David R. Henderson  

Maymin on Financial Regulation

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One might think that the ideal regulations would be those that find the right numbers for these portfolios, not too small and not too large--the Goldilocks of risk.

Surprisingly enough, it is not possible. It turns out that no algorithm for calculating the required risk capital for given portfolios results in lower systemic risk.


This is from the March Feature Article, "Why Financial Regulation is Doomed to Fail" by Philip Maymin, an Assistant Professor of Finance and Risk Engineering at NYU-Polytechnic Institute and the founding managing editor of Algorithmic Finance.


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CATEGORIES: Finance , Regulation



COMMENTS (10 to date)
Various writes:

I agree with this paper completely. The Basel II and Basel III accords made the formula for determining capital adequacy too complicated, and thus subject to being gamed. Basel I was far superior. It would be better to set up a "dumb" formula that has, perhaps, only 7 or so categories of securities, with relatively arbitrary (but very hard to game) capital adequacy requirements for each category. In other words, going back to Basel I, or something very similar.

The regulatory environment and our legislature remind me of Wile E. Coyote (the antagonist in the Road Runner cartoon). Outwardly brilliant, his complex schemes always end up backfiring.

Chris Koresko writes:

Fascinating article. The argument sounds very plausible: that enforcing homogeneity creates systemic risk. It seems obvious once it's been pointed out.

I believe this is a truism in some fields (ecology, for example).

It occurs to me that one could avoid this problem by issuing regulations at random, e.g., every bank is periodically issued a new set of risk-assessment guidelines which are generated by throwing dice.

David R. Henderson writes:

@Various,
"Wile E. Coyote." I love it. I'll probably use this sometime. Thanks.

Cahal writes:

He presents an excellent case against unilateral requirements like Basel, of which I have long been suspicious. However, that doesn't mean that any type of regulation is out of the question.

I fail to see how the agency that evaluated each asset would have to be god like. The key to this agency would be its recognition of our limited capacity to understand finance. If they were unsure, the product would be banned.

Maybe this sounds implausible, but the same thing happens for drugs - they are subject to rigorous testing upon their inception, and despite our limited knowledge of the human body, you see few, if any, drugs enter pharmacies that cause huge problems.

Somewhat amusing is his inference that because certain sorts of financial regulation have been unsuccessful, the same must apply to all regulation. See here: http://www.chron.com/disp/story.mpl/editorial/7437332.html. Regulation often exists for a reason!

Also objectionable is the view that because this particular type of regulation causes more problems than it solves, the free market is the automatic answer. It reminds me of creationists who seem to think that if a significant hole in evolution is discovered, ID becomes the automatic answer. This daft perversion of the term 'free market' needs to be challenged: http://www.globalresearch.ca/index.php?context=va&aid=12418

In the end it boils down to evidence: if financial regulation is doomed to fail, then why, before we had the 'big bang' in the 80s, the abolition of the GS and the 'light touch' rhetoric were there few (0?) systemic failures of the financial sector?

Phil Maymin writes:

@Cahal:

"I fail to see how the agency that evaluated each asset would have to be god like. The key to this agency would be its recognition of our limited capacity to understand finance. If they were unsure, the product would be banned."

Then all products would be banned.

Swimmy writes:

This was a great article, but I too think they go a bit too far in dismissing all potential regulations.

One of the reasons people can't beat the market is because the market can stay irrational longer than they can stay solvent. Hence Robin Hanson's recommendation: establish an agency that exists entirely as a market actor that shorts bubbles. Give them a sufficient amount of money to do so. If they really are financial geniuses who can tell the difference between bubbles and genuine price increases, we should never have to give them more money--they will make it on their own.

I don't have a lot of confidence in this plan, since I don't think financial regulators are market geniuses, but it avoids some of the problems Maymin describes.

Cahal writes:

Phil,

I don't see why that would be the case. Options and Futures on tangible goods and simple stocks would not be banned. Derivatives on loans could be subjected to tests based on the interest rates of those loans. Loans would not simply be allowed to be bundled together and repackaged etc.

My understand of finance is limited but it seems that the two main problems are short termism and products that are far detached from their initial source of value. I don't see why it would be hugely difficult to enforce ad-hoc regulation based on these principles.

Thomas Sewell writes:

Instead of regulation, how about accountability?

Setup the system so that the people who make the ultimate decisions and control the decision making also have the most risked.

If you have to do that artificially by adding extra penalties for failure to take into account externalities, then do that.

If you want regulators to be in charge, then send the regulator to jail and take all their family assets if the company they are regulating goes under.

Might be simpler to just hold the people running public companies directly responsible for what they do with shareholder assets, though.... Would have to be at least somewhat retroactive in time... no leaving a company to watch it go bust in two years because of your decisions... you're still responsible.

In other words, price the risk into the reward.

Think natural incentives to do the right thing, not elite watchers.

Phil Maymin writes:

Cahal,

All financial products, including options and futures and even simple stocks, have uncertainty about their risk. By your proposal, they should all be banned.

Your drug analogy is on point because it is the same issue -- lots of drugs are currently banned that could save lives. (Proof: when the FDA announces a new approval and claims it will save X lives per year, that means drug laws effectively killed X people the previous year.)

Both may be an illustration of Bastiat's "what is seen and what is not seen." We don't know what would have happened without regulations. We discuss this financial regulation or that financial regulation, this drug or that drug. This paper proves that the option of no regulation of banks is at least worthy of discussion. The same as the option of no regulation of drugs.

Phil

David R. Henderson writes:

@Swimmy,
I read Hanson's piece that you link to. I think that at the end we would be out the $300 billion that he would have the taxpayers pay. I'd rather cut the deficit.

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