For all the well-intentioned discussion about taking a forward-looking approach to prevent the next financial crisis, we have been too focused on the rearview mirror.
A pattern of overreliance on the past to try to predict future problems has been going on for years. Recent incarnations include fixating on hedge funds after Long Term Capital Management imploded and on technology stocks after the Internet bubble burst. While we rightfully tried to address the causes of those problems, it was too late and we failed to prepare for the next emerging risk — an overheating housing market that would become yet another crisis to take on after the fact.
The question presented for policymakers today is not simply what caused the last crisis. It is what will cause the next one. We must finally implement reforms that reflect the empirical reality that we do not know.
It is encouraging that Senator Dodd's regulatory reform bill creates an Office of Financial Research to plug the glaring holes in forward-looking data collection and analysis, but we must do more to combat dangerous trends in the financial markets.
The military monitors emerging risks worldwide and plots out scenarios of responses and preemptive actions. We need a financial war-gaming center led by diverse thought leaders from the private sector, think tanks and academia that reports to but is not made up of financial policymakers and regulators.
Such a center would provide an independent perspective to data collected by regulators and by an Office of Financial Research. It must translate the information into an action plan that lays out possible responses and highlights gaps in regulation, with a sole focus on long-term concerns. This analysis would help the market adjust before any action is needed and would help the systemic-risk regulator.
A war-gaming center's first mission would be to model scenarios based on a broad horizontal review of potential market risks. It must pay special attention to risks that could give rise to high-impact events, including those with low probability, such as "black swans." Risks that deserve particular monitoring include rapidly rising asset prices, very high leverage, fiscal and monetary imbalances, financial infrastructure failures and extensive dependence on financial modeling. The beginning of shifts in these areas can reflect new economic realities driven by technology, structural forces or other reasons. But changes can also reflect bubbles and risky imbalances, which should be the primary point of focus.
Its second mission would be to identify risks of regulatory failure, including gaps in oversight among U.S. agencies and globally, as well as instances of regulatory capture. Getting the right perspective on regulatory risk requires appropriate distance, and promptly identifying cracks in supervision can fortify our defenses against emerging threats.
Finally, the center would lay out options for policymakers, regulators and market participants to respond to risks emerging in the financial markets. These options would be based on independent and forward-looking analysis that counters pro-cyclical thinking and other types of herd mentality. Debunking conventional wisdom is never easy or popular, as the wide acceptance of the "we needed to dance to the music" explanation of the housing bubble conveys. However, armed with impartial analysis and a call to action, all stakeholders — government and industry alike — would be more empowered to address looming problems before it is too late. Ideally, industry would self-correct using this enhanced information and eliminate the need for government intervention.
It's impossible to make fully accurate predictions about the likelihood of future events, especially rare and potentially catastrophic ones. But that isn't the goal. The goal is to be aware and think creatively, with the best information available, about the range of developing risks and consider solutions well in advance.