It is beginning to look as though we may get serious about reforming systemic regulation. The Group of 20 leaders have met, Congress is holding hearings, and the think tanks are gearing up.
But the debate needs to get a little broader. So far the ideas have focused on agency scope, consolidation, and some piecemeal repairs to Basel II to deal with cyclicality, liquidity, and interest rates. The danger is that these fixes will add up to nothing but fighting the last war.
Let's step back for a minute and take a more fundamental look at the financial system. It has evolved very rapidly since the 1970s, powered by technology, math, globalization, and money. It has grown in complexity and sophistication, and companies have become much more tightly interlinked.
New products like credit-default swaps and subprime mortgages proliferated. New customers were drawn in. Large institutions grew larger. Hedge and private-equity funds came on the scene. New structures and businesses like Internet banking and special-purpose vehicles emerged. The interlinked institutions, practices, and products evolved in unforeseen ways, both good and bad.
This year change shuddered to a halt. Hopefully, this is temporary. If so, we should be thinking about how to regulate the evolution when it resumes.
Thinking of the financial system as a series of co-evolving populations has some radical implications.
First of all, having a healthy system requires healthy populations, which are not the same thing as healthy individuals. That may seem counterintuitive, but the fact is that in nature, healthy populations stay healthy when weaker individuals die off and make way for stronger ones.
Translated into the financial context, it means no institution should ever be "too big to fail." Regulators should therefore avoid the formation of mega-institutions and look for ways to encourage the emergence of value from the break-up of existing ones. And they should foster new entrants into financial services to renew the sector.
A second implication is that population diversity is a good idea. When unpredictable things happen, diversity increases the likelihood that at least some members of the population will survive and prosper. Applied to financial services, that means that encouraging conformity, however clever the model being advocated, is counterproductive.
If Basel II is ramped up as a consequence of this crisis and becomes a global blueprint for all financial institutions, ultimately it will make the sector much more inflexible and vulnerable when something happens that the Basel engineers did not anticipate.
A third implication is that transparency — cheap and dependable information — is hugely valuable. That is not radical; the traditional view is that transparency promotes efficient and fair markets, protecting consumers and investors. But it is important, too, for evolution, which works through search, innovation, an of these mechanisms.
Evolutionary scientists often talk about the "fitness landscape," where populations are more fit on the hills and less fit in the valleys. Evolution is a population trek across this landscape. According to that view, the job of systemic regulation is to look across the landscape, encourage the population to stay on the ridges that go from peak to peak, and steer it clear of any nasty-looking precipices.
Macro-prudential regulation should be less about setting rules and forcing compliance and more about looking ahead — less of the policeman and more of the farsighted shepherd.
So how should regulators become more farsighted? In the past 30 years great progress has been made in understanding complex, interconnected systems. Scientists in fields like meteorology, seismography, and biology have shifted from thinking about static systems to evolving ones. Advanced analytical techniques like agent simulation and nested modeling have been developed and applied. These methods produce complex and rigorous scenarios that help scientists anticipate how events unfold. They can penetrate to second- and third-order changes and identify future forks in the road.
When applied to financial systems, these methods may help us see the precipices in time to steer the system on to a less dangerous path. It may take a while for good scenario analysis to help regulators figure out exactly what to look for. In the meantime, a practical "rule of three" would be to look out for three things.
- Shifting standards of behavior, such as underwriting or leverage.
- Changing composition of populations such as borrowers, products, lenders, deposit-takers, traders, and investors
- Disproportionate rates of change, such as rapid, profitable growth of new products or the rise in home prices in relation to rental costs, the gross national product, and household incomes.
Then what should regulators do? When things get sufficiently out of kilter in these three dimensions in any part of the system, regulators should "tune" it — much as the macro-economy is tuned with monetary policy. They should adjust institutional capital — for size, systemic centrality, the business cycle, and sources of risk. They should address leveraging, reserving, and margins. They should alter incentives for institutional and individual risk-taker, and they should address the cost of liquidity.Regulators should get organized around simulation, monitoring, and tuning of the financial system. They should focus on having a healthy, diverse system in which incentives encourage socially desirable outcomes. They should simulate the system through wide-ranging, disciplined scenarios, so they can understand the medium- and long-term implications of emergent trends. And they should tune capital and leverage to steer the system away from trouble. This is an attainable agenda.
