Financial Conglomerates and Information Barriers
Andrew F. Tuch
Washington University in Saint Louis - School of Law
February 17, 2014
Journal of Corporation Law (Forthcoming)
Washington University in St. Louis Legal Studies Research Paper No. 13-11-01
The organizational structure of financial conglomerates gives rise to fundamental regulatory challenges. Legally, the structure subjects firms to multiple, incompatible client duties. Practically, the structure provides firms with a huge reservoir of non-public information that they may use to further their self-interests, potentially harming clients and third parties. The primary regulatory response to these challenges and a core feature of the financial regulatory architecture is the Chinese wall or information barrier. Rather than examine measures to strengthen Chinese walls, to date legal scholars have focused on the circumstances in which to deny them legal effect, while economists have focused on demonstrating Chinese walls' practical ineffectiveness in a range of important contexts.
This paper discusses the phenomenon of failing Chinese walls, explains why it occurs, and proposes a regulatory solution. The paper argues that limits on market discipline and evidential difficulties in detecting and proving the use of non-public information account for the failures of Chinese walls. It shows how the Volcker Rule, a core plank of the Dodd-Frank Act, will likely reduce harms flowing from failing Chinese walls, despite the rule’s intended focus on financial stability. To address the ongoing regulatory challenges, the article proposes the use of statistical inference to both detect and prove trading by financial conglomerates using non-public information and thus the failure of Chinese walls. Employed in so-called forensic finance to detect wrongdoing, the analyses can be used to rule out benign rationales – including superior trading skill and mere coincidence – for financial conglomerates’ abnormal trading returns. The article designs a regulatory strategy based on the use of statistical analyses. Although recognizing limits with the strategy, the article argues that it nevertheless holds promise in addressing the regulatory challenges of financial conglomeration.
Number of Pages in PDF File: 68
Keywords: Chinese walls, Financial conglomerates, Information Barriers, Volcker Rule, Insider trading, Statistical evidence
JEL Classification: K22, G21, G24working papers series
Date posted: December 6, 2013 ; Last revised: February 20, 2014
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