Lecture 12: Misbehavior, Crises, Regulation and Self Regulation

What this lecture covers

Following the previous lecture on behavioral finance, this lecture asks what institutions have developed to contain the human failings and misbehavior just described. Shiller frames regulators as referees: necessary for a competitive system to avoid a race to the bottom, even though the players (market participants) get more attention and admiration.

He organizes the lecture around five increasingly broad levels of regulation: within the firm, trade groups, local, national, and international. For each, he explains why it emerged historically and gives concrete institutions and cases. After watching, you should be able to name the main regulatory body at each level and explain, with an example, what problem it was created to solve.

Key ideas

• Micro-prudential vs. macro-prudential regulation: micro-prudential rules protect individual investors from being cheated; macro-prudential rules protect the financial system as a whole from systemic collapse, including the "too big to fail" problem.
• Too big to fail: large firms carry an implicit government guarantee because their collapse threatens the whole system, which encourages them to take on more risk than small firms.
• Tunneling: a range of ways insiders divert a company's value to themselves (underpriced asset sales, inflated contracts, excessive executive pay, expropriated business opportunities, insider trading), which is the core problem firm-level regulation, especially the board of directors, exists to prevent.
• Duty of care and duty of loyalty: the two legal obligations of a board member, requiring active oversight of management (not passive attendance) and primary loyalty to shareholders.
• The Buttonwood Agreement (1792): the short founding document of the New York Stock Exchange, created after America's first stock market crash; Shiller reads it and notes it functioned partly as a cartel (fixed minimum commissions) before it became a self-regulatory ethical body.
• Disclosure as regulatory philosophy: the SEC, founded in 1934, is built on Louis Brandeis's idea that "sunshine is the best disinfectant," requiring public companies to file information (via EDGAR) rather than banning specific practices outright.
• Accredited and super-accredited investors: SEC rules that restrict access to lightly regulated vehicles like hedge funds to wealthy individuals, based on income or net worth thresholds, on the theory that small investors need more protection.
• Market surveillance: exchanges and the SEC actively investigate suspicious trading patterns, illustrated with real insider-trading and fraud prosecutions.

Walkthrough

The importance of regulation and its challenges (0:00)

Shiller opens with the referee analogy: regulation prevents a competitive race to the bottom and deserves more respect than it usually gets. He introduces the too-big-to-fail problem and the micro-prudential/macro-prudential distinction, framing the rest of the lecture as a tour through five levels of regulation, from firm to international.

Firm-level regulation: the board and its duties (8:10)

Using Yale's own governing board as an example, Shiller explains why boards mix inside and outside directors and why outside directors' reputations effectively vouch for the company. He works through tunneling in detail, listing mechanisms such as underpriced asset sales to insiders, inflated contracts, excessive executive compensation, expropriated corporate opportunities, and insider trading. He then defines a board member's duty of care (active, informed oversight) and duty of loyalty (primarily to shareholders), arguing board service is a moral obligation, not an honorary role.

Trade group regulation and its controversies (25:37)

Shiller recounts the founding of the New York Stock Exchange in 1792 after the first US stock market crash, reads the short Buttonwood Agreement aloud, and notes it functioned as a price-fixing cartel that excluded untrustworthy traders like William Duer. He traces how fixed commissions persisted until "Mayday" (May 1, 1975), when the SEC banned them, and the UK's comparable 1986 "Big Bang" deregulation under Margaret Thatcher, both of which broke monopoly pricing and lowered costs for investors while ending an era of restricted competition.

Local regulation: the Progressive Era (38:17)

Before the 1930s, US financial regulation was mostly local. Shiller describes the state-level Blue Sky laws that emerged during the Progressive Era, starting in Kansas in 1911 and influenced by Louis Brandeis's writing on securities fraud, and explains their key weakness: state regulators struggled to police cross-state fraud schemes like telephone "boiler rooms."

National regulation: the Securities and Exchange Commission (42:59)

The SEC, created in 1934 under the New Deal, is presented as the central national regulator, built on disclosure rather than prohibition. Shiller cites early SEC chairman William O. Douglas's conflicts with Wall Street and later chairman Arthur Levitt's push for plain-English disclosure. He explains the IPO process as the gateway between private and public securities regulation.

Minimal regulation: hedge funds (49:41)

Hedge funds are described as lightly regulated private investment vehicles restricted to accredited or super-accredited wealthy investors, with specific income and net-worth thresholds. Shiller explains the "two and twenty" fee structure and why hedge funds can attract talented managers from public mutual funds, while noting the SEC deliberately keeps small investors out of this less-protected space.

Market surveillance: preventing manipulation (55:39)

Two real cases illustrate enforcement: a 1995 insider-trading ring traced back to an IBM secretary's tip about the Lotus takeover, and a former employee who shorted his old company's stock (EMX) and then sent a fake press release from a community college library to drive the price down. Both were caught through record-tracing, showing how exchanges and the SEC monitor unusual trading activity. Shiller also introduces private self-regulatory bodies like FASB (accounting standards) and SIPC (brokerage account insurance, parallel to FDIC for banks).

Regulatory pushes at home and abroad (1:04:25)

The lecture closes with recent national and international regulation: the 2010 Dodd-Frank Act, which created the Financial Stability Oversight Council (macro-prudential) and the Consumer Financial Protection Bureau (micro-prudential, associated with Elizabeth Warren); the European Supervisory Framework of 2010, spreading new agencies across Frankfurt, London, and Paris; and international bodies based mostly in Basel, including the Bank for International Settlements, the Basel Committee (source of the Basel I, II, and III agreements), and the G7's expansion into the G20 and its Financial Stability Board after the 2008 crisis.

Before you watch

• This lecture builds directly on the previous lecture on behavioral finance and human failings; watching it first gives context for why regulation is framed as a response to psychological weaknesses.
• Basic familiarity with what a stock exchange and a public company IPO are will help the trade-group and SEC sections.

Check your understanding

1. Why does the "too big to fail" problem create an incentive for large firms to take on more risk than small firms?
2. What is tunneling, and what are three different mechanisms Shiller describes for how it can occur inside a company?
3. How did the philosophy behind the SEC's approach to regulation, as expressed by Brandeis's "sunshine is the best disinfectant," shape institutions like EDGAR?
4. Why are hedge funds subject to lighter regulation than mutual funds, and what does the SEC's accredited investor rule try to achieve?
5. What distinguishes micro-prudential from macro-prudential regulation, and which category does the Dodd-Frank Act's Financial Stability Oversight Council fall into?