Contracting and Enforcement with a Self-Regulatory Organization
46 Pages Posted: 17 Jan 2002
Date Written: August 2001
Self regulation is a feature of a number of professions. For example, 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 analyze 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 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 the SRO's objective is to maximize the welfare of its members, the agents. We show that in the static case, the SRO chooses a more lax enforcement policy - less frequent investigations and lower penalties - 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. A similar result applies in a dynamic setting where customers can impose discipline by monitoring an agent's reputation for past performance. Here there are circumstances for which the SRO would choose a more aggressive enforcement policy than is preferred by customers.
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