As we work to update the regulatory architecture for finance, it seems obvious that it’s not stone-age simplicity that will help to pre-empt the next crisis but greater insights into, and better understanding of, the financial system we have wrought.
Does a complex and ever changing financial system require a complex and ever changing system of regulation? History has taught us over and over again that it is not credible to argue that the financial system should be unregulated. We can generally agree that some regulation of the financial markets is vital to striking an appropriate balance between protecting investors from the unknown or unexpected risks they should not have to bear and allowing them to take financial risks knowingly and willingly in hopes of maximizing their returns. In addition, regulation appears to be the only way to prevent the build up, both intentional and unintentional, of excessive risk in the financial system. But are complex formulas, proscriptive regulations, and heavy policing the only ways to achieve free but fair global financial markets?
SEC Commissioner Daniel M. Gallagher in a recent address pointed out the obvious difficulty regulators must deal with as they face a truly "de-localized" financial system:
Today financial products and markets are truly global. This is obvious to the point of being cliché, but it is nonetheless important to remind ourselves. You can trade essentially any financial product almost anywhere, without leaving wherever you happen to be. Capital markets and their participants are, in other words, well on their way to becoming fully de-localized. As they do, jurisdictional questions assume new prominence. What legal regime applies to a given product or trade — why, to what extent, and for how long? Should more than one country’s regulators be able to assert a jurisdictional claim on a transaction and those who enter into it? When more than one authority claims jurisdiction over an entity, product, or trade, whose regulations should prevail— and with what effect?
Gallagher's observation seems to argue for a simpler regulatory approach, however. A simpler more principles-based regulatory scheme is more likely to be adopted by multiple jurisdictions, at the very least allowing them to apply concepts like "substitute compliance," “substantial equivalence,” and “mutual recognition," where one country’s securities regulation regime or a portion thereof is deemed to be “equivalent” to another’s. The goal under such an approach is not to fully harmonize the rules across jurisdictions but instead to allow one regulator to accept as sufficient the regulatory actions of a different regulator in the context of a financial services activity that spans multiple jurisdictions.
Commissioner Gallagher believes, with respect to the US, the opportunity to try a principles-based approach has already been missed with the passing of the massive Dodd-Frank Act.
The most dramatic governmental response in the wake of the crisis was over two thousand pages of new legislation affecting the securities industry: the Dodd-Frank Act. Putting aside the wisdom of any particular aspect of that legislation or the question of the utility of the massive amount of rulemaking it entails, that legislative explosion meant that “mutual recognition” in the classic sense, always difficult and controversial, had become, from a practical standpoint, impossible. The regulatory landscape in the United States — our regulatory bodies as well as our “rulebook” — was, like those in other countries, changing so fast that it had become nonsensical to attempt a freeze-frame evaluation of the entirety of U.S. securities regulations against those of any other country. It simply couldn’t be done, and even if we had been foolhardy enough to attempt it, I doubt that any other jurisdiction’s regulators would ever have been willing to expend the resources necessary even to begin the effort.
This leaves us with the reality that, as to any given financial product or activity, there may be a number of regulatory treatments. And according to Gallagher, the only way to ensure high quality, but not unduly burdensome, regulation of those products and activities will be for one state to defer to another’s regulatory approach as to that product, service, or transaction. This deference would have to run both ways; its mutuality would be the key. And, of course, seemingly innumerable complex details would need to be resolved as to each set of activities or market participants subject to regulation.
Others studying the simple versus complex regulation question are coming to similar conclusions as Commissioner Gallagher. Nitin Mehta of the CFA Institute recently took up this very question in an on-line article, "
Simple or Complex — What History Has Taught Us about Financial Regulation." Mehta performs an interesting application of the ways system theory and "
cybernetics" (an approach for exploring regulatory systems, their structures, constraints, and possibilities) may help us think about financial regulation. Mehta believes that finance can learn much about regulating complexity from other disciplines that have been wrestling for long with similar problems. For example:
A useful theorem derived from cybernetics by Roger Conant and W. Ross Ashby is termed the Good Regulator. They showed that “every Good Regulator of a system must be a model of that system”. That is, success in regulation requires the building of a good model of understanding of the system being regulated. An associated theorem is Ashby’s Law of Requisite Variety, which states that “variety in a system can successfully counter a variety of disturbances in the environment”. In other words, the larger the variety of options available to a control system, the greater the volatility it is able to compensate. Both these fundamental postulates are important for financial regulators to understand.
Applying these theories and historical lessons to financial regulation, Mehta comes to the conclusion that simplicity is not the answer, but robust analytics and keeping up with financial market evolution are regulators' only hope of pre-empting the next crisis.
As we work to update the regulatory architecture for finance, it seems obvious that it’s not stone-age simplicity that will help to pre-empt the next crisis but greater insights into, and better understanding of, the financial system we have wrought. That system is not going to grow simpler, but ever more complex, defying the law of entropy, just as life on earth has done ever since time immemorial. Greater complexity will yield financial systems that exhibit new properties and generate new challenges. Systems of control and regulation which aim at fostering stability will need to match the complexity with better models to understand it. We can kiss goodbye any hope of keeping our financial system or its regulation simple.
Regulators should be aware, however, that even the most complex, well considered, and sophisticated regulations sometimes may fall victim to their very precision and be undermined or circumvented by simple means. One example of this is the Volker Rule's limitations on bank investments in private equity funds, but not necessarily private equity-style investments outside of a formal fund structure. It seems that
Goldman Sachs has found a way around this restriction merely by lining up clients who are willing to put money into accounts set up to invest in private equity-style deals without using a traditional private equity fund. Using these accounts, rather than pooling investments, Goldman would then make investments in a syndicate fashion, contributing investor money, along with its own capital and partner moneys, avoiding the Volker Rule restriction altogether.