Adjusting to reregulation

May 19, 2009

I spent a few days recently in New York. One of the days I participated in a working conference on operational risk taxonomy organized by IBM Data Governance Solutions and on reviewing the data needed for more effective regulation of the financial sector. In attendance were a wide range of risk analysts with considerable experience on Wall street as well as a few officials from the regulatory community, the U.S. Fed and some academics. The discussions were lively and very interesting as a number of very creative ideas were presented with respect to building a financial dictionary that would be agreed to across the industry; improving risk analysis; and targeting data appropriate for a regulator charged with unwinding potentially systemic threatening situations before they exploded.There were many experienced and bright people in attendance.

One of the prominent people there was the author of a stimulating recent work on hedge funds and the dangers that their complex trading strategies   and the widespread uncertainty and unpredictability of nature pose for global markets . His argument is one plausible partial explanation for the recent crash which certainly ought to be carefully considered by regulators.His name is Richard Bookstaber and the book he has written was published before the crash in 2007; A Demon of our own design: markets, Hedge Funds and the Perils of Financial Innovation . Bookstaber who is a Wall street 25 year veteran and a quantitative finance specialist with a Ph.D. from M.I.T. in economics with hedge fund, trader and risk management experience at Salomon Brothers, Morgan Stanley and several other Wall street firms argues that complexity and unknowability are at the heart of the problem. He is somewhat skeptical that greater regulation will solve the problem because adding further controls will ’’exacerbate complexity and obscurity’’.

But after the enormous crash of the past year it is not clear to me whether Bookstaber still wholeheartedly embraces this anti-regulation sentiment. In any case it was a sentiment that many of the private sector actors at the meeting seemed to share . To me it seemed that some of them were still somewhat shell shocked by what has happened although fortunately they are already hard at work at trying to repair some of the damage by developing better risk management techniques and a common lexicon and working co-operatively on a common strategy.These are all desirable objectives, although risk and uncertainty cannot be totally banished.

It is clear that there will be far greater regulation because the public demands it.

It is also clear as Bookstaber admits that the perfect market hypothesis is wrong. Rather than the flow of equally accessible information being the essence of markets, Bookstaber argues it is the flow of liquidity and the demand for it that drives prices in the financial markets.Because of this price instability including dramatic unexpected shocks are more likely. Bookstaber attempts to shore up the legitimacy of his own industry by arguing that hedge funds serve a major function by supplying very necessary liquidity which can reduce price volatility. But he also admits that the complexity of the debt instruments and derivatives that hedge funds rely upon opens the markets to much greater risk of uncertainty and non knowability. Keynes argued something very similar in his work on probability.   Hence the necessity of better regulation and data transparency.

The trick will be how to pitch regulation at the right level so as to enhance innovation and economic growth yet at the same time, creative construction of a better and more equitable society.It is one thing for risk takers to knowingly undertake a risky investment but it is quite another to impose the consequences of that risk on unwilling non participants in the venture. Negative externalities need to be factored in before hand otherwise the benefits flow one way and the burdens another.