Notice & Comment

In-House Regulators: A Theory of Ossification Inside Regulated Entities, by Kirby M. Smith

As administrative law scholars have long noted, the structure of administrative law—and administrative agencies—has a powerful status quo bias. Ossification slows a deregulatory process, and burrowing may exacerbate deregulation’s lethargic pace. In other words, deregulating is difficult.

But regulation also affects the structure of regulated firms. New regulation causes observable changes within firms. And in areas such as finance, privacy, and medicine, regulation is now accomplished through broad standards that firms must implement themselves. This shift to regulation through delegation requires regulated firms to gain regulatory expertise. To do this, firms hire experts—they invest in processes that will allow them to comply with inherently opaque regulatory pronouncements. The presence of these firm-specific regulatory experts (or “in-house regulators”) may create hurdles to deregulating inside the firm.

In a recent Essay in the Yale Journal on Regulation Bulletin, I present a simple hypothesis: regulation creates extragovernmental hurdles to deregulation by changing how firms are organized. Simply put, in-house regulators will attempt to fortify their influence within the firm regardless of the regulatory climate.

In some ways, ossification and burrowing may aid their quest. For example, agency costs—a divergence of interest between a principle and agent—exist between senior management and in-house regulators. Although regulatory staff has great autonomy and, within the firm, is expert on its processes and regulatory developments, senior managers may want to reduce regulatory staff in a deregulatory environment. But because senior managers have less expertise in the guts of regulation, in-house regulators can use their technical expertise to encourage managers to reassess their initial inclinations. They can also highlight recent regulatory actions that occur in a deregulatory environment to mitigate management’s view on deregulation.

Take, for example, the Federal Reserve’s recent treatment of Wells Fargo. Because of regulatory lapses in the past, in February of 2018, the Federal Reserve fined Wells Fargo and prevented them from expanding until the issues are fixed. Bank compliance staff can employ this example should their managers seek to trim staff because of deregulatory presidential rhetoric. They can use the Wells Fargo example to argue that their positions are valuable—agency staff may still be able to regulate despite top-down deregulatory guidance. Moreover, because their knowledge of the regulatory landscape is greater than senior management’s, the regulatory staff can use burrowing and prosecutorial discretion to their advantage. They can assert that the Wells Fargo example is not an anomaly, but the result of regulatory resistance that will persist even as deregulation makes its way through the ossified process.

Agency costs are not the only reason to think that in-house regulators will be persistent. External forces may create regulatory inertia too. For instance, external reliance on information produced by in-house regulators increases their value to the firm. Once one firm within an industry discloses, pressure on others will grow to disclose similar information. And if the information is dynamic—that is, it changes over time—reliance interests will pressure the firm for ongoing disclosure, else a negative inference is drawn about the firm.

For example, bank equity analysts have started to drill down on capital and risk numbers in recent years. Because firms rely on the in-house regulators to supply these numbers, their value to management increases as external parties become more-and-more reliant on this information. Several financial firms have started to release forward guidance on their risk plans, and firms that did not have been chided by equity analysts.

These are not the only pathways through which changes to internal firm structures may allow in-house regulators, and through them regulation in some form, to persist in a deregulatory environment. The Essay suggests several other pathways for deregulatory inertia within the firm. Collectively, these theories suggest that regulated entities’ responses to deregulation will not be swift. If anything, their responses will be slow, plodding, and constrained by a host of internal and external forces. And this evaluation suggests that regulation that causes firms to centralize and create internal and external dependencies on in-house regulators will be more persistent. Although these forces will not play out equally everywhere, it presents a hypothesis of how agency action relates to firm structure and in turn further ossifies itself. A hypothesis that can be tested and observed in the current deregulatory climate and that future regulators should consider when drafting regulation for persistence and durability.

Kirby M. Smith received his J.D. from The University of Chicago Law School in 2017.  This post is based on Smith’s latest article from JREG Bulletin which can be read here.