November 22, 2011
Uncertainty, Risk and Financial Law Reform
Posted by Diane Lourdes Dick

In thinking about financial law reform, several questions must loom particularly large among legal scholars: Is legal reform a source of market risk and/or uncertainty? And what are the relationships among market stability, risk and uncertainty?

I raise these questions because, as my previous post explored, the dominant judicial decision-making paradigm in finance and lending asserts that stable financial markets require an environment of legal certainty. This so-called "Certainty Imperative" ultimately constrains legal reform efforts by limiting the role of courts in shaping financial law and policy. What is more, the existing legal construct essentially assumes away these important questions, declaring legal reform as a source of uncertainty and a threat to market stability.

However, a recent book, Pandora's Risk: Uncertainty at the Core of Finance, published in July 2011 by economist Kent Osband, offers new insights as to the relationships among market stability, legal reform and certainty. These insights contradict foundational assumptions of the dominant legal paradigm.

In particular, Osband argues that markets are intrinsically uncertain environments. As Frank Knight articulated almost a century ago, risk is generally quantifiable, while uncertainty is randomness that cannot be measured. Challenging the Efficient Market Hypothesis, Osband asserts that changes in price are not caused by constantly updated (and thus highly certain) risk computations, but rather they reflect constantly shifting (and thus highly uncertain) perceptions of risk. Some perceptions of risk prove to be more accurate than other perceptions of risk, but all are inherently uncertain. Indeed, Osband alleges that our fixation with eradicating risk leads to greater market instability.

This book has caused me to further question the dominant paradigm in lending and finance. If it's true that markets are intrinsically uncertain environments, then is it appropriate to fear legal reform because it may introduce further uncertainty? And is the pervasive "Certainty Imperative" rhetoric even accurate? In other words, does the dominant paradigm simply use "legal certainty" as an umbrella term to loosely convey the absence of legal uncertainty and legal risk, or does it in fact distinguish unquantifiable "legal uncertainty" from quantifiable "legal risk"? If so, this distinction may explain why the Certainty Imperative primarily targets the judicial branch. Legal reforms that derive from the legislative and executive branches may be viewed as a lesser evil because they pose quantifiable risk to financial markets, whereas judicial reforms may be believed to introduce unquantifiable legal uncertainty.

Of course, if this is indeed the case, then the questions raised in this post are only the tip of the financial reform iceberg, and a host of normative implications also lurk below the surface. These questions and hypotheses deserve additional consideration, particularly from an interdisciplinary perspective. I welcome your insights.

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