Thursday, March 11, 2010

Why a National Institute of Finance Will Fall Short

It seems like a good idea. Create a separate federal agency to monitor systemic risk exposure in financial markets. Require the major players to report trading data to this agency that they withhold from the public, so that a better picture can be drawn. Require this agency, the National Institute of Finance, to issue periodic reports, alerting the rest of us to developments that pose a risk of widespread disruption.

Certainly it’s better than nothing, which happens to be the status quo. (In theory the Fed should be doing this already, but in practice they have no interest.) If we had had such an Institute five years ago, perhaps they would have added their voice to those in the economics and finance professions who said leverage was careening out of control.


But the approach embodied in the bill currently gestating in the Senate Banking Committee is built on a compromise that puts sound risk management, well, at risk. It goes like this:

As we have come to realize, a large part of the instability of global finance resulted from the pyramiding of increasingly complex financial instruments. There was an arms race between quants to develop evermore devious contracts, whose terms would be triggered by intricate combinations of market outcomes. Firms invested heavily in these strategies, and algorithms and instruments were jealously guarded as intellectual property. Trades were conducted in private, with no central registry, much less a public reporting of their terms. The terrible truth we learned in 2008 is that no one could possibly know how the system as a whole would respond to the seismic shocks of bubble-bursting, illiquidity and default. We waited breathlessly, week after week, to see how the unraveling would take place: real-time, real-life enactment was the only way the structural properties would be revealed.

Would an Institute of Finance be able to figure out the stability and dynamics of the system before it collapses? It depends on the information they are able to get. If they have access only to the data that are already publicly available, they’ll be in the same boat that independent analysts are in already. And true enough, many of us were able to see aspects of this crisis in advance, and we sounded the alarms. It is also true, however, that no one saw the entire process (we saw chunks of it), and our voices were drowned out by those who thought our fears were overblown. If the Finance Institute becomes one more such voice in the wilderness, will it make a difference?

But the discussions under way have broached the possibility that Institute staff would receive more reporting data than is currently made public, under a guarantee of confidentiality. This could make their pronouncements more credible and influential. Yet there are two shortcomings. First, it can be assumed that the Institute will not get all the trading details, only some. There will be negotiations with the banks, equity funds and other players, and deals will be cut. Even so, you can be sure that the details of some trades, perhaps the most essential for those who want to analyze the health of the system, will be withheld precisely because they are both profitable and risky, and participants want to milk them to the end. Second, it is the unfathomable complexity of interacting algorithms that is at issue. The players can’t figure it out, and, even with piles of trading data, it is likely that civil servants will be stumped too.

There is a much simpler, more effective solution. Require all contracts to be traded on exchanges, and all their terms to be reported publicly. (Perhaps the identity of the parties could be confidential; this is all.) There would be no intellectual property in financial instruments, and no incentive to devise ultra-complex variations. Algorithms used internally by investors to decide what positions to take would still be proprietary, of course, but these pose few systemic challenges. Contracts would standardize in convenient ways, and the public as a whole would be in a position to assess where the system is heading. You could be your own Institute of Finance.

What is the downside? Less profit opportunity in finance, a more routine, predictable, boring role for the financial sector, and fewer job openings for math jocks on Wall St. That’s probably enough to kill the idea politically, but from a public point of view, this down is all up, up, up.


Shag from Brookline said...

I used to get bored at house parties when conversations would center on how guests' home values were increasing, as if such increases reflected their great investment wisdon. So I stopped going - until recently, after the bubble popped. Not so surprisingly, I do not hear guests complaining about how their homes are decreasing in value. Perhaps this silence is a means of protecting their great investment wisdom from challenge. Too many of us went along for the ride, hoping no one would rain on our parade. Perhaps if the smart guys on Wall Street had been reined in, we'd all be better off. But some of us are still ahead of where we were before the bubble was created. Unfortunately, some paid top dollar as the bubble expanded. Is this how the "free market" should work?

Kaleberg said...

You have some good ideas, but it might make sense to restore the old firewall between finance and business. For one thing, the Fed should open a retail door for individuals and small businesses (aside from farmers who already such a door). That way individuals and businesses can get credit even when finance collapses. It's not as if finance needs business anymore except as something to bet on. I have nothing against horse racing, but most of us rely on horse-free transportation. We should also have finance free banking.

Kaleberg said...

BTW, Shag, where I live, a lot of people used to complain about rising home prices, because that meant higher property taxes. Now, they're in a great mood with the valuation collapse, and some friends are watching the comps to appeal for even further cuts. It's not as if you can borrow against the value of your home, so you might as well carry it as cheaply as you can.

(Then again, out here, unlike Brookline, the property boom was no great shakes.)

Shag from Brookline said...

With the boom in the Northeast in home values, many homeowners would frequently refinance to pull out cash tax free, using their homes as ATMs, so long as they had equity. Many such homeowners felt that home values would continue to increase, so why save, when it was so easy to refinance? When we bought our home, we needed it for raising four children, then all under four years of age. The market rise was far down the road after 1973. We paid off our mortgage and never refinanced, so we didn't get into the real estate as ATM trap. But many baby boomers were snared. We've have heavy rains along the Northeast coast the past several days such that it's not only some mortgages that are under water.

As for tax abatements, the risk is that if you plan to sell your home, it might become a negative. But there surely has been a property tax bubble here in the Northeast; from 1973 to date our property taxes have increased tenfold. (I had a good income in 1973 and following years, but not tenfold increases.) Query whether such increases would have come about but for the boom? (I doubt it.)