Saturday, October 22, 2011

You’re Doing It Wrong

And he sampled the time-winds, sensing the turmoil, the storm nexus that now focused on this moment place. Even the faint gaps were closed now. Here was the unborn jihad, he knew. Here was the race consciousness that he had known once as his own terrible purpose. Here was reason enough for a Kwisatz Haderach or a Lisan al-Gaib or even the halting schemes of the Bene Gesserit. The race of humans had felt its own dormancy, sensed itself grown stale and knew now only the need to experience turmoil in which the genes would mingle and the strong new mixtures survive. All humans were alive as an unconscious single organism in this moment, experiencing a kind of sexual heat that could override any barrier.

— Frank Herbert, Dune

There is something deeply wrong with this country, O Dearly Beloved.

We seem to have painted ourselves into a corner from which we cannot escape. Grass roots movements as diverse as the Tea Party and Occupy Wall Street implicitly recognize this fact and have sprung up in response to it. People from a broad spectrum of Americans less committed, strident, and/or crazy than these activists have shown themselves to be largely sympathetic to their discontent. Depending on where you stand, and which hobby horse you happen to be riding at the moment, our predicament can appear in any number of guises: corrupt crony capitalism, grossly overbearing and inefficient government, a broken financial system deeply riddled with self-interest, or a society-wide breakdown of personal responsibility and uprightness.1 Our so-called leaders—the very men and women we elected to get us out of this mess—cannot seem to tie their own shoes, much less offer a solution or even a direction in which to begin marching. Politicians are the only group of individuals more despised and less respected than investment bankers nowadays. Believe you me, as one of the latter, I can attest that that is a pretty damning indictment.

A common feature of many of our ills is the unmanageable size and complexity of our institutions and practices. This is certainly true of the government itself, our regulatory and tax systems, and our financial system. Part of this problem—size—may be an ineluctable outgrowth of the sheer mass of our nation and economy. One can certainly argue that size itself can lead to myriad ills. One can credibly entertain the notion that perhaps governing over 300 million people and managing a $14 trillion economy may be beyond the collective ability of any group of people, however intelligent or dedicated. Size certainly seems to have flummoxed the captains of my industry and their regulators in the most recent crisis.

But the bigger culprit, in my opinion, is complexity. Complexity makes things more difficult to manage. Complexity imposes substantial extrinsic costs, which must be expended simply to deal with complexity itself, apart from any underlying issues at hand. Complexity increases uncertainty, introduces distortions, and encourages mistakes. Want examples? Just think of the tax code, or the current state of the global financial system.

And yet we cannot seem to hit the rewind button on complexity. The latest example of this is the appalling complexification that the Volcker Rule—which was included in the Dodd-Frank financial reform act in order to prevent risky proprietary trading by government-backed depositary institutions—has undergone at the hands of those drafting the final regulations. The Beltway rulemaking sausage factory has turned what was a three-page initial proposal and a ten-page section in Dodd-Frank into a 300-page monster. A monster which, by all accounts, nobody loves.

Now, without a doubt a substantial portion of blame for this complexification can be laid squarely at the feet of industry lobbyists and banks themselves. They were the ones who lobbied so expensively and extensively for exemptions and extensions. They were the ones who no doubt insisted that the simple premise of the Volcker Rule was too simplistic to impose on a complex, interconnected industry without causing unacceptably expensive and potentially dangerous disruptions to established business practices.2 I’m sure they offered all sorts of eminently reasonable objections to straightforward implementation of a separation between proprietary trading and depositary lending, while simultaneously missing or pretending not to understand that THAT IS THE VOLCKER RULE’S ENTIRE FUCKING POINT. That these dickwads and their hired guns were able to impose their will to neuter this piece of legislation you may credit to another virulent contagion in our polity: the pervasive and poisonous influence of corporate and individual money on politics and regulation.3, 4

* * *

But the more general contributor to this legislative abortion is a structural one. Too many (all?) of the people writing these rules—both on the regulatory side and the industry itself—are lawyers. And lawyers have strong professional and cognitive biases against simplicity when drafting rules, laws, contracts, or indeed any sort of document designed to govern behavior. In all such situations, it is lawyers’ job, objective, and desire to minimize interpretation. They do this because they want to forestall future disputes and potentially expensive litigation by exhaustively codifying behavioral rules and spelling them out under every conceivable circumstance. Since when have you not seen a lawyer sorely tempted to insert a “provided, however” phrase into the simplest contract? Yeah, me neither.

A charitable reader like yourself might understand this impulse as a natural outgrowth of the pervasively litigious culture in the United States. For whatever reason, this tendency to sue first and ask questions later has led to a preponderance of rule-based, as opposed to principle-based regulation in this country. Nevertheless, codifying a principle as clear and straightforward as the Volcker Rule into a 300-page cookbook of recipes for what is and is not allowed in the financial sector is a wrongheaded exercise in futility. For one thing, exactly no-one can possibly anticipate how the financial markets and their constituent banks will change over the forseeable future. The global financial system is just too dynamic, and the likelihood that a piece of regulation penned in 2011 will be able to effectively anticipate and regulate financial market developments over the next several years is simply ludicrous. Investment banks themselves don’t know what kind of opportunities and threats they will face—and hence what they’re actually going to be doing—next quarter, much less in 2012 or 2015. How can we expect a static document drafted by a bunch of underpaid, cover-your-ass government lawyers who couldn’t recognize a proprietary trading desk if they were sitting at it to do so?

Because of this, regulators must have the ability to flexibly interpret and respond to changing conditions in the financial markets and the businesses of their regulatees.5 The relentless, rapid evolution of finance requires that financial regulation be principle-based, not rule-based. Reformed quant Emanuel Derman makes the case persuasively that we cannot understand financial markets using rigidly codified models. If that is true, how, then, can we ever hope to regulate them with a framework based on rigid, over-codified rules?

No points for guessing: we can’t.

* * *

So what does that mean for the Volcker Rule and financial reform in general? Well, one might argue that the best solution is to scrap that overlawyered piece of toilet paper and go back to the author of the eponymous rule’s own suggestion:

“I’d write a much simpler bill. I’d love to see a four-page bill that bans proprietary trading and makes the board and chief executive responsible for compliance. And I’d have strong regulators. If the banks didn’t comply with the spirit of the bill, they’d go after them.”

Of course, this would be principle-based regulation. As Mr. Volcker points out, such a regulatory regime would require strong and well-informed regulators. I have made the same point, too many times to link to here, over and over in the past. Professor Derman is with me too. You would want ex-bankers, experienced in sales, trading, structured finance, and derivatives, who would work closely with regulated banks to monitor, understand, and control the changing nature of risks, activities, and opportunities in the markets. You would create performance incentives which completely insulate them from the results of their regulatees, and you would impose strict prohibitions on them returning to the industry before their active market and industry knowledge has gone stale.

Such regulation would demand close, realtime cooperation and consultation between regulators and industry participants. But if it is done properly, it should work out to everyone’s benefit. Regulators would get realtime information on risk exposures and market practices from their regulatees, and regulatees would receive realtime feedback and guidance from regulators on overall market developments and trends in risk management. Done properly, this model would not stifle innovation or profit-making. It would enhance it, while simultaneously reducing systemic risk and giving regulators early warning of developing threats to global financial security.

* * *

The Dodd-Frank legislation at over 2,000 pages is an abortion. The Volcker Rule at 300 pages is an abortion. They cannot succeed. If we cannot empower intelligent, experienced regulators to monitor and control the wholesale financial system using heuristic principles, we are fucked. Under the current financial regulatory system, and its proposed rules, we are all fucked. I will leave it to my Loyal and Long-Suffering Readers to decide whether that is a state of affairs which can be corrected. I suspect these pearls will be trampled like all the others into the muck of the pig wallow. Only time will tell.

In the meantime, we need to reinvent our rulemaking processes. Currently we make laws and regulations like oysters make pearls, except instead of starting with a tiny grain of sand and covering it with precious nacre, we start with a tiny pearl of sensible principles and cover it with layer upon layer of sand, grit, and detritus. This makes for ugly pearls, and lousy legislation.

When are we going to wake up?

Related reading:
Paul Kingsnorth, This economic collapse is a ‘crisis of bigness’ (The Guardian, September 25, 2011)
Grains of Sand (August 10, 2007)
James Stewart, Volcker Rule, Once Simple, Now Boggles (The New York Times, October 21, 2011)
Emanuel Derman, Maybe markets need more principles and less regulation (Reuters, October 21, 2011)

1 For the avoidance of doubt, just in case you do care, I believe all of these things to be true. In my opinion, we are in deep doo-doo, and I see no-one on the horizon with a shovel.
2 The premise behind these shenanigans is faulty. It is not the obligation of regulators to adapt, weaken, and modify regulations to minimize disruption to regulatees’ current business practices. It is the obligation of regulatees to modify their fucking business practices to comply with regulation. Jesus.
3 There is a part of me that hopes the Volcker Rule is implemented in its currently bastardized form so mega-banks will be forced to expend ridiculous amounts of shareholder money and management attention complying with the Frankenstein’s monster they have helped create. Karma can be a bitch.
4 As an aside, SCOTUS’s decision in Citizens United was an abortion of American jurisprudence. Just sayin’.
5 My focus throughout this piece is on regulation of the wholesale financial sector; that is, investment banks, commercial banks, and other entities which provide services to corporations, institutional investors, hedge funds, and other such non-retail customers. I have nothing to say about retail financial regulation, since that is neither my area of expertise nor my day-to-day concern. Perhaps more rule-based regulation makes sense for consumer finance, since I suspect that field is less changeable and dynamic than the wholesale sector. But I defer to others with better knowledge on that topic.

© 2011 The Epicurean Dealmaker. All rights reserved.