This Article examines situations in which government regulation makes mandatory the use of certain devices and institutions that have been generated by markets and private ordering in the financial sector. I refer to the process of taking devices and institutions created by market processes and making their use mandatory “regulation by assimilation” because the process involves the adoption and incorporation by the government of devices and institutions developed by participants in the financial markets for different (though often somewhat related) purposes. Devices and institutions that have been developed internally by market participants and then assimilated into regulation include the credit ratings generated by credit rating agencies (which were designated by regulators as Nationally Recognized Statistical Rating Organizations or NRSROs), the Value at Risk (VaR) models that measure the risk of financial institutions’ portfolios, the advisory and fairness opinions issued by investment banks in the context of significant corporate transactions, and the audits of corporations’ financial results by independent outside auditors. This Article makes two contributions to our understanding of the regulation of financial market participants. First, I show that the phenomenon of regulation by assimilation is common, if not ubiquitous, in the financial world. Second, I show that the process of regulation by assimilation has negative consequences that have not previously been anticipated or even identified. These negative consequences manifest themselves by ossifying, as well as weakening, and even corrupting the efficacy of the private sector institutions and techniques that have been assimilated. The analysis in this Article indicates that the previously unidentified phenomenon of regulation by assimilation was a major cause of the financial crisis of 2007 and 2008 because it distorted the ability of firms and markets to measure and assess the riskiness of their activities.
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