Complexity Theory and the Failure of Financial Reform: Part One

Complexity Theory and the Failure of Financial Reform: Part One
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This is a two-part essay about the implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act, a 2,300-page piece of legislation now making its way through the federal rulemaking mill in 21 different federal agencies, via nearly 250 rulemaking initiatives and 70 special reports. The Dodd-Frank legislative process was both hurried and complicated, and as one examines the resulting proposed rules, it is clear that the rulemaking stage has done little to clarify matters. Many issues remain definitionally murky and the rule makers in many cases are left with no alternative but to punt interpretation of these matters to enforcers at specific agencies post-implementation.

In Part One of this essay, we parse the politics surrounding the implementation of this complicated and tentacular piece of legislation. We start with politics - the interests that influence electoral, legislative, and regulatory outcomes - because that is where our minds naturally locate a zone of comfort. The politics is what seems real.

Part Two of the essay, however, will explode the idea that the politics actually matter, and focus our attention on the deeper dynamics of complexity theory as it applies to financial reform. We will descend into the rabbit hole of barking dogs, fat tails, and the conclusion that implementation of Dodd-Frank will in no way reduce the risk of catastrophic failure built into our financial markets.

The Politics of Financial Regulation

Dodd-Frank receives bland praise for its earnest efforts to reach some low common denominator of consensus about how to manage financial risk without tearing apart banking institutions. A political process watered down the legislation so it could sufficiently clear partisan hurdles to pass Congress. However, the real question is whether the forthcoming rules do anything more than kick the can further down the road.

It is generally tempting to continue to focus on the politics of financial reform, and to wonder about the meaning for financial reform of such events as the return of the House of Representatives to Republican control. In reality, the dynamics of legislative process are predictable bargaining games. And shifts in power are akin to changes in the weather, outputs of the bi-annual election cycle that grip the media imagination but that fail to do more than scratch the surface of the relationship between finance and regulation.

With the shift to Republican control in the House of Representatives, the ubiquitous and garrulous Barney Frank, co-author of the Dodd-Frank legislation, is now irrelevant. Spencer Bachus, Republican from a wealthy district surrounding Birmingham, Alabama, now presides over the House Committee on Financial Services, and he is determined to bring Dodd-Frank to its knees.

Bachus is a wily and pragmatic politician, who benefits in a conservative state from the absence of any serious opposition to his seat. Bachus is no moderate, however. When it comes to financial matters, Bachus worships both God and Mammon. It is an article of faith for him that the purpose of government is to serve and protect banking interests. Bachus also has gained notoriety for rapid-fire market trades - rare for elected federal officials - that netted him more than $160,000 in 2007.

Bachus does not pull his punches on the new HCFS website. As redesigned by the Republican majority, the website is no longer merely an information resource for policy wonks. The HCFS website is now closer to a Predator drone taking deadly aim at all "job-killing" Democratic financial reform measures associated with Dodd-Frank.

Enter the Volcker Rule

Demolition of Freddie Mac and Fannie Mae remains the top priority for Chairman Bachus. However, Bachus and the HCFS also don't mince words about their distaste for the Volcker Rule and their determination to obstruct its implementation.

The Volcker Rule prohibits banking entities from engaging in proprietary trading and from sponsoring or investing in private equity or hedge funds. This prohibition matters because many investment banks became bank holding companies in 2008 to gain shelter from the financial storm under the TARP of the federal government.

The Volcker Rule promotes the quaint idea, associated with the Glass-Steagall Banking Act of 1933, that the government should protect banks that responsibly provide credit to consumers and businesses, but that banks receiving such protection should not engage in risky or speculative behavior associated with proprietary trading and the sponsorship of hedge funds.

Bachus has opposed the Volcker Rule, arguing that proprietary trading was unrelated to the financial crisis and that the prohibition on proprietary trading would limit banking profits, eliminate an important source of income diversification, undermine the global competitiveness of U.S. banks, and harm the ability of non-financial companies to engage in legitimate hedging of commodities for business purposes.

In Part Two of this essay, we will explore interesting ideas about fat tails and barking dogs, and consider the hard choices we need to make to avoid succumbing to the pitfalls of complexity as they apply to financial reform.

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