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John Coffee and his theory and practice of financial reform

by Robert Teitelman | Published March 13, 2012 at 12:52 PM

Columbia University Law School's John Coffee posted an excerpt from a paper early this week on the Harvard Law School Forum on Corporate Governance and Financial Regulation (the paper itself will also run in the Cornell Law Review). Coffee, of course, is one of the leading lights in corporate governance at Columbia's Center for Law and Economic Studies; his chair -- he's the Adolph A. Berle professor of law -- is like the Jehovah chair in terms of governance. In "The Political Economy of Dodd-Frank: Why Financial Reform Tends to Be Frustrated and Systemic Risk Perpetuated," Coffee is taking a mighty cut that aims not only at the dynamics of financial reform in a democracy like ours, but, inevitably, at the root causes of the financial crisis. I'm not sure he has succeeded. In fact, beyond his basic thesis on financial reform, which does make sense -- reforms get slapped together after a crisis, then get revised and presumably improved as better times return, a pattern he calls the "regulatory Sine curve" -- I'm not exactly sure what he's getting at except that he thinks those who attack reform efforts, notably Roberta Romano at Yale Law School and UCLA School of Law's Stephen Bainbridge, are wrong.

What's difficult here is how those two themes -- the dynamics of reform and the free-market critics -- fit together. At one point, after describing and criticizing Romano's argument that excessive and poorly written post-crisis reform should be accompanied by sunset provisions, Coffee declares: "This article is not a response to Romano's proposal." That may well be, but he then returns again and again to take whacks at her argument, including her charge (amplified by Bainbridge in his new book) that reform efforts often resemble governance "quack science." He justifies this close attention by noting: "But this article is a response to a world view favored by these scholars and an attempt to focus attention on the critical implementation stage at which financial reform is regularly frustrated." What's the difference between Romano's "proposal" and a "world view" that feeds off it? Hell if I know. Many pages later, as he launches his conclusion, Coffee insists one more time: "The key and recurring debate over financial reform is between those who distrust both legislation and regulation (a position the Tea Party Caucus exemplifies) and those who believe strong regulation is necessary to restrain risk." The Tea Party Caucus, by the way, is his term of opprobrium for Romano and her fellow travelers.

In other words, you're with reform or you're against it. There's no middle ground. Is that really the case? Personally, I think there needs to be stronger regulation, with re-energized and better-funded regulators, and (perhaps) a return to caps on size and limitations on certain financial businesses. My problem with Dodd-Frank is that it may not be effective enough. I even believe sunset laws are absurd -- and an attack on the underlying democracy. But I also think that much of what goes under the name of corporate governance smacks of empirically untested science, or interest group politics, and that the approach of Dodd-Frank, continuing the creeping incursion of federalization of governance from the states (meaning, mostly, Delaware), is a mistake as is the attempt to control a dynamic, if occasionally dangerous finance through rulemaking, often executed by the same regulators who presided over deregulation in the first place.

What is remarkable about Coffee's paper is that he often seems to agree on much of this. He admits that Romano's critique of some aspects of Sarbanes is correct, that legislation is an often messy, often "hasty" and "unprincipled" process. His thesis is Manichean; but his narrative often confesses to complexities. Still, he wriggles out of these ambiguities by arguing, "The key lesson to be learned from reviewing the response to SOX is that the 'correction' of reform legislation is virtually inevitable." Why worry? It's virtually inevitable. Coffee dives into his political science to provide an explanation, but the more he elaborates the more elusive it gets. He cites Mancur Olson's notion that smaller, better organized groups -- so-called policy entrepreneurs -- tend to be more effective politically than larger, more diffuse groups. The latter demand reforms after a crisis; the former (call them lobbyists) then go to work as the crisis passes: This is the source of the Sine curve. What's strange here is that Coffee is essentially arguing that we shouldn't worry that reform legislation is bad, because policy entrepreneurs, in this case the banks and their lobbyists, will change it all anyway. And what's odd about this is that when Coffee is refuting Romano, this "change" represents beneficial "evolution": Sarbanes was a mess, and some of the changes are probably sensible, so why worry. But when he is talking about the process of reform in general, or specifically about Dodd-Frank, the critics are mostly wrong, not to say ideological, and the trend toward reforming reform is sinister. So is the process of honing reform legislation over time good or bad?

This is actually an important question of political economy. Who calls the shots? Can a democracy make an administrative state and a cutting-edge financial sector function adequately well? What is the role of regulators? On the regulator question, Coffee is also confusing. He believes in technocratic solutions, and he's kinder to regulators than you might think. At one point he insists that "reform" processes allow regulators to put into place rules that they secretly desire but that Congress resists. His example: The Securities and Exchange Commission's Arthur Levitt wanted accounting reform and, after Enron and WorldCom, got it in Sarbanes. At times, he seems to say that the post-reform phase of Dodd-Frank is good because the technocratic experts, the regulators, get to write the rules. But what he ignores about the financial crisis is the degree that regulators over the last few decades have engineered, with the connivance of Congress, deregulation. In particular, the Federal Reserve led the way on bank consolidation, the hollowing out of Glass-Steagall and the hands-off attitude toward derivatives, not to say subprime lending. Regulators leaned over backward to satisfy demands of competition and efficiency.

Coffee realizes all that. But his argument turns on the thinnest of distinctions. He insists that "the model does not depend on 'industry capture,' " and he decries the overuse and under-definition of that term. At one point, he denies that regulators have been "captured" at all. But while avoiding the word (he offers no definition of his own), he describes the practice. "But if anything can be safely predicted," he writes in a discussion of contingent capital in Dodd-Frank, "it is that the Federal Reserve is too closely embedded within the banking community to propose any intrusive remedy that would be invoked well before a banking crisis has begun." Coffee notes that regulators tend to spring into action only after the crisis has broken. "Beyond this lack of imagination and political nerve, the greater problem is that financial regulators are often so closely intertwined with those they regulate that they respond in an equivocal and even timid fashion." That's not capture? Given that situation, Coffee calls for "stronger prophylactic rules ... with less delegation to administrative agencies." Yes, but such rules, which he admits can be too rigid, also restrict the "improvement" of what he calls overhasty, overcompromised legislation.

So around and around you go. Coffee takes us on another merry-go-round when he turns to executive compensation, which he accepts, with Harvard Law's Lucian Bebchuk, to be one of the primary "causes" of the crisis. He then turns to the work of Ohio State's René Stulz, who has been battling Bebchuk on the pay issue, and agrees with his research too. The only way to reconcile the two of them is to argue that shareholders pushed high pay and high leverage -- and that shareholder-manager alignment led to overleveraging and high risk. In other words, the traditional tenets of corporate governance, at least as they apply to financial firms, is fundamentally flawed. Somebody tell Berle. All this might be a blast of fresh air if Coffee also doesn't spend time opposing "investors" as the party of a sort of national interest (large, diffuse, passive) against the policy entrepreneurs of the financial firms. Given all that, Coffee has to dance very hard for any of this to make sense.

Despite the confusion, Coffee is reaching for a deeper point, though I'm just not sure he gets there. It's not the Sine curve, which is a fancy name for a phenomenon recognized for years. The question really is, who calls the shots when a complex system like finance breaks down? Who do you trust? Taxpayers? Their representatives? Regulators? The industry? Shareholders? Is democracy worth the occasional mess? Is finance so important that it should be taken from voters' hands? The true problem of political economy these days is that none of these groups really merits much in the way of trust, including voters. And so we go round and round. - Robert Teitelman

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