Complexity Theory and the Failure of Financial Reform: Part Two

Complexity Theory and the Failure of Financial Reform: Part Two
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In Part One of this essay, we mapped the tactile, political surface of financial reform - focusing on the ideas and behaviors of individual political actors - notably Representatives Spencer Bachus and Barney Frank - in relation to passage and implementation of the Volcker Rule, a central provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act. In Part Two, we suggest that none of this matters.

Barking Dogs and Fat Tails

While Spencer Bachus is perhaps more annoying than Barney Frank, and certainly less amusing than Barney Frank, the differences between him and Barney Frank do not alter a simple reality - politicians are mostly interchangeable. It doesn't matter if one is dealing with Barney Frank or Spencer Bachus. By definition, both are barking dogs. They are elected officials who vocalize in order to get attention and to be fed. The problem with paying too much attention to barking dogs is that we may ignore the vigor with which they are wagged by fat tails over which they have no control.

In The Black Swan, Nassim Taleb discourses on the fat tail, nonlinear probabilistic environments that lead to increasingly unpredictable and extreme outcomes. We typically encounter fat tails within institutions and markets characterized by complexity, with circuitous feedback loops possessing multiple nodes, intersections, and choice points.

Modern financial markets have fat tails. We have significant evidence for this - deductio ad absurdum - in the emergence of exotic and synthetic securities, traded by hedge funds and investment banks, using enormous data sets and complex mathematical models, fed into program trading systems that take the decision-making out of the hands of individuals.

These trading systems are black boxes. They display impressive spit and polish, and reassure us with references to risk management, arbitrage, and hedging. However, these systems are incredibly fragile precisely because the range of outcomes and the risk spectrums they model are so complicated. The collapse of John Meriwether's Long-Term Capital Management hedge fund in 1998 provide evidence to complexity theorists of the futility of black box trading systems that claim to model complexity and manage risk mathematically when these systems themselves are adding volatility and dynamism into the systems they model.

The Return to Glass-Steagall

The spirit of the Volcker Rule is that commercial banks that depend on the protection of the federal government to support their lending operations should not expose taxpayers to the risks associated with this financial complexity. The Volcker Rule in its purest form is an elegant and simple way to restore the firewall between commercial and investment banking created by the passage of the Glass-Steagall Banking Act of 1933.

Glass-Steagall was not a complicated piece of legislation. All of 37 pages in length, the law simply stated to any bank dependent upon the Federal Reserve for access to funds for lending: Thou shalt not speculate. The broadened scope of federal lawmaking and rulemaking in the past 75 years has guaranteed the impossibility of any return to the golden age of Glass-Steagall, however. Compromises necessary to keep the prohibition on proprietary trading in the Dodd-Frank legislation added layers of complexity and nuance that instantly hollowed out the impact of the Volcker Rule.

The Volcker Rule Succumbs to Complexity

As the Dodd-Frank legislation was finalized, changes were made to allow banks to invest up to three percent of their capital in hedge funds or private equity funds, with no dollar limit on the total. The substitution in the bill of "Tier 1 capital" for "tangible common equity" created a technical loophole that boosted by 40 percent the funds banks could legally transfer to hedge funds or private equity funds. And this was only the evisceration of the Volcker Rule that occurred during the legislative process.

On January 18, the Financial Stability Oversight Council released its long-awaited report on Prohibitions on Proprietary Trading & Certain Relationships with Hedge Funds & Private Equity Funds. In its introduction, the Council summarizes the ban in terms that lucidly echo Glass.

The Volcker Rule prohibits banking entities, which benefit from federal insurance on customer deposits or access to the discount window, from engaging in proprietary trading and from investing in or sponsoring hedge funds and private equity funds, subject to certain exceptions.

The devil is in the "exceptions". While still on Page 1, the Council introduces an impressive amount of bureaucratic noise about exceptions to the rule needed to account for legitimate market making, hedging, and underwriting transactions. The Council also admits to difficulties in differentiating legitimate from illegitimate trading and acknowledges that agencies will have a devil of time figuring it all out.

As Dodd-Frank, and the Volcker Rule, find their way into the concrete details of agency regulation, financial institutions will navigate or evade the spirit and the intent of the legislation wherever they need to. With unlimited funds for lobbying, litigating, bargaining, and glad-handing - they will overwhelm the regulators. And as the economy settles down, the sense of urgency that led to the drafting of Dodd-Frank will dissipate.

The Hard Choice

The risk will not disappear, however. There may be something about human nature that makes it difficult to focus for long on fat tail risk - the unlikely, but catastrophic, failures that accompany complexity. Rather than address fat tail risk, which is inconvenient, we create new layers of complexity that serve to mask, but not eliminate, fat tail risk. The compromises associated with Dodd-Frank inevitably result in further complexity and confusion which will be left at the doorstep a myriad of regulatory agencies. We will leave the details of term definition, proper models of risk compliance, and interpretation of legislative intention to federal bureaucracies staffed by humans no more prepared to manage or comprehend this complexity than the financial institutions.

If we are serious about addressing fat tail financial risk, we face a hard choice. How do we return to simplicity, to the clarity of purpose that made Glass-Steagall such an effective piece of legislation? We must be honest. We cannot manage financial risk without tearing apart our financial institutions. This does not mean destroying them. It does mean forcing them to choose. Do they want the protection of the U.S. government? Or do they want to risk their own money? At the end of the day, simplification - even as only a kind of management of complexity - requires these kinds of meaningful choices, in every part of our lives, both public and private.

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