Financial Regulation Is No Magic Bullet

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“man's eye view of mansion” by Aditya Vyas on Unsplash

The cries for more regulation in the financial system are never silent. To many, “more regulation” seems a sensible, obvious thing to demand. If something is out-of-hand, restrict it! Unfortunately, things are not this simple. A patching up of the holes won’t be sufficient. What we are faced with today is an opaque financial system, confoundingly complex, and dangerously intertwined.

Many people felt the pain quite personally in 2008 and were enlightened to the unsavory reality that the narrative of the stable, prosperous financial infrastructure had been something of a myth all along.

A slew of regulatory measures have been applied since that fateful year, yet we truly are not any more protected from another such crisis. If anything, we are almost certainly in worse shape. It is quite easy to lament an apparent dearth of regulations and to verbally clamor for more because this seems the most logical, straightforward way to curb so-called excesses and risk in the financial sector. Make no mistake however: An onslaught of regulations will not fix the underlying flaws of the financial system. The regulatory plea is a simplistic antidote.

Here’s an analogy: Everyone knows that if you impose too many rules on a child, they will rebel. They will sense a shadow that is too overbearing and work to outrun it. If you want your child to turn out properly, then it would behoove you as a wise, judicious parent to give them a handful of solid, soundly enforced rules that make sense. After all, children hunger for structure and to give them no rules at all would be a profound disservice. Should you, as a parent, become too tyrannical and impinge an obvious surfeit of rules on your child — rules that are perhaps slapped on somewhat arbitrarily and prove to be ineffectual and tedious — then respect for (and adherence to) these rules will likely be difficult to produce. Too many rules and your subjects will rebel. Likewise, a cascading list of regulations will not manufacture uncomplicated compliance.

It’s a very human thing to shake off needless rules and overabundant rules; after all, we don’t take kindly to feeling subjugated and we are also expedient creatures that are more inclined towards pragmatism than we are to obedience. That’s just the truth.

Herein lies the danger of copious rules and regulations: Humans (and organizations, made up of humans) are not mechanistic machines and thus, control doesn’t automatically correlate to the desired effects. That deserves to be recognized…furthermore, it needs to be. Some consideration should be given for the perfectly human desire to capitalize on available options. No one’s going to bend unthinkingly to a score of rules if they don’t have to.

Regulatory arbitrage is evidence of just this appetite for loopholes. Arbitrage — or taking advantage of differing prices of assets in different markets or forms — has become resoundingly popular. Its instruments are things like credit default swaps, CDOs, and other sketchy derivatives which are somewhat modern inventions — complex financial products that all had their origins in regulatory arbitrage.

When regulations were superficially imposed on the markets, the institutions contained therein did not cower and consent. No, they got clever and crafty (and this is to be expected; this is human rationality, not deviance to be expressly condemned) and simply sought different avenues. The governmental agencies were lobbing new restrictions at them, some of them capricious and intricate. So what did the finance people do? They ducked, of course. What did you think they would do? And thus, the practices that were sought to be regulated against certainly weren’t given up and walked away from in dejection, but were simply taken underground in a sense.

Derivatives flourished in this new environment, successfully skirting new crops of regulations. Derivatives are a means of hedging risk, essentially. Derivatives do, in fact, have a history of having been maligned for their shady nature and questionable ethics, so that’s nothing new. However, I don’t think there’s anything inherently sinister about derivatives. What should be more pressing is the question of why they came about, and in such great volumes. They were incentivized. They were the consequence, the natural outgrowth, of something.

In recent decades, derivatives have absolutely exploded in quantity. The financial sphere is rife with them, swimming in them. What is potentially dangerous about derivatives is their seeming endlessness. Multiple rounds of securitization can be partaken in. It’s a seductively unlimited endeavor.

Before long, a single security can produce a pile of derivatives that are sold, and then perhaps tranced, and then sold again, and so on. Their powers of multiplication are poorly contended with — or at least, few attempt to grapple with the realities. (Another danger of these instruments is that true credit strength progressively becomes indeterminate and vague.)

It is true that the financial system will always be too complex and impossible for any one person to get a conclusive grasp on. But we’ve created a monster! All those stately, premier investment banks of Wall Street? They have no idea what they’re doing. They don’t have the full picture. They might valiantly try, but the truth is that no one has the entire scope. No one is sure where exactly all the risk lies — despite all the extremely arithmetical efforts to accomplish this. At best, there’s a lot of stumbling around in the dark, though of course there is incentives not to admit this. 21st century America, it should be noted, has embraced risk with a truly voracious appetite.

I find it interesting that if you would turn the clock back a century or so, the most speculative investment that somebody could snatch up was a stock. Stocks seem pretty tame and pedestrian nowadays compared to the assortment of other options, glittering as they are with the promise of high returns and all tarted up with statistical polish. As previously mentioned, there is little evidence to suggest that the complex financial instruments debuted in the past few decades have contributed to overall prosperity, improved productivity, or otherwise added to the economy.

It’s a bit of a myth — and a leap of belief that many take, almost unknowingly — that an ever-increasing, ever-more-complex financial system is something to celebrate. Complexity within the financial system is incorrectly seen as a perfectly natural and inevitable progression, as if we genuinely need things to be more complex, as if we’re becoming more sophisticated and necessarily more “evolved” as a consequence. And we shouldn’t assume that! That we have a grip on the unprecedented scale of the current system is a little utopian and a little arrogantly misguided, no?

Historically speaking, with more complexity usually came more risk, more obscurity, more artificiality, and more market manipulation.

At is core, finance is not a creative industry. It’s a service industry. Keep in mind that a well-functioning financial system is very necessary, but it need only facilitate several basic aims. Speculation will always be one of them, but the gargantuan volumes of trading in shaky derivatives markets that occur nowadays are needless, excessive, and suspect.

If you’d go back a century, you’d be hard-pressed to find the hunger for risk that is present today. Banking culture was probably more conservative and yet this was because they had reputations to uphold. If a particular financial move felt too risky, it simply wasn’t engaged in most of the time. Commonsensical behavior was easier to come by and a natural, healthy caution was exercised.

The modern counterparts of these old bankers are a little drunk on financialization. And they might contend that now we have sophisticated risk models and that staffing firms with all these brilliant actuarial minds has made clean and tidy work of essentially extracting most of the risk from the system. But this is a rather bold idea.

They also argue that taking on risks and “diversifying them across a broad area” somehow makes the finance sector more resilient. If anything, I would think such diversification would do little to decrease risk precisely because the world economy is so tightly coupled around central banks and no one can quite locate all the risk in the system, ergo, diversification cannot be seen as a solid protection against high risks. Seen this way, diversification is little but rhetorical flourish in some respects — a persuasive defense with a reasonable sheen to it.

Humans have an innate desire to flirt with risk and we like to gamble (or at least, we’d like the freedom to gamble). And there have been prohibitions attempted at such wagering in the financial markets in the form of cumbersome regulations. But such attempts are not very successful, much like the prohibition of alcohol in the 1920s was very unsuccessful and simply led to underground operations and black markets. This is a decent parallel to how superficial financial regulation won’t fix the underlying fundamental problems.

You can’t throw several thousand road-block signs out there and act alarmed when people start digging tunnels. Yet speculation itself isn’t inherently bad. It is a freedom that it is good to allow people to have, especially when taking into account basic human nature. But with freedom comes responsibility and the possibility of danger.

However, the virtue of responsibility is notably absent from the financial arena. There’s a carelessness to a lot of the action contained therein, a frantic tossing about of transactions at blindingly fast paces. The accounting is often shoddy or guesswork or alternately, falsely optimistic — not to mention, usually mark-to-market. The tentacles of government are all entangled in and around the whole thing.

So let’s not pretend that the financial system is some villainous creature run amok that would discredit the integrity of free market theory. Let’s not pretend that the “sensible, wise” government simply can’t corral this beast. That’s not what’s happening. Government intervention in the markets and the financial system as a whole has a way of supplanting responsibility from the system. Moral hazard thrives in this environment wherein everyone is compelled to act with more short-sightedness.

If you have a free market that imposes the honest weight of risk on the parties concerned, then responsibility is clearly present and is not something that can be thusly outmaneuvered. There’s less of a game to play if you kick the government out because then you have to contend with reality. Suddenly, reputations are not just artificially-constructed appearances and must be based on something solid, fundamental, believable.

In some ways, this new era of financialization is just an era of irresponsible gambling with other people’s money (due to rampant securitization) under the guise of, “Oh, it’s inevitable; the markets are going to become more complex because it is just progress.” And you can’t approach “irresponsible gambling with other people’s money” with an impinging array of restrictions and regulations. You confront it with demanding responsibility where responsibility and personal liability is due. You confront it by removing artifice and insisting on reality and clarity.

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Writer of economics, psychology, and lots in between.

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