Late to this. In light of depressing evidence that it probably won’t happen under Obama, Tyler Cowen makes a case against consolidating multiple financial regulatory bodies:
1. Getting current regulators to do a better job may be a better goal.
2. The consolidation behind the Department of Homeland Security has not been a smashing success. It’s too easy for regulators to focus on formal goals of consolidation at the expense of substantive goals of mission. And the prevention of forum-shopping can be achieved without formal consolidation.
3. The major overseer probably would have to be the Federal Reserve and that would mean the long-run chances for restoring an independent central bank would be slim. The Fed as super-regulator would be more accountable to Congress than is desirable.
4. Many of the real regulatory problems are due to the preferences of Congressional committees and it is high time we admitted this. How about reforming them?
I want to add two followup points for the affirmative case on why we should consolidate.
Finance hangs together.
One simple rule in finance is the idea of No Arbitrage Pricing. The streets are not littered with $20 bills. Prices converge to make sure any ‘free money’ disappears. What that means in practice is that all prices hang together – they inform one another and react to the constraints each other faces.
Let’s take a simple application, the Modigliani-Miller Theorem. It would tells us that having one agency to regulate bonds and another agency to regulate stocks is a bad idea because they are made of the same thing. If a firm can optimally not-disclose correct information or mislead because Regulatory Agency Stocks is more corrupted than Regulatory Agency Bonds, they’ll simply issue less bonds and issue more stocks.
My gut reaction is that that is generalizable to large segments of finance. Post Black-Scholes, it is very easy to see bits and pieces of financial instruments all blur together. A derivative is just a piece of a bond and a piece of a stock. A CDS can look identical to a bond. Interest-rate swaps can create any bond you want. As such, any one agency would need to know what every other agency is up to in order to be effective, and one thing I don’t trust is inter-agency communication. The market, as a result of innovations in financial engineering, will be able to feel the entire structure and the moment it finds a weak link be able to adjust a lot of types of instruments to take advantage of it.
The Department of Homeland Security has, among other agencies, those responsible for border security, the Coast Guard, and the Secret Service. These do not hang together in the same way as finance does post 1973.
Silos of Risks
If that is too finance theory heavy, I want to point out this fantastic post you should read from a sociologist of markets that I’ll reprint a lot of here. There are two big changes in the sociology of markets since 1973 that are relevant here. One is that Black-Scholes and derivatives more generally gave us a framework that blurred the lines between products. Another is that technology evolved in a way that facilitated and encouraged this blurring. The new technology created needs for more theory and research that involved blurring instruments and functions.
There was a time when capital, financial, housing markets were distinct-but-related. Housing prices changed with changes in interest rates; the dot-com boom and bust created and lost jobs; the stock and bond markets moved in conjunction with these changes. But while related, they were pretty much distinct kinds of markets. This was true for a few reasons.
First, different people traded different markets. Equity desks (stocks) and futures traders (fixed income) were different people, with different skill sets necessary to actually trade these markets. Mergers and acquisitions departments were deal-makers; private wealth desks were relationship managers; futures traders were cowboys; municipal bond traders were plodders.
Second, different technologies of trading made these markets comparable via performance (that is, returns on investment) but not otherwise comparable.
And so, the world looked something like this:
This changes with two things: risk models, and technology…It is not just that Black-Scholes-Merton formula allows us to price options. It allowed sophisticated analyses of returns, captured by risk and volatility…Understanding returns as a function of risk and volatility (assumptions and measures about transaction costs, liquidity, and the like can be incorporated as well) means that real estate, bonds, stocks, derivatives, collateralized debt obligations, fine art, even your Uncle Earl’s gold coin collection can all be translated into a common metric: how much risk, how much volatility, equals how much return?
Risk becomes something that can itself be traded. When portfolio managers argue that a portfolio ‘needs more vol’, for example, it means that it needs more ‘risk’. Risk is being commoditized…
that one of the main effects of automated trading would be to provide a degree of standardization across a number of financial exchanges. This standardization would lead to mergers (implicit) across exchanges. These exchanges had, for the better part of the last century, been not only distinct but direct rivals…The ability to now trade across exchanges, or better, to have a technology that allows you to have different “back end” trading systems and a single “front end” platform. Think about it like a web browser. The back-end servers may run Unix, windows, OSX, Ubuntu, or whatever. The front-end web browser makes them all work for any user. Likewise, front-end electronic systems allow traders to actually make trades across a wide variety of financial (and non-financial) products.
So now the world looks less like a set of distinct silos and more like this:
As a result of this fact – this fact of the contemporary world of risk management and globalized finance – a number of assumptions that we had previously held to be true no longer are. For example, arguably commercial banks, insurance companies, and investment banks are indeed all doing the same thing: they are all trading in risk. The ways they do this continue to differ, but the underlying ways that they can calculate their worlds have moved closer.
When you listen to people talk about the futures and forwards market you’ll hear them reference “the underlying.” That means that the same equations, same inputs, same terminology and often even the same technology can be used to trade any underlining – be it oil, pigs, the interest rate, oranges, gold. This blurring is real, and it leaves our regulatory agencies in a distinct pre-modern period.
I’m pretty sure it’s ‘the underlying’, not underlining, no? At CBOT/CME we always talked about it as underlying.
Ha! Good catch, and changed. I need to proofread these better. Underlining, is like underlining text? Maybe a piece of bedding? Certainly not the ‘underlying.’
That is a great argument, but it supposes a government we do not have and probably never will.
Right now we have two major power centers – Fed and Treasury – and a constellation of special purpose agencies (FDIC, Controller of the Currency, SEC, CFTC, etc) on the national level, plus a mess of local regulators when you get across the imaginary line from finance to “insurance.”
Fed is a terrible place to have regulation, because the entire concept of an independent central bank as guardian of the currency falls apart when that guardian is messing around with the major players in the currency. Much less likely to raise rates and wrong-foot a bank holding company into oblivion when you’re working with that bank.
Treasury is also a flawed place, since it is the economic policy arm of the government. For years it was ignored – I’m not sure anyone talked to John Snow the entire time he was in DC – but it’s the actual place for the White House to do things (the CEA and other informal groups are just that).
Perhaps you could cobble together a new super-nerd-squad from the alphabet soup of pure regulators and make them one. But remember, the underlying laws are different in different markets. Your buddy who is dating a girl in Chevron’s legal team tells you she is spending all her time in Irving and you buy a share, you’re going to jail. You go golfing with someone from the Japanese central bank and he tells you they are dumping dollars for euros, you’re welcome to get ahead of the crowd. Does that lend itself to the same squad? The consumer-facing regulators are supposed to encourage a nanny state where every disclosure has to be laboriously made and every trade idiot-proof. The synthetics are going to need a different audience, refereed by different people.
We have to deal with the US government, not a Scandinavian or Singaporean state.
Thanks for this great post.
«Right now we have two major power centers – Fed and Treasury»
These are not power centers — they are are just fairly obedient enforcers of decisons taken by the real power centers, whch are various factions within the business community; these guys have a lot of power and thus a lot of money.
Consider the New York fed: it is by far the most powerful fed, but that is because it is the one that represents (rather than regulate) the interests of the most powerful business community.
If you notice there is a pattern in “regulators”: every faction of the business community want their own, to represent their interests. Not quite viceversa. Turf wars among regulators are really turf wars among factions in the business community, and Congress, whose members are sponsored by the broader business community, sort of mediates, as a kind of mediator among the various interests.
There is nothing inevitable about the degree of regulatory capture in the USA; it all depends on culture, on who else has got the money or the will to contrast the influence of the various factions of the business community on the organization of the state. But selling out has been part of the USA culture for a long time.
«For example, arguably commercial banks, insurance companies, and investment banks are indeed all doing the same thing: they are all trading in risk.»
This reminds me of 1960 conglomerates, when it was said that all industries requires only one skill, “management”, and that did not end well. If there is one thing that conglomerates like GE have been good at is using the only skill that does apply across industries, competence at “managing” accounting.
But more importantly, “commercial banks, insurance companies, and investment banks” are not just trading in risk — they also trade in *uncertainty* as that funny guy said, and in very different degrees of uncertainty.
To think that they are trading in risk only implies thinking that (recent) history is a reliable guide to the future, and (recent) history shows how true that is :-).
Sure, you can misapply the same flawed models to any trade involving money and finance, but that does not seem to work out that well.
A regulator’s theoretical role is to detect and prevent actions that are illegal or game the system, and these are very different in different financial industries, because a lot of fraud or gaming depends on the profile of the customers, not of the activity performed by that financial industry (even if it were all just risk trading, which it is not).
i don’t think that levin’s point is really true. markets are still separate. plus, in terms of the sociology of banking, these silos are still in existence.
we do not have consistency between even the credit markets and equity markets; these markets frequently move the wrong way with respect to each other. traders specialize within an area, and these areas are generally institutionally separate within banks (ie there are credit desks, and treasury bond desks, and so on).
i agree that at there are bridges between the silos (generally in hedge funds and smaller places) and there is a unified risk function in most institutions that reports to upper management, but this risk function is separate from trading and generally very far from the market as such.
Rereading his post, I think I dealt with only half of his point.
I’ll stand by what I wrote; in terms of sociology the markets are separate and the trading functions are siloed and have different cultures. An M&A trader cannot go trade index options cannot trade CDOs. If there is any integration within investment banks, it is at the management level, through risk reporting.
In the remainder of his post (the part you didn’t quote) he talks about liquidity:
Why does the stock market drop 700 points when people are worried about credit markets? In no small part because hedge funds are bracing for mass extractions of capital. And so they are dumping their most liquid investments to have cash on hand.
How does the Modigliani-Miller theorem function when asset prices are a function of liquidity?
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