Thursday, March 31, 2011

The FDR Framework passes the test of our times

Alan Greenspan wrote a column for the Financial Times in which he observed that the Dodd-Frank Act was based on the assumption that
... much of what occurred in the market place leading up to the Lehman Brothers bankruptcy was excess (hardly controversial) and that its causes would be readily addressed by this wide-ranging statute (questionable).
The act requires regulators to create a couple of hundred detailed regulations.  The potential problem with this he observes is that
... the regulators are being entrusted with forecasting, and presumably preventing, all undesirable repercussions that might happen to a market when its regulatory conditions are
importantly altered. No one has such skills. 
This is why this blog has urged regulators to adopt the FDR Framework.  Adopting the FDR Framework first simplifies the task and provides regulators with guidance as they create the new detailed regulations under the Dodd-Frank Act.

Mr. Greenspan then goes on to confuse opacity with the Adam Smith's "invisible hand".
... The problem is that regulators, and for that matter everyone else, can never get more than a glimpse at the internal workings of the simplest of modern financial systems. Today’s competitive markets, whether we seek to recognise it or not, are driven by an international version of Adam Smith’s “invisible hand” that is unredeemably opaque. With notably rare exceptions (2008, for example), the global “invisible hand” has created relatively stable exchange rates, interest rates, prices, and wage rates. 
In the most regulated financial markets, the overwhelming set of interactions is never visible. This is the reason that interpretation of contemporaneous financial market behaviour is subject to so wide a variety of “explanations”, especially in contrast to the physical sciences where cause and effect is much more soundly grounded. 
Under the FDR Framework, visibility into the overwhelming set of interactions is not necessary.

What market participants require is visibility and access to all the useful, relevant information in an appropriate, timely manner when they consider an investment.  It is the responsibility of the market participant to do their homework on this information as they know that it is buyer beware when they make an investment.

Mr. Greenspan then goes on to argue that financial complexity was a contributor to today's standard of living and productivity.
Is the answer to complex modern-day finance that we return to the simpler banking practices of a half century ago? That may not be possible if we wish to maintain today’s levels of productivity and standards of living. During the postwar years, the degree of financial complexity has appeared to grow with the rising division of labour, globalisation, and the level of technology. 
...The vexing question confronting regulators is whether this rising share of finance has been a necessary condition of growth in the past half century, or coincidence. 
In moving forward with regulatory repair, we may have to address the as yet unproved tie between the degree of financial complexity and higher standards of living.
The answer is that we must return to the principles on which our capital markets were based over a half century ago.  These principles, which are reflected in the FDR Framework, combine a philosophy of disclosure and the practice of caveat emptor (buyer beware).

Where complexity exists in financial products, it is the regulators' responsibility to make sure that this complexity does not create opacity with regards to all the useful, relevant information.

Where opacity exists in looking at a financial institution's current asset and liability-level exposures, it is the regulators' responsibility to make sure that this opacity is eliminated and that all useful, relevant information is made available to all market participants.

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