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The Regulator Effect in Financial Regulation, 98 Cornell Law Review 591 (2013)


This Article examines situations in which government regulation makes

mandatory the use of certain devices and institutions that have been generated

by markets and private ordering in the financial sector. I refer to the

process of taking devices and institutions created by market processes and

making their use mandatory “regulation by assimilation” because the process

involves the adoption and incorporation by the government of devices and

institutions developed by participants in the financial markets for different

(though often somewhat related) purposes. Devices and institutions that

have been developed internally by market participants and then assimilated

into regulation include the credit ratings generated by credit rating agencies

(which were designated by regulators as Nationally Recognized Statistical

Rating Organizations or NRSROs), the Value at Risk (VaR) models that

measure the risk of financial institutions’ portfolios, the advisory and fairness

opinions issued by investment banks in the context of significant corporate

transactions, and the audits of corporations’ financial results by

independent outside auditors.

This Article makes two contributions to our understanding of the regulation

of financial market participants. First, I show that the phenomenon

of regulation by assimilation is common, if not ubiquitous, in the financial

world. Second, I show that the process of regulation by assimilation has

negative consequences that have not previously been anticipated or even

identified. These negative consequences manifest themselves by ossifying, as

well as weakening, and even corrupting the efficacy of the private sector institutions

and techniques that have been assimilated. The analysis in this Article

indicates that the previously unidentified phenomenon of regulation by

assimilation was a major cause of the financial crisis of 2007 and 2008

because it distorted the ability of firms and markets to measure and assess the

riskiness of their activities.

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