1. 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. 8 th MIT-UAlbany System Dynamics PhD Research Colloquium Sloan School of Management, MIT April 30th, 2004 Cambridge, MA

2. Overview Purpose of the Research The Case Dynamic Hypothesis

3. 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)

4. 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.

5. Purpose Elaborate a Dynamic Theory of Compliance in Securities Industry

6. Market Behavior

7. Policy Structure in Financial Sector with Multileveled Control Mechanisms

8. Layers of Control… Self-regulatory Organizations NYSE, NASD Public Regulators, Prosecutors SEC oversees SRO’s (NYSE, NASD) SRO’s oversee and set rules for Broker- Dealer Firms

9. 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.

10. 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

14. Hypothesis

20. 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.

21. 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

22. Questions?

23. Thanks!