Arnold Kling  

Thoughts on Financial Regulation

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from Andrew Lo.

The functional approach to studying financial institutions and regulation begins with the observation that there are six functions of the financial system--a payments system, a pooling mechanism for undertaking large-scale investments, resource transfer across time and space, risk management, information provision for coordinating decisions, and a means of contracting and managing agency problems. Because functions tend to be more stable than institutions, regulations designed around functional specifications are less likely to generate unintended consequences.

Thanks to David Warsh for the pointer. Lo has a number of interesting proposals, including the creation of a "risk balance sheet." His point is that accounting statements are historical snapshots, but they don't say much about the susceptibility of the firm's finances to possible future events. I would caution that the Risk Disclosure Problem is not easily solved.

James Martin, the guru of information engineering, claimed that within a firm, the data entities are more stable than the business processes, and the business processes are more stable than the organizational structure. So if you're a bank, there will always be entities such as "customer," "account," "interest rate," and so on. The business process may change--you can introduce online banking for example. And you can always do a re-org--you could put transaction processing under "customer relationship management" or under "operations."

A lot of the regulatory "turf wars" that take place in Washington are based on organizational structure--this agency regulates banks, that agency regulates futures markets, and so on. The higher level of abstraction--business processes--is too difficult a concept. The concept of data entities takes abstraction still higher.

When I was at Freddie Mac, we tried to use information engineering, but it was too difficult. The result is that we were stuck with a variety of systems that did not talk with one another very well. I suspect that in the real world this is often the case. This suggests another reason to have limited expectations for regulatory reform.

Comments and Sharing

COMMENTS (2 to date)
Mr. Econotarian writes:

If we could predict future risk well through full knowledge of the complex economy, it would be equivalent to solving the Socialist Calculation Problem!

The only way to move forward is to recognize that we are best at preventing past risk revealed through history, and that we will probably encounter future, unexpected risk.

The only way to survive future, unexpected risk is to have a flexible economy which can intuitively shift resources around to their best use without extensive regulation bogging it down.

Dewey Munson writes:

"The market" is the real time adjustment to risk.
Any regulation except improving transparency extends the markets time interval. Even discussions of regulation extends the market's reaction time.

It no wonder that "bundling" brought down the system - even the bundlers don't know what's in the entity - the opposite of transparency.

Professional economists persist in acting as though the market is made up of ....professional economists!

Nothing is further from the truth.

Unbundle with lots of noise as soon as possible!

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