Multiple Regulatory Agencies

by: Rortybomb

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 underlining.” 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.