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Sedimentary Innovation: How Regulation Should Respond To Incremental Change

Cristie Ford
법학연구소 (The Institute of Legal Studies Konkuk University)|2017.11|경제규제와 법|제10권 제2호|pp. 54-84

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complexityderivativesfinancial regulationsecuritizationregulatory failureDodd-Frank ActFinancial innovationEnronasset-backed commercial paperVolcker RuleBasel capital adequacy rulesregulatory assumptions
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초록

From self-driving cars to subprime mortgage- backed securities, innovation carries both risk, and opportunity. It also throws up profound regulatory challenges. As it evolves, innovation continually undermines, circumvents, and sidelines regulatory structures designed to accommodate it – no matter how sophisticated they may be. This article is drawn from one chapter of Cristie Ford’s new book, Innovation and the State: Finance, Regulation, and Justice (New York: Cambridge University Press, 2017). The book examines the relationships between contemporary regulatory approaches, and private sector innovation. It then considers the implications of both for broader social welfare priorities including equality and voice. Using financial regulation as her primary example, Dr. Ford argues for a fresh approach to regulation, which recognizes innovation for the regulatory challenge that it is, and which binds our cherished social values and our regulatory tools ever more tightly together. This chapter is entitled, “Sedimentary Innovation: Responding to Incremental Change.” It examines “sedimentary”, or incremental, innovation, which is the main way in which innovation actually develops in the real world. Sedimentary innovation is at the other end of the spectrum from “seismic,” or radical innovation, and it consists of incremental improvements based on imitation, tweaking, bricolage, and diffusion. Individually these moves seem innocuous, but collectively over time their effects can be enormous. Sedimentary innovation develops differently in different industry spaces, because it depends on its environmental conditions. In finance, the precise ways in which sedimentary innovation develops are shaped by forces including structural and social networks in the global financial industry, the importance of the first mover advantage, and pernicious collective action problems. This chapter examines the ways in which sedimentary innovation presents a fundamental challenge to regulation. Like innovation generally, sedimentary innovation can profoundly undermine regulation across time. It can bury structures designed to contain it and transform the landscape, even while not seeming to be doing much at all. Sedimentary innovation is conceptually linked to the dominant contemporary regulatory approach, “flexible regulation,” but also presents challenges for it. For example, humans struggle to recognize sedimentary change in real time, due to cognitive limitations and bounded rationality. Regulatory boundary and coordination problems also pose unique problems in this context, as does the hindsight bias. After canvassing these challenges, the chapter concludes by offering some potential regulatory responses to the challenges that sedimentary innovation poses, including improving regulators’ analytic capacity, recognizing network effects and predictable cognitive limits, and building in institutional contrarians and system “breakers.” Regulation is at the leading edge of policy in ways that we do not always fully grasp. Seemingly mundane regulatory design choices have profound, practical ramifications for our most cherished social commitments. This book argues that we need to recognize innovation, and financial innovation in particular, as a central challenge for regulation. Innovation is a complex phenomenon that needs to be understood not only in technical terms, but also in human ones. It can obscure and sideline our normative priorities. It can undermine the best-laid regulatory plans. By looking closely at contemporary regulatory strategies, the nature of innovation, and the relationships between the two, we can design regulation to better recognize and withstand innovation’s corrosive effects.

Abstract

From self-driving cars to subprime mortgage- backed securities, innovation carries both risk, and opportunity. It also throws up profound regulatory challenges. As it evolves, innovation continually undermines, circumvents, and sidelines regulatory structures designed to accommodate it – no matter how sophisticated they may be. This article is drawn from one chapter of Cristie Ford’s new book, Innovation and the State: Finance, Regulation, and Justice (New York: Cambridge University Press, 2017). The book examines the relationships between contemporary regulatory approaches, and private sector innovation. It then considers the implications of both for broader social welfare priorities including equality and voice. Using financial regulation as her primary example, Dr. Ford argues for a fresh approach to regulation, which recognizes innovation for the regulatory challenge that it is, and which binds our cherished social values and our regulatory tools ever more tightly together. This chapter is entitled, “Sedimentary Innovation: Responding to Incremental Change.” It examines “sedimentary”, or incremental, innovation, which is the main way in which innovation actually develops in the real world. Sedimentary innovation is at the other end of the spectrum from “seismic,” or radical innovation, and it consists of incremental improvements based on imitation, tweaking, bricolage, and diffusion. Individually these moves seem innocuous, but collectively over time their effects can be enormous. Sedimentary innovation develops differently in different industry spaces, because it depends on its environmental conditions. In finance, the precise ways in which sedimentary innovation develops are shaped by forces including structural and social networks in the global financial industry, the importance of the first mover advantage, and pernicious collective action problems. This chapter examines the ways in which sedimentary innovation presents a fundamental challenge to regulation. Like innovation generally, sedimentary innovation can profoundly undermine regulation across time. It can bury structures designed to contain it and transform the landscape, even while not seeming to be doing much at all. Sedimentary innovation is conceptually linked to the dominant contemporary regulatory approach, “flexible regulation,” but also presents challenges for it. For example, humans struggle to recognize sedimentary change in real time, due to cognitive limitations and bounded rationality. Regulatory boundary and coordination problems also pose unique problems in this context, as does the hindsight bias. After canvassing these challenges, the chapter concludes by offering some potential regulatory responses to the challenges that sedimentary innovation poses, including improving regulators’ analytic capacity, recognizing network effects and predictable cognitive limits, and building in institutional contrarians and system “breakers.” Regulation is at the leading edge of policy in ways that we do not always fully grasp. Seemingly mundane regulatory design choices have profound, practical ramifications for our most cherished social commitments. This book argues that we need to recognize innovation, and financial innovation in particular, as a central challenge for regulation. Innovation is a complex phenomenon that needs to be understood not only in technical terms, but also in human ones. It can obscure and sideline our normative priorities. It can undermine the best-laid regulatory plans. By looking closely at contemporary regulatory strategies, the nature of innovation, and the relationships between the two, we can design regulation to better recognize and withstand innovation’s corrosive effects.

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