Tuesday, March 29, 2011

The FDR Framework Eliminates Reliance on Only Regulators as Risk Managers

Richard Bookstaber is a veteran financial institution risk manager and senior governmental advisor.  To the best of your humble blogger's knowledge, the two of us have never spoken.  What is remarkable is how in his interview with Fortune and posts on his blog is how he presents the problem that the FDR Framework is uniquely designed to solve.

In his Fortune interview, he observed
Start by looking at the huge structure that exists in finance and ask: What is that about? 
First, the main function of finance and Wall Street generally is to provide capital. Now, the people who provide capital will do it more willingly if they have the liquidity to get out of their obligations by selling to other people. So you add the markets for trading to provide that liquidity. 
Go one step further. When people buy and sell securities they are taking on risk. So to address that, Wall Street offers instruments to help with hedging and risk management. You end up with derivatives and the like. 
All of that is reasonable. But the next step is where things start to get into trouble. Those in finance start to realize that it's hard to make money in a competitive market. They look for ways to get an edge. And to do that, they try to create informational asymmetries and institutional barriers.
Yves Smith at NakedCapitalism frames the creation of informational asymmetries and institutional barriers as
But opacity, leverage, and moral hazard are not accidental byproducts of otherwise salutary innovations; they are the direct intent of the innovations. No one at the major capital markets firms was celebrated for creating markets to connect borrowers and savers transparently and with low risk. After all, efficient markets produce minimal profits. They were instead rewarded for making sure no one, the regulators, the press, the community at large, could see and understand what they were doing.
The FDR Framework is built on the foundation of disclosure and caveat emptor (buyer beware).  It is the responsibility of government to ensure that all market participants have access to all the useful, relevant information in an appropriate, timely manner.

If the government performs its responsibilities, informational asymmetries are minimized.

Mr. Bookstaber then discusses risk management in his interview
The first step in risk management is getting the data. You can't manage what you can't measure. Step two is to create a process for analyzing that data and, as issues occur, learn from those issues to refine that process.
This quote parallels the basis for our financial markets under the FDR Framework.  The first step is to get the data. You shouldn't invest in what you can't analyze.  Step two is to analyze the data.  This is the responsibility of the investor under buyer beware.  This analysis is done both before investing and while an investor in a security.

Mr. Bookstaber then discusses why it is so difficult to develop rules for Wall Street and what can be done to improve the effectiveness of regulation.
If you find a valve in a nuclear power plant that isn't working right and replace it, the valve is not going to try to fool you into thinking it's on when it's really off. In the market, traders will try to fool you. In other words, there's a realm of feedback and gaming that can occur in the financial markets that doesn't occur in an engineering system. That makes developing rules much more difficult for Wall Street than for safety in engineering. 
When you observe the market, the very fact that you are observing it as a regulator almost guarantees that the people in the market will react as a military adversary and develop the best defense against it. They will try to find ways around it. And, as I said in my testimony before Congress, derivatives are the weapon of choice for gaming the system. 
The key point is that, whether rule- or principle-based, rather than looking at the regulation itself, it's more important to look at the system and understand in what way the system is structured that makes it difficult to regulate. 
And that gets back to themes in my book about complexity and tight coupling. 
If you make the system more transparent and simple then regulators have a chance to observe what's occurring and the time required to respond accordingly. That makes the regulation more effective.
The FDR Framework is focused on maximizing the transparency of the system.  It has the added benefit that this transparency lets the market exert discipline before the regulators are required to step in.

Finally, Mr. Bookstaber observes how hard it is to get someone to be responsible for reducing risk and verifying that it is done.
That is an issue of governance. When I was in charge of risk management at Salomon Brothers, the big issue wasn't so much finding the outsized risk as it was making sure that somebody took responsibility for reducing it and then verifying that it was done. 
The last two steps are the most difficult. Nobody wants to take the step of doing something about an outsized risk because that's costly. Taking off a trade that you think will work has both transaction and opportunity costs. So it's tough for a regulator to step in and say cut that out so the risk doesn't slam the economy. The CEO may say, "I can't believe you increased our financing cost or made us reduce our exposure. Because of you, we had to walk away from revenue!" The regulators are caught in a counter-factual argument. If they do their job and as a result the potential crisis doesn't happen, then it looks like all they did was to unnecessarily tamp down profit opportunities. 
One of the key features of the FDR Framework is that it makes someone in addition to the regulators responsible for reducing risk and verifying that it is done.

As has been discussed previously on this blog, under the FDR Framework, financial institutions would be required to disclose their current asset and liability level data.  With access to this data, market participants, including investors and competitors, could analyze the risk of the firm.

With the result of their analysis, market participants could adjust both their exposure and the cost of this exposure based on the risk of the financial institution.  Financial firms with higher risk could expect to find that their cost of funds increases and their access to funds decreases.  Financial firms with lower risk could expect to find that their cost of funds decreases and their access to funds increases.

Who is responsible for managing risk at a financial institution?  Management.  They have to select the risk profile that optimizes their cost of and access to funds.

Who is responsible for verifying risk is addressed?  The market participants.  They have a strong incentive to do this as it is their investment that will be lost.

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