Rule Dynamics
Competing Pressures in Norm Formation:
Effectiveness Erosion of Control Systems in
the Securities Industry
Ignacio J. Martínez-Moyano and David P. McCaffrey, Ph.D.
8th MIT-UAlbany System Dynamics PhD Research Colloquium
Sloan School of Management, MIT
April 30th, 2004
Cambridge, MA
Overview



Purpose of the Research
The Case
Dynamic Hypothesis
Financial Sector
The Problem and Motivation


Incredible attempts to change the way
business is run in the Financial Sector that
seems to be not effective.
Sustained increment in sanctions (leading to
the $1.4 billion settlement between SEC and
financial firms related to the Research
Analysts’ Case)
Financial Sector
The Problem and Motivation



Managers in Financial Firms are subject to
pressures to produce and pressures to
comply with the rules
Financial Firms are interested in playing
fair and square to (1) gain reputation in the
market, and (2) to protect the market.
Financial Firms are interested in avoiding
regulatory action against them.
Purpose

Elaborate a Dynamic Theory of Compliance
in Securities Industry
Market Behavior
800,000.00
14,000.00
12,000.00
600,000.00
NYSE Share
Volume (millions)
10,000.00
500,000.00
8,000.00
400,000.00
6,000.00
300,000.00
4,000.00
200,000.00
2,000.00
100,000.00
0.00
0.00
1987
1991
1995
1999
2003
Dow Jones Industrial Average
Share Volume (millions) and Trades (thousands)
700,000.00
NYSE Trades
(thousands)
Dow Jones
Industrial
Average
Policy Structure in Financial Sector
with Multileveled Control Mechanisms
Legislation
Expertise regarding
regulated activities
Public
Regulation
Self-Regulatory
Organizations
Private
Litigation
Market Controls
Internal
Controls
Producer
Self-Restraint
Favoring of public
interest
considerations
Layers of Control…

Self-regulatory Organizations


NYSE, NASD
Public Regulators, Prosecutors


SEC oversees SRO’s (NYSE, NASD)
SRO’s oversee and set rules for BrokerDealer Firms
Layers of Control…
Attorney representing firms:
“[Representative John] Dingell beats
on the SEC, the SEC beats on the
Exchange, and the Exchange beats
on us.”

Congress

Can redefine the rules and exert pressure on the
system for change.
Data





SEC’s Documentation of the $1.4 billion “Research
Analysts’ Case” settlement with financial firms
Supplementary data from NYSE, NASD, and other
sources
Legal cases, industry conference proceedings,
reports, Congressional hearings, trade press, and
other documents
Interviews with individuals across different levels of
regulatory system and experts in securities regulation
Coding of NYSE disciplinary cases:

Cases from 1990-2003
600
10000
500
8000
400
6000
300
4000
200
2000
100
Year
20
03
20
01
19
99
19
97
19
95
19
93
19
91
19
89
19
87
19
85
19
83
19
81
19
79
0
19
77
0
Total Arbitration
Cases Received
Class Actions
12000
19
75
Civil Actions and Arbitrations
Securities Civil Lawsuits and Class Actions and Securities Arbitrations Filed, 1975-2003
Civil Suits Initiated
Under Federal
Securities and
Commodities Laws
Federal Securities
Fraud Class Action
Lawsuits Filed
Enforcement and Disciplinary Actions by Securities and
Exchange Commission and Securities Industry Self-Regulatory
Organizations (SROs), 1985-2002
3000
Total
Enforcement
Actions
Total Number
2500
2000
1500
Final SRO
Disciplinary
Actions
Reported to
SEC
1000
500
0
8
9
1
5
8
9
1
7
8
9
1
9
9
9
1
1
9
9
1
3
9
9
1
5
Year
9
9
1
7
9
9
1
9
0
0
2
1
0
0
2
3
Total Corporate Underwritting
2500
1500
Total Corporate
Underwitting
1000
500
Time
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
0
1990
$ Billions
2000
Hypothesis
Producers Problem
Threshold
Relevance of
+
Problems
+
Pressure to
Comply with the
Rules
+
Actual Rule
Compliance
Producers
Perception of
Problems
+
B
Self-Control
Loop
Number of Deals
- Done (Activity
Stream)
Extent of
Problems
+
Controllers
Problem Threshold
Relevance of +
Problems to the
Controller
B
Internal
Control Loop
Controllers
Producers Problem
Perception of
Threshold
Problems
+
+
Relevance of
+
Problems
Producers
Perception of
Problems
+
Pressure to
+
B
Comply with the
Rules
Extent of
Self-Control
Problems
+
Loop
+
Actual Rule
Compliance
Number of Deals
- Done (Activity
Stream)
Clients Problem
Threshold
Relevance of
Problems to the
Client
+
Controllers
Problem Threshold
Relevance of +
Problems to the
Controller
B
B
Market Control
Loop
Internal
Control Loop
Controllers
Producers Problem
Perception of
Threshold
Problems
Clients Perception
+
+
of Problems
Relevance of
+
+
Problems
Producers
Perception of
Problems
+
+
Pressure to
+
B
Comply with the
Rules
Extent of
Self-Control
Problems
+
Loop
+
Actual Rule
Compliance
Number of Deals
- Done (Activity
Stream)
Effectiveness of the
Regulatory System
+ +
Pressure to Increase the
Effectiveness of the
Control System
Status of the
Market
+
Controllers
Problem Threshold
Relevance of +
Problems to the
Controller
+
Effectiveness of the
Internal Control
System
+
Clients Problem
Threshold
Relevance of
Problems to the
Client
+
B
B
Market Control
Loop
Internal
+
Control Loop
Controllers
Producers Problem
Perception of
Threshold
Problems
Clients Perception
+
+
of Problems
Relevance of
+
+
Problems
Producers
Perception of
Problems
+
+
+ Pressure
to
+
B
Comply with the
Rules
Extent of
Self-Control
Problems
+
Loop
+
Actual Rule
Compliance
Number of Deals
- Done (Activity
Stream)
Effectiveness of the
Regulatory System
+ +
Pressure to Increase the
Effectiveness of the
Control System
Status of the
Market
+
Controllers
Problem Threshold
Relevance of +
Problems to the
Controller
+
Effectiveness of the
Internal Control
System
+
Clients Problem
Threshold
Relevance of
Problems to the
Client
+
B
B
Market Control
Loop
Internal
+
Control Loop
Controllers
Producers Problem
Perception of
Threshold
Problems
Clients Perception
+
+
of Problems
Relevance of
+
+
Problems
Producers
Perception of
Problems
+
+
+ Pressure
to
+
B
Comply with the
Rules
Extent of
Self-Control
Problems
+
Loop
+
Actual Rule
Compliance
Number of Deals
- Done (Activity
Stream)
+
Actual Deal
Production
+
Pressure to
Produce
Some Inferences


Control Systems vary in
Effectiveness
Interactive Layers of
Actors in the System
manage to deal with
complex problems
through informal
‘networked’
arrangements


Also, informal networks
can come to “live with”
certain questionable
practices (the
“normalization of
deviance”)
Control Systems seem
to respond to ‘external’
shocks from other
layers in the system.
Modeling Effort—Financial Sector

Mix of:




Rule-following preferences
Propagation of changes in systems of rules
Erosion of compliance standards (change in
norms)
Erosion of risk-perception capacity
Questions?
Thanks!