“Regulatory pendulum” models the cyclical pattern of compliance rules

In an economy that values financial success and high revenues, organizations of all types continually struggle to balance efficiency with production-constraining regulations.

“Organizations have two motivations: production and compliance,” explained Rogelio Oliva, associate professor of information and operations management at Mays and Ford Faculty Fellow. “They are trying to grow their businesses while, at the same time, knowing they must follow the rules.”

Oliva and his colleagues – Ignacio Martinez-Moyano from the University of Chicago and David McCaffrey from the University at Albany – have been conducting ongoing studies that model rule development and compliance in organizations. Their most recent study examines United States financial markets as a case area and suggests that recurring regulatory problems over the past 60 years are structurally similar.

“There are some structural reasons why we have a financial crisis every so often,” said Oliva. “The crises change in specifics, but they all have the same origin. The system is rigged so that the actors in a system become lax in compliance due to an enormous pressure to produce.”

Oliva and his colleagues propose a model of drift and adjustment in rule compliance. This model centers on the tension between production goals that focus on short-term benefits and required adherence to production-constraining rules that attempt to mitigate long-term risks.

“The pressure for companies to produce leads to one of two outcomes: working hard or cutting corners,” said Oliva. As organizations face high volume and time pressures, they may adopt a “Will we get caught?” decision-making mindset. In an attempt to evade controls and avoid delays, they will often commit a number of small infractions that will, for a while, remain undetected or tolerated.

However, adopting this mentality can lead to a decrease in service quality and an accumulation of regulatory and criminal violations.

“Eventually the violations pile up so that people can see the evidence,” explained Oliva. “This leads to strong backlash from regulators and an increase in the number of regulations. After a while, there are too many regulations and they start to back off, leading to the same cycle all over again.” This “regulatory pendulum” can be applied to settings beyond financial markets as well, since this phenomenon occurs in virtually every industry.

One surprising discovery uncovered by the research is how fast-paced the evolution of new products and regulations is. “It reminded us of the evolutionary race between predators and prey,” said Oliva. “New products are designed to address customer needs and soon someone starts abusing the system with these new products.” Eventually, however, these new products lead to even more regulations, which causes the pendulum to swing again.

This study is one of the first attempts to bring all plausible explanations together to form an aggregated picture of what is occurring in the market. Oliva and his colleagues have received support and validation from industry partners for their research and are presently working to validate their theory by creating a detailed model capable of replicating these dynamics.

“Ultimately, we have analyzed the micro decisions that are made in the industry in order to identify a structure that is responsible for the behavior,” said Oliva.

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“Drift and Adjustment in Organizational Rule Compliance: Explaining the ‘Regulatory Pendulum’ in Financial Markets” was published in Organization Science and is authored by Rogelio Oliva of Mays, Ignacio J. Martinez-Moyano of the University of Chicago and David P. McCaffrey of the University at Albany, State University of New York.