Some days the tone of the financial news matches that of the sports page. Adversaries appear to be locked in an epic battle, with the official sector setting regulations in an attempt to keep the system safe on one side, and financiers pushing for rules that ensure profitability on the other. The skirmish over the level of large bank capital requirements and the clash over whether municipal bonds can be used to meet liquidity requirements are just two recent examples. (See our earlier posts here and here.)
Following the day-to-day struggle can make it hard to see who is winning. But if history is any guide, the financiers will prevail—to the benefit of their owners and managers—at the expense of systemic fragility.
Can we change this? Can we create a system with greater balance between the authorities and the institutions?
The official sector has made tremendous progress since the crisis. While they may not be high enough or simple enough, capital requirements seem to be a real constraint on banks’ activity. For the first time we have liquidity requirements. Authorities are focusing on the need to strengthen market infrastructures—like central clearing parties and tri-party repo. And governments are working to implement resolution regimes such that large institutions can fail without jeopardizing the system.
Not only has the rule book been rewritten, but enforcement has become more diligent. And, most importantly, regulators’ perspective has changed. There is a renewed appreciation for the implications of the fact that the financial system is evolving continuously. That means that in order to maintain resilience, ensuring that the frequency and severity of financial crises remains tolerably low, the rules have to change with it.
Attempts to control human disease provide a useful analogy. Through our governments and international institutions we work to track mutations of viruses and bacteria. Infectious disease specialists are always on the lookout for bacterial mutations that might be resistant to antibiotics or new viruses that might be particularly easily transmitted in the population. Among the simplest examples is the work doctors and technicians do to isolate new flu viruses early enough to forge each year’s vaccine and keep infection rates low.
Systemically risky innovation is to a financial system as viral mutation is to humanity. First, financial changes are often complex and difficult to detect, at least initially. Rapid change and opacity make it harder for counterparties and authorities (think antibodies) to figure out what is going on. Second, like mutations, many innovations arise randomly, with the few survivors being the best adapted to the environment. Third, like drug-resistant strains, some innovations prosper precisely because they help circumvent regulation. Fourth, like viruses, financial innovations know no borders: many are easily transplanted abroad. Fifth, halting the diffusion of systemically risky innovations can prevent widespread crises (pandemics). Finally, in the same way that biological warriors have an incentive to create drug-resistant strains, the profit motive spurs financiers toward innovations that circumvent rules designed to make the financial system safe.
The immediate implication is that, in the same way that an effective health care system needs to continuously update the list of diseases and their treatments, anticipating mutations whenever possible, financial regulatory authorities need to keep track of the continuous evolution of the system itself. But the pressures opposing reform, especially those policies that would reduce system risk at the expense of private rewards, are almost overwhelming.
To see how daunting the task is, note first that financial innovation is often a good thing. Most people would agree that, by comparison with the system of a generation ago, today’s financial system is much more efficient at mobilizing savings and allocating them to the most productive uses, while ensuring that risk goes to those most able to bear it. Just consider the innovations—like mobile payments—that are making financial access feasible for the unbanked, who still number about two billion adults. These changes increase the productive capacity of the global economy, and make us all better off.
But financial institutions also devote substantial resources to circumventing regulatory rules through legal and accounting schemes that do not improve the allocation of resources or alter the risks undertaken in any material way. For example, banks hire phalanxes of lawyers, risk managers, and financial engineers to help them meet the letter of new regulations while minimizing their functional impact. (For a theoretical discussion, see here.) And, banks employ a permanent team of lobbyists working (for the most part far out of public view) to shape the regulations and their legal underpinnings in a manner consistent with maximizing the profits of incumbent firms. Finally, there are laws and rules that—whether or not they were sought by the financial industry—trigger responses that add to financial fragility (see here for an example of how the bankruptcy code may increase systemic risk by exempting too wide a range of financial instruments from the usual resolution procedures.)
In the parlance of national defense, financiers have large and costly intelligence operations designed to influence and exploit the official rules and regulations, as well as gain a competitive edge. Now, of course, the incentive to innovate and the desire to out-flank regulators and competitors are really two sides of the same coin. They both come from the creativity that is so prized and rewarded in an effective market-based economy.
So, how can we keep the good innovation while filtering out the bad? In the same way that the U.S. Centers for Disease Control and their counterparts abroad anticipate and monitor the initial appearance and subsequent transmission of disease, regulators need to anticipate and monitor changes in the financial system. It is essential that officials understand how banks and other players are adapting to new regulations and head off some of the most damaging behaviors. They can’t just respond to vulnerabilities once they materialize. They (and their political masters) need to face the fact that this is an arms race.
The key to success is to impose the lowest cost rules that nevertheless ensure resilience of the system. Doing so limits as much as possible the incentive for and the feasibility of circumvention. It is for this reason, for example, that some reformers would prefer to raise capital requirements as a substitute for relatively complex regulatory changes whose enforcement is difficult and effectiveness uncertain.
To understand what is at stake, consider the following simple calculation: global GDP is currently at about $80 trillion, measured at market exchange rates. In OECD countries, measured value-added in finance is around 4 percent of GDP. Applying this share globally, people in the financial sector are fighting for a slice of $3 trillion per year! To put this number into perspective, recall that finance is a spread business, with spreads between the cost of liabilities and the yield on assets commonly ranging around 300 basis points. So, for each basis point increase in the spread, industry profits rise by something like $10 billion worldwide. With rewards like that, armies of highly-trained professionals must seem like a bargain.
This all leads us to the conclusion that the official sector needs a Regulatory Counterintelligence Agency (RCIA) that understands the financial industry’s penchant for profiting from obfuscation, complexity, and the creation of systemic risk. The job of the RCIA would be two-fold: anticipate and monitor arbitrage of current laws and regulations, and predict reactions to new proposed rules. At the very least, this job requires a group of experts who can develop and maintain a realistic model of bank behavior that they can use to simulate responses to changes in both the rules and the broader environment in which institutions operate.
To be clear, we are not proposing the creation of another regulatory agency in the United States. As we have written before, this nation already is burdened with an absurdly complex regulatory structure full of overlapping jurisdictions and loopholes. Yet, in any streamlined structure, the functions of an RCIA ought to be present and prominent.
We are far from having this capacity today. The necessary modeling methodology is barely in its infancy. And, we suffer no illusions that even well-informed regulators can make the financial system safe in the absence of greater market discipline. More likely, it is when our laws and regulatory framework empower market discipline that they work best. But without the expertise and focus of an RCIA, how could we possibly get there? So long as there is complexity and obfuscation, private incentives will remain incompatible in the long run with financial resilience.