Regulating Through Financial Firms as Surrogate Regulators: Rationale and Limitations

This article examines the rationale and limitations of employing financial firms to act as regulators, which is referred to as the financial surrogate regulatory approach. This approach is based on the highly regulated nature of financial services and the market’s demand for finance, allowing the state to achieve certain policy objectives or to enforce laws via financial firms. This article identifies limitations to the financial surrogate regulatory approach, including regulatory intensity, elasticity of market demand, and transaction costs associated with acquisition of information, monitoring and enforcement. These factors may undermine financial firms’ compliance with the state’s request to be surrogate regulators and their ability to influence customers’ conduct. This article examines abstractly three models of observed financial surrogate regulatory approach: private ordering, mandatory, and voluntary code models. Given the restraints of transaction costs, this article predicts that financial firms may be less inclined to comply with the state’s demand unless when their business interests happen to coincide those of the state. Even with mandated compliance, financial firms may not fully implement the requirements beyond the extent of their business interests. Given potential transaction costs, financial firms may choose to be passive regulators rather than active regulating customers’ behavior. Moreover, transaction costs may be passed to their customers, created negative externalities associated with the financial surrogate regulatory approach. This could lead to superficial compliance or window-dressing activities if firms and customers cannot fully absorb the costs. Thus, the state should avoid relying excessively on financial firms to play some regulatory function. For the financial surrogate regulatory approach to be effective, the state should align regulatory objective with a financial firm’s business interests and consider ways to reduce overall information and monitoring costs.