,"href":"https:\/\/law.marquette.edu\/facultyblog\/wp-json\/wp\/v2\/posts\/6431\/revisions"}],"wp:attachment":[{"href":"https:\/\/law.marquette.edu\/facultyblog\/wp-json\/wp\/v2\/media?parent=6431"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/law.marquette.edu\/facultyblog\/wp-json\/wp\/v2\/categories?post=6431"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/law.marquette.edu\/facultyblog\/wp-json\/wp\/v2\/tags?post=6431"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}