Legal Protection in Retail Financial Markets

Given the importance of sound advice in retail financial markets and the fact that financial institutions outsource their advice services, what legal rules maximize social welfare in the market? We address this question by posing a theoretical model of retail markets in which a firm and a broker face a bilateral hidden action problem when they service clients in the market. All participants in the market are rational, and prices are set based on consistent beliefs about equilibrium actions of the firm and the broker. We characterize the optimal law within our modeling context, and derive how the legal system splits the blame between parties to the transaction. We also analyze how complexity in assessing clients and conflicts of interest affect the law. Since these markets are large, the implications of the analysis have great welfare import. We would like to thank Tony Bernardo, Doug Diamond, Denis Gromb, Raghu Rajan, Adriano Rampini, Jacob Sagi, and Andrei Shleifer for helpful discussions at the inception of this project. Also providing useful comments and suggestions were Moez Bennouri, Utpal Bhattacharya, Brendan Daley, Jakub Jurek, Rachel Kranton, Rich Mathews, Sébastien Michenaud, as well as seminar participants at Duke University (law school and economics department), Rice University, Texas A&M University, UCLA, the University of Miami, the University of Texas at Austin, the University of Virginia, the UBC Summer Finance Conference, the Conference of the Financial Intermediation Research Society, and the Mitsui Finance Symposium held at the University of Michigan. All remaining errors are of course the authors’ responsibility. Anderson School of Management, University of California, Los Angeles, 110 Westwood Plaza Suite C519, Los Angeles, CA 90095, [email protected], (310) 825-7246. Fuqua School of Business, Duke University, One Towerview Drive, Durham, NC 27708-0120, [email protected], (919) 660-7683.