A New Philosophy for Financial Stability Regulation

The financial crisis of 2007–2008 revealed many inadequacies in the pre-crisis approach to financial stability regulation. In the United States, Congress responded by enacting the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Act calls for government agencies to make numerous rules regulating activities that have the potential to harm financial stability, but there has been no real effort to rethink how these rules should be assessed. The cost-benefit analysis standard used to evaluate financial stability regulation prior to the crisis persists today, and both the courts and Congress have sought to further entrench that standard. However, cost-benefit analysis gives too much primacy to the short-term interests of the financial industry and too little to financial stability. This Article therefore rejects strict cost-benefit analysis and develops a substitute precautionary standard for assessing financial stability regulation, drawing analogies from the literature on the use of the precautionary principle in regulating complex environmental systems. A precautionary approach is more responsive than strict 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 profitability of the financial sector. This Article also considers a practical framework for precautionary review of innovative financial products as a concrete illustration of how the precautionary approach 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, collective action problems, and remediating limits on regulatory funding and expertise