Thursday, April 28, 2011

Nassim Taleb Wants Regulatory Black Swans Eliminated

I thought that readers of this blog would find the following cross-post interesting.  It was written on April 15, 2009 and is being reposted with the permission of the author.
Nassim Taleb got me musing a little today...

In a Bloomberg television interview (reported in Bloomberg News), Nassim Nicolas Taleb argued for the simplification of the financial system.

“Regulators are fundamentally dumb,” he said. “Traders will go around them. I want the system where regulators can be stupid without you and I being harmed by it.” [A very straightforward statement by Mr. Black Swan.]
Regular readers of this blog know that the FDR Framework defines the very simple system that Mr. Taleb would like.  All market participants would have access to all the useful, relevant information in an appropriate, timely manner.

By breaking the regulators' monopoly on all the current asset and liability-level information for financial institutions, the FDR Framework ends the creation of financial black swans caused by this monopoly.
There is little question that regulators have been blind to many of the abuses unleashed by the financial elite in the past fifteen years. However prosaic it may be to term them "fundamentally dumb," it is not particularly helpful in describing the problem or fashioning a solution. By focusing on the inability of regulators to prevent the crisis and attributing it to their being "fundamentally dumb," Taleb fails to focus on the role political power and the ability to influence legislation played in the formation of the crisis.

It is true that regulators lost sight of their need for useful data on a timely basis. They also succumbed to the political power and lobbying of the financial elite and eviscerated the stringent disclosure provisions in the final language of Reg AB.

However, not all blame can be placed with the regulatory system. Congress, in its infinite wisdom, buckled to the lobbying of the financial services oligarchy and passed legislation that overturned the almost century old bucket shop rules, thereby unleashing the Credit Default Swap doomsday machine. The rolling back of the "bucket shop" laws through the passage of the Commodity Futures Modernization Act of 2000 was chronicled in a 60 Minutes broadcast, "The Bet That Blew Up Wall Street."
As discussed previously on this blog, the issue has nothing to do with the intelligence of regulators (which your humble blogger thinks is uniformly very high), but that there is a very strong bias in the regulatory and political system to dismiss evidence of the financial black swans before it is too late (see earlier posts on the Nyberg Report on Ireland).

It is the combination of the regulatory information monopoly and the regulators' relationship to the political system that guarantee that evidence of financial black swans will have to be overwhelming to all market participants before regulators will take any action. Unfortunately, by then it is too late.

The easy solution to prevent future regulatory black swans and their related financial instability is to eliminate the regulators' information monopoly.  With this information now available to all market participants, the market participants can do a better of assessing risk and properly pricing and limiting their investment exposures.
While it is now a given that re-regulation of the financial services industry will be the price to be paid by the bankers and traders for blowing up the economy and unleashing massive economic ruin and untold hardship across the world, the battle is by no means ended.

Regulators are not fundamentally stupid. There is little doubt though that the denizens of Wall Street are exceptionally bright and ethically challenged, as Prof Stiglitz has stated. They seek out areas of opacity to ply their trades, areas where they believe that with the benefit of asymmetrical information, they will earn outrageous profits.

Because those profits are often outrageous, they will continue to fight attempts at imposing substantive and substantial transparency. No level playing fields permitted.

Restoring financial stability will not be easy, pleasant or cheap.

First, we need better trained and better informed regulators with less inherent conflicts of interest (e.g., the regulator should not be referring to the regulated as "customers") and a better environment for regulation. Wall Street has proven incapable of policing itself for the public good, but more than capable of availing itself of the public weal.

We also need regulators across the world looking at the same information. In this exceedingly complex, globally connected system, the more regulatory eyeballs looking at a complete set of data, the better for the world to prevent a future financial crisis. No longer can a single country's regulator hope to be able to process, free of political interference, all of the data. Moreover, by decentralizing the "eyeball" process, it becomes more difficult for the financial elite to advance its regulatory agenda.

Second, we need a financial system with an extremely high level of disclosure. No longer can we afford to buckle to the lobbying by the bankers that compliance is too "expensive." We've seen costs this time that make the costs of compliance a mere pittance.
Andy Haldane of the Bank of England placed the cost of the crisis at $4+ trillion.
Third, we need to articulate an exit strategy from the plethora of government guarantees that have our financial system on government life support. That will require filling the capital hole and a functioning secondary market.

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