Self-Regulation and Government Oversight

Self-Regulation and Government Oversight

Review of Economic Studies.
2005, Vol. 72, Pages 687-706
Self-regulation is a feature of a number of professions. For example, in the U.S. the government
delegates aspects of financial market regulation to self-regulatory organizations (SROs) like the New
York Stock Exchange and the National Association of Securities Dealers. We analyse one regulatory
task of an SRO, enforcing antifraud rules so agents will not cheat customers. Specifically, we model
contracting/enforcement as a two-tier problem. An SRO chooses its enforcement policy: the likelihood
that an agent is investigated for fraud and a penalty schedule. Given an enforcement policy, agents compete
by offering contracts that maximize customers’ expected utility. We assume that the SRO’s objective is to
maximize the welfare of its members, the agents. We show that the SRO chooses a more lax enforcement
policy—meaning less frequent investigations—than what customers would choose. A general conclusion
is that control of the enforcement policy governing contracts confers substantial market power to a group
of otherwise competitive agents. We also investigate government oversight of the self-regulatory process.
The threat of government enforcement leads to more enforcement by the SRO, just enough to pre-empt
any government enforcement.