Yglesias has a good write-up of the problems with regulating big financial firms, but he (and Elizabeth Warren) get to the wrong solutions. To paraphrase, the problem is that many regulated firms are effectively judgment proof. We may threaten sanctions against accounting firms that commit fraud, or chemical firms that dump waste into the river, or banks that swindle their counter-parties. The problem is that the typical criminal sanction is too big, since indictment triggers a run on the firm by its employees, trading partners, and (eventually) creditors. Prosecutors have therefore basically stopped indicting, leading to the rise of deferred-prosecution agreements, as nicely chronicled by my law school classmate Brandon Garrett.
For Yglesias, and to lesser degree Garrett, the deferred prosecution agreement is too wimpy. Since firms know that the government won’t indict, they have no reason to cave, leading to quite defendant-friendly deals. This leads to under-deterrence. Yglesias endorses Sen. Warren’s proposed solution, which is to credibly put the threat of indictment back on the table.
But prosecutors are not wrong to avoid indictment, since that leads to over-deterrence. Over-deterrence is bad not only for firms that sink too much money into compliance, but also for society. It’s like the problem of medieval justice: if the sentence for every crime is hanging, bandits have no marginal incentive to avoid killing their victims.
My own view, as I sketch in this new draft, is that the problem is caused by the choice of ex post remedies. When regulators are facing defendants who are, in effect, judgment proof, the better solution is to switch to other incentives. So, for example, we might impose a tariff on chemicals that would be hazardous if dumped, or use anti-trust to keep banks too small to impose systemic risks. Obviously, there’s a tradeoff: not all firms will dump the chemical. A key part of my argument is that regulators can adjust their ex ante prices to account for expected variations in ex post behavior; firms that are at higher risk of dumping pay more for the chemical.