Incomplete Law - A Conceptual and Analytical Framework 1 - And its Application to the Evolution of Financial Market Regulation

This paper develops a theory of the incompleteness of law. It argues that law is inherently incomplete and that the incompleteness of law has important implications for the design of lawmaking and law enforcement institutions. When law is incomplete, residual lawmaking rights must be allocated. In addition, agents have to be vested with law enforcement rights. We analyze the optimal allocation of lawmaking and law enforcement rights under incomplete law, focusing on the legislature, regulators and courts as possible holders of residual lawmaking rights, and courts as well as regulators as possible law enforcers. Each of these three agents has different properties. Legislatures and regulators are ex ante lawmakers, courts are ex post lawmakers. Courst are reactive law enforcers, regulators are proactive law enforcers. We show that the optimal allocation of residual lawmaking and law enforcement rights to these agents is determined by the degree and nature of incompleteness of law and the magnitude of expected externalities of harmful actions. In the second part of the paper we apply this analytical framework to the development of financial market regulation in England, with some comparative references to developments in the United States and Germany. The empirical evidence demonstrates that financial market regulators with both residual lawmaking and proactive law enforcement rights emerged in response to under-enforcement problems, which resulted from the incompleteness of law. JLE Classification: G3, K2, K4, N2 1 An earlier version of this paper, entitled “Law Enforcement under Incomplete Law” was presented at the Harvard Law and Economics Seminar. We would like to thank the participants at these seminars for helpful comments and suggestions.