Diversifying to Mitigate Risk: Can Dodd–Frank Section 342 Help Stabilize the Financial Sector?

Table of contentsI. Introduction.1796II. The Empirical Foundation for Enhanced Diversity in Finance.1806III. The Increasing "Publicness" of Financial Institutions.1819A. Federal Regulation of "Publicness".1820B. Financial Innovation and Complexity.1825C. Public Subsidies for Private Institutions.1830IV.Systemic Risk and Risk Management.A.Risk Regulation in Financial MarketsV.Regulating Diversity.1840A. Mechanics of Section 342.1842B. Diversity Standards for Regulated Entities.18451. Joint Standards.18462. Voluntariness.1848VI. Safety & Soundness and Diversifying to Mitigate Risk.1851A. The Federal Banking Regulators.1852B. The SEC and the Securities Industry.1860VII. Conclusion.1867I. IntroductionAs the global financial crisis of 2007-2009 continues to reverberate across the global economy,1 financial regulation remains at the forefront of public discourse.2 The underlying causes of the crisis still generate controversy.3 By any measure, however, the financial institutions at the center of the financial crisis are special for many reasons.4 Increasingly, these businesses demonstrate a uniquely "public" character.5 While historically some financial firms may have organized as partnerships6 and the consequences of their decision-making perceived as "private,"7 in the contemporary period, the great financial crisis reveals that decisions made in the inner-sanctum of these businesses may adversely affect domestic and international economies and the public at large.8 Many such institutions engineered and invested in high risk financial instruments that ultimately generated large losses.9 These losses triggered a run on the shadow banking sector10 and later crippled the conventional banking sector and spelled calamity for the global economy.11 Ultimately, the entire financial sector benefited from the federal bailout of the industry.12 Remarkably, the homogenous demographic make-up of the senior management teams13 changed very little after the financial crisis.14For almost a century, a complex web of federal legislation was purportedly designed to protect the general public from the negative consequences of financial institutions' business decisions.15 Banking laws for example, include specific capital and reserve requirements, governance mandates, and detailed licensing standards, to reduce systemic risk.16 Federal securities laws include an intricate mandatory disclosure framework for public companies to protect investors and to promote efficient and transparent markets.17Commentators frequently posited that the culture within financial firms encouraged flouting rules.18 Many claimed that the insular settings reinforced biases and encouraged excessive risk-taking across financial markets.19 Unprecedented compensation20 and brazen behavior, buttressed by perceptions that decisions made on behalf of the firm would have limited consequences for individual senior managers, created an environment devoid of accountability.21 The fact that these institutions sported little cultural diversity did not escape notice.22A veil of "privateness" obscured many of the complex financial products and transactions that facilitated the crisis.23 Regulators and lawmakers deemed large financial institutions to be "too sophisticated to regulate" and acted to exempt them from regulation.24 Notwithstanding the litany of existing federal regulation, expanding notions of "privateness"-and concomitant deregulation-dominated the pre-crisis period.25 Even financial institutions that were publicly-traded companies successfully evaded conventional disclosure mechanisms for financial instruments that were too complex to depict.26 When the crisis erupted in the fall of 2007, both public and private institutions clamored to gain direct or indirect access to federal bailout funds.27 The crisis revealed flaws in federal regulation of financial institutions' risk management oversight. …