Streetwise Professor

July 18, 2009

An Inbreeding Theory of the Last Financial Crisis–and the Next One

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 12:31 pm

Isolated and inbred populations lack genetic and immunological diversity, making them more susceptible to genetic illness and more vulnerable to epidemics caused by new bacteria or viruses.  That is, this limited diversity increases systemic risk; the population is systemically more vulnerable to shocks.  Europeans died from smallpox, but due to the effects of accumulated exposure had enough immunological diversity to limit its impact: in contrast, it virtually wiped out Amerind populations.

This came to mind when reading Jeffrey Friedman’s excellent “A Crisis of Politics, Not Economics: Complexity, Ignorance, and Policy Failure,” an introduction to a Critical Review special issue on the financial crisis.  In this essay, Friedman notes that proscriptive laws and regulations impose constraints that increase the homogeneity of behavior.  That is, systems with fewer such laws and regulations exhibit a greater diversity of behavior.  Moreover, the laws and regulations are predicated on a worldview, and if that worldview is seriously flawed, the resulting homogeneity can be particularly vulnerable to shocks, unintended consequences, or just the perverse results arising from the inherent contradictions in the worldview.  But homogeneity increases systemic risk even abstracting from the possibility for cognitive error.

I’ll let Friedman speak for himself:

By its very nature as a law, a regulation is imposed on every market participant.  This means that even if the regulation takes the form of an inducement rather than a prohibition, it has a homogenizing systemic effect.  The whole point of regulation is to get market participants, on the whole, to behave differently than they otherwise would.  But this means that every regulation imposes one opinion–the regulator’s–on all market participants, even if only by advantaging those who go along with it.

. . . .

The process of competition, like the process of biological evolution, need not have some master note-taker standing above the process and learning its lessons if the process is to work.  This is crucial because such a synoptic perceptor, being human (hence fallible), could not be relied on to learn the right lessons. . . . [T]he regulator is required to be a synoptic perceptor, codifying what he thinks leads to market failure.  If he errs in this analysis, the mistake is imposed on everyone else.

. . . .

But where there are many power centers, as in a capitalist economy, there is more chance of heterogeneity than when there is a single regulator of all the participants.  At worst, in the limit case of complete market homogeneity, unregulated capitalism would be no worse than regulated capitalism, since a theory that is homogeneously accepted by all market participants at that time and place is likely to be accepted by the regulators of that time and place, too.

Just so.  And here’s my favorite:

Geithner may be right or he may be wrong.  He, too, is human, as he demonstrated in his years at the New York Fed when he did nothing to prevent the crisis.  But as much as he may recognize his fallibility, his role as regulator compels him to act as if he were omniscient.

This is all so pertinent in the current setting.  Geithner et al believe–or act as if they believe–that they KNOW the causes of the crisis, and they KNOW how to address them.  Their preferred solution is to impose a set of regulations that will sharply constrain market participants’ behaviors, and induce and/or compel them to utilize a very sharply constrained set of institutions to consummate financial transactions.  They want to compel standardization of financial contracts; compel the use of standardized clearing mechanisms; compel the use of standardized trading mechanisms.  They want to greatly homogenize–“simplify”–the markets for trading financial risks.

But, as Friedman notes, and the inbreeding analogy suggests, such simplicity can create systemic risks of its own.  The resulting lack of diversity means that shocks to which these institutions are acutely vulnerable will lead to a systemic crisis.  And remember that every institution is unduly vulnerable to some shocks, and it is highly unlikely that a particular set of institutions is more robust to all shocks than any other set.  Even if Geithner et al are right that their favored institutions are more resilient to most shocks than the incumbent institutions–a contention that I dispute–the lack of diversity means that when the kind of shock to which these institutions are acutely vulnerable arises, the effects will be systemic and devastating.  And if–as I believe the case–Geithner et al’s analysis is incredibly wrong, we have the worst of both worlds.  We will have created a monoculture in which risks are systemic due to excessive homogeneity, and one that is fundamentally defective because it is predicated on a serious cognitive and analytical error, increasing the likelihood of a system-threatening shock.

Friedman also reprises a theme that I have echoed often on SWP: “The greatest lesson of the Great Depression is that we learned the wrong lessons from the Great Depression.”  Citing the work of Gary Gorton, and the chapter by Bhide in the Critical Review special issue, Friedman notes that how a US-centric view of banking panics led to a failure to understand the role of US laws and regulations in causing them to occur disproportionately in America.  And this misdiagnosis begat deposit insurance.  And deposit insurance begat reserve requirements . . .

And reserve requirements (in large part) begat the financial crisis.  Here Friedman provides a convincing case for something that I’ve believed to be a major cause of the financial crisis: the Basel bank capital rules.  A key factor that distinguishes this financial crisis from other collapses in securities prices (e.g., the Dot-com implosion) is that banks had invested heavily in mortgage backed securities, and asset backed and CDO securities derived from those.  The housing price collapse caused the prices of these instruments to fall, precipitating the crisis because banks and other financial intermediaries had loaded up on them.

But why had they loaded up?  The Basel rules–combined with the institutionalization of credit ratings, another factor Friedman emphasizes–gave preferential capital treatment to these instruments.  And since all banks were subject to the same capital requirements, with a few exceptions (e.g., J.P. Morgan), they nearly uniformly took exposure to the same risk.  Thus, whereas the dot-com burst was not systemic, the housing and subprime burst was.

This is particularly worrisome, because the conventional wisdom (not surprisingly the mantra of Geithner et al) is that tightened capital requirements will be a pillar of regulatory changes.  Indeed, they are seen as an all-purpose tool: Geithner’s “reform” plan proposes to use higher capital charges on OTC derivatives in order to channel more trading onto clearing and exchange platforms–i.e., the proposed financial monoculture.

“TIghter capital requirements” seems like a no-brainer, but the foregoing makes it very, very clear that the details are incredibly important.  They can induce excessive homogeneity in behavior that increases systemic risk.

In sum, “simplified” and “standardized” are not synonymous with “systemically robust.”  Indeed, the exact opposite is likely to be the case.  I believe that there is a strong argument to be made that the diversity of institutions in derivatives markets, e.g., the co-existence of exchanges, cleared OTC, and non-cleared OTC, is a discriminating match between trading mechanisms, instruments, and market participants.  Maybe I’m wrong.  But I am highly, highly confident that this more diversified set of institutions is more systemically robust than the kind of monoculture that the administration and leading legislators are hell-bent on creating, even were I not to believe that their diagnosis of the current crisis and its causes were incorrect.  For even if against the astronomical odds they were right about this, they cannot assume that all crises are alike, akin to Tolstoy’s happy families.  Indeed, they are instead like Tolstoy’s unhappy families–unhappy in their own way.  By creating an institutional monoculture they are merely legislating a particular systemic vulnerability that will be the root of the next 21st century financial crisis.

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  1. […] excellent Richard Fernandez at Belmont Club echoes a theme that I addressed in my post on the Critical Review’s special issue on the financial crisis, to wit, how government regulation tends to impose a variance-reducing standardization that by […]

    Pingback by Streetwise Professor » Excellent Observations From a Couple of My Faves — October 26, 2009 @ 8:47 pm

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