Thursday, January 2, 2014

2/1/2014: Risk, Regulation, Financial Crises: A Panacea Worse than the Disease?

An interesting - both challenging and revealing - piece on 'preventing the future crisis' via

Few points worth commenting on:

Per article: "…Record investment management industry profits as well as record market highs belie the fact we remain truly exposed to complex financial products and services not yet fully restrained since the crisis of 2008." As a logical conclusion to this, of the "three things in particular should concern all of us who are stakeholders in the finance industry as we move into the new year" the first one is:

"…complacency that another crisis can't happen because we have fixed the gaps in regulation."

So far nothing to argue with. Financial innovation (aka a path of increasing complexity) remains the main source of margins uplift in the industry. As long as that is the case, we are going to have less transparency, lower capacity to price risks and, as the result, greater fragility of the system, especially with respect to tail events.

"Nothing could be further from reality and the list of unfinished regulatory business is long. " And the article rolls on with a brief list of reforms and changes yet to take place. Alas, desired or not, these changes are hardly going to bring about any significant change in the way the sector operates. The irony is: the article warns against complacency and then complacently assumes (or even postulates - take your pick) that implementing the list of regulations and reforms supplied will resolve the problem of 'gaps in regulation'.

Really? Now, wait a second. We have a problem of 2 parts:
Part 1: complexity of system is high.
Part 2: complexity of regulation lagging complexity of system.

Matching Part 1 to Part 2 by raising complexity of regulation can only address the problem of risk buildup if and only if Part 1 is independent of Part 2. Otherwise, rising complexity in 2 can lead to rising complexity in 1 and a race in complexity.

Still with me? That is a major problem of the financial system as we know it since at least 19th century. The problem is that rising complexity of regulation is driving financial innovation probably as much as the need for higher margins. The race to match Part 1 and Part 2 above is a loss-making game for regulators, and thus, for economies at large.

If that is at least partially true, the argument should not be about regulations that are yet to be implemented, but rather about which regulations can help reducing complexity (and increase risk management effectiveness) in both Parts 1 and 2. We are still missing that argument, having departed firmly on the path of reasoning that suggests that higher complexity of regulation = higher system ability to absorb shocks. More dangerously, we are seemingly traveling along the line of logic that suggests that higher complexity of regulation = higher ability of system to 'prevent' shocks.

The article goes on to list another major source of risk: "investment management industry overconfidence that it is back in control". Specifically, "We in the industry perceive ourselves as having rectified our inability to see building counterparty, leverage and liquidity risks, masked through Federal Reserve policy by the unorthodox government support of financial markets and the nearly 10,000-point move in the Dow Jones industrial average since the financial crisis."

In reality, "Systemic risks are still building, undetected. Transparency is not increasing and the unwillingness or inability to remove government support in the markets is unprecedented."

Guess what? If you assume that more regulation + more complex regulation = better risk management, you are going to become complacent and you are going to get a false sense of security, control. This brings us back to the first point above.

And now to the non-point point number 3: "Finally, we in the investment management profession seem totally nonchalant about the current state of our existing regulatory system. It is alarmingly outdated, under-resourced and no match for the complexity of markets in the 21st century. To be clear, we are not talking about the new regulations addressing the crisis, rather the basic requirements of our present regulatory structure."

Back to point one above, then, again…

The reason I am commenting on this article is precisely because it embodies the very poor logical reasoning that is leading us to structure regulatory responses to the crisis in such a way that it will assure the emergence of a new crisis. But the real kicker is not that. The real kicker is that the very belief that regulatory system based on matching complexity of regulated services can ever be calibrated well-enough to assure stability of the system is a belief suffering from gross over-extension of faith.

A constant race to increase complexity of the system will lead to system collapse. 
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