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Complexity and transparency in finance

January 29, 2012

The blog interfluidity, written by Steve Randy Waldman, posted a while back on opacity and complexity in the financial system, arguing that it is opacity and the resulting lack of understanding of risk that makes the financial system work.

Although I like a lot of what this guy writes, I don’t agree with his logic. First, he uses the idea of equilibrium from economics, which I simply don’t trust, and second, his basic assumption is that people need to not have complete information to be optimistic. But that’s simply not true: people are known to be optimistic about things that have complete clarity, like the lottery. In other words, it’s not opacity that makes finance work, it’s human nature, and we don’t need any fancy math to explain that.

Partly in response to this idea, I wrote this post on how people in the financial system make money from information they know but you don’t.

But then Steve wrote a follow-up post which I really enjoy and has a lot of interesting ideas, and I want to address some of them today. Again he assumes that we don’t want a transparent financial system because it would prevent people from buying in to it. I’d just like to argue a bit more against this before going on.

In a p.s. to the follow-up post Steve defines transparency in terms of risks. But as anyone knows who has worked in finance, transparency is broadly understood to mean that the data is available. This could be data about who bought what for how much money, or it could refer to the data of which mortgages are bundled in which CDO’s, and whose houses those refer to and what is the credit score of the mortgagees, or all of the above. Let’s just say all of the above, say we have all the data we could legally ask for about everything on the market.

That’s still not a risk model. In fact, making good risk models from so much data is really hard, and is partly why the ratings agencies existed, so that people could outsource this work. Of course it turns out those guys sucked at it too.

My point is this: a transparent system is at best a system that gives you the raw ingredients to allow you to cook up some risk soup, but it’s left up to you to do so. Every person does this differently, and most people are optimistic about both the measurement of risk and the chances of something bad happening to them (see AIG for a great example of this).

I conclude from this that transparency is a goal we should not be afraid of, because first of all it won’t be all that useful unless people have excellent modeling skills, second of all because no two firms will agree on the risks, and third of all we are so far from transparent right now that it’s laughable to be afraid of such an unlikely scenario.

Going on to the second post of Steve now, he has some good points about how we should handle the very dysfunctional and very opaque current financial system. First, he talks about the relationship between bankers and regulators and argues for strong regulation. The incentives for bankers to make things opaque are large, and the payoffs huge. This creates an incentive for bankers to essentially bribe regulators and to share in the proceeds, which in turn creates an incentive for the regulators to actually encourage opacity, since it makes it easier for them to claim they were trying to do their job but things got too complicated. This sounds like a pretty good explanation for the current problems to me, by the way. He then goes on:

… I think that high quality financial regulation is very, very difficult to provide and maintain. But for as long as we are stuck with opaque finance, we have to work at it. There are some pretty obvious things we should be doing. It is much easier for regulators to supervise and hold to account smaller, simpler banks than huge, interconnected behemoths. Banks should not be permitted to arrange themselves in ways that are opaque to regulators, and where the boundary between legitimate and illegitimate behavior is fuzzy, regulators should err on the side of conservatism. “Shadow banking” must either be made regulable, or else prohibited. Outright fraud should be aggressively sought, and when found aggressively pursued. Opaque finance is by its nature “criminogenic”, to use Bill Black’s appropriate term. We need some disinfectant to stand-in for the missing sunlight. But it’s hard to get right. If regulation will be very intensive, we need regulators who are themselves good capital allocators, who are capable of designing incentives that discriminate between high-quality investment and cost-shifting gambles. If all we get is “tough” regulation that makes it frightening for intermediaries to accept even productive risks, the whole purpose of opaque finance will be thwarted. Capital mobilized in bulk from the general public will be stalled one level up, and we won’t get the continuous investment-at-scale that opaque finance is supposed to engender. “Good” opaque finance is fragile and difficult to maintain, but we haven’t invented an alternative.

I agree with everything he said here. We need strong and smart regulators, and we need to see regulation in every part of finance. Why is this so hard? Because of the vested interests of the people in control of the system now – they’ve even invented a kind of moral philosophy around why they should be allowed to legally rape and plunder the economy. As he explains:

I think we need to pay a great deal more attention to culture and ideology. Part of what has made opaque finance particularly destructive is a culture, in banking and other elite professions, that conflates self-interest and virtue. “What the market will bear” is not a sufficient statistic for ones social contribution. Sometimes virtue and pay are inversely correlated. Really! People have always been greedy, but bankers have sometimes understood that they are entrusted with other people’s wealth, and that this fact imposes obligations as well as opportunities. That this wealth is coaxed deceptively into their care ought increase the standard to which they hold themselves. If stolen resources are placed into your hands, you have a duty to steward those resources carefully until they can be returned to their owners, even if there are other uses you would find more remunerative. Bankers’ adversarial view of regulation, their clear delight in treating legal constraint as an obstacle to overcome rather than a standard to aspire to, is perverse. Yes, bankers are in the business of mobilizing capital, but they are also in the business of regulating the allocation of capital. That’s right: bankers themselves are regulators, it is a core part of their job that should be central to their culture. Obviously, one cannot create culture by fiat. The big meanie in me can’t help but point out that what you can do by fiat is dismember organizations with clearly deficient cultures.

Hear, hear! But how?

Categories: finance
  1. PragmaticLibertarian
    January 29, 2012 at 12:15 pm | #1

    You need highly simple regulation, which sets limits on leverage, size and interlinks for financial institutions which provide credit. Unfortunately, doing this seriously would require massive further deleveraging which we can’t afford.

  2. vbounded
    January 29, 2012 at 4:46 pm | #2

    Unless one pays regulators like plaintiff lawyers, one isn’t going to get regulators that are qualified and incented to regulate the boys. The politicians aren’t willing to stomach paying regulators that much. So if that’s off the table, you are left with are restricting instituions so they are small and simple enough that the regulators are comfortable running them through bankruptcy. This incents the credit and stock market to police the banks, since investors will actually lose money. You can add the wrinkles of personal liability for executives and directors with a prohibition on indemnification; Brazil does stuff like this. You can also add the wrinkle of making shareholders liable for up to 100% of the par value of their shares in the bank; before the FDIC, the US used to do stuff like this.

  3. January 29, 2012 at 5:00 pm | #3

    Great blog and good question.
    Risk opacity and data opacity/ information asymmetry are too often conflated. Finance has become an adversarial game rather than collaborative process. When the Real Economy pays the piper but dances to the financial economy’s tune, things have gone badly wrong.

  4. Nichol
    January 31, 2012 at 11:58 am | #4

    How much would serious regulation need to cost? Can banks caught breaking the rules be fined enough to cover a good part of the cost of investigating?

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