Systemic Risk, Hedge Funds, and Financial Regulation

One of our readers recommended the Congressional testimony by Andrew Lo during last Thursday’s session on hedge funds. Lo is not only a professor at the MIT Sloan School of Management, but the Chief Scientific Officer of an asset management firm that manages, among other things, several hedge funds. He discusses a topic – systemic risk – that has been thrown around loosely by many people, including me, and tries to define it and suggest ways of measuring it. He recommends, among other things, that

  • large hedge funds should provided data to regulators so that they can measure systemic risk
  • the largest hedge funds (and other institutions engaged in similar activities) should be directly overseen by the Federal Reserve
  • financial regulation should function on functions, such as providing liquidity, rather than institutions, which tend to change in ways that make regulatory structures obsolete
  • a Capital Markets Safety Board should be established to investigate failures in the financial system and devise appropriate responses
  • minimum requirements for disclosure, “truth-in-labeling,” and financial expertise be established for sales of financial instruments (such as exist, for example, for pharmaceuticals)

Lo also has a talent for explaining seemingly arcane topics in language that should be accessible to the readers of this site. The testimony is over 30 pages long, but it’s a good read. Here are a couple of examples to whet your appetite.

On the incentives within an investment bank:

Consider, for example, the case of a Chief Risk Officer (CRO) of a major investment bank XYZ, a firm actively engaged in issuing and trading collateralized debt obligations (CDO’s) in 2004. Suppose this CRO was convinced that U.S. residential real estate was a bubble that was about to burst, and based on a simple scenario analysis, realized there would be devastating consequences for his firm. What possible actions could he have taken to protect his shareholders? He might ask the firm to exit the CDO business, to which his superiors would respond that the CDO business was one of the most profitable over the past decade with considerable growth potential, other competitors are getting into the business, not leaving, and the historical data suggest that real-estate values are unlikely to fall by more than 1 or 2 percent per year, so why should XYZ consider exiting and giving up its precious market share? Unable to convince senior management of the likelihood of a real-estate downturn, the CRO suggests a compromise—reduce the firm’s CDO exposure by half. Senior management’s likely response would be that such a reduction in XYZ’s CDO business will decrease the group’s profits by half, causing the most talented members of the group to leave the firm, either to join XYZ’s competitors or to start their own hedge fund. Given the cost of assembling and training these professionals, and the fact that they have generated sizable profits over the recent past, scaling down their business is also difficult to justify. Finally, suppose the CRO takes matters into his own hands and implements a hedging strategy using OTC derivatives to bet against the CDO market. From 2004 to 2006, such a hedging strategy would likely have yielded significant losses, and the reduction in XYZ’s earnings due to this hedge, coupled with the strong performance of the CDO business for XYZ and its competitors, would be sufficient grounds for dismissing the CRO.

In this simple thought experiment, all parties are acting in good faith and, from their individual perspectives, acting in the best interests of the shareholders. Yet the most likely outcome is the current financial crisis. This suggests that the ultimate origin of the crisis may be human behavior—the profit motive, the intoxicating and anesthetic effects of success, and the panic selloff that inevitably brings that success to an end.

On the role of regulation in a free-market economy:

Why are fire codes necessary? In particular, given the costs associated with compliance, why not let markets determine the appropriate level of fire protection demanded by the public? Those seeking safer buildings should be willing to pay more to occupy them, and those willing to take the risk need not pay for what they deem to be unnecessary fire protection. A perfectly satisfactory outcome of this free-market approach should be a world with two types of buildings, one with fire protection and another without, leaving the public free to choose between the two according to their risk preferences.

But this is not the outcome that society has chosen. Instead, we require all new buildings to have extensive fire protection, and the simplest explanation for this state of affairs is the recognition—after years of experience and many lost lives—that we systematically under-estimate the likelihood of a fire. In fact, assuming that improbable events are impossible is a universal human trait (see, for example, Plous, 1993, and Slovic, 2000), hence the typical builder will not voluntarily spend significant sums to prepare for an event that most individuals will not value because they judge the likelihood of such an event to be nil. Of course, experience has shown that fires do occur, and when they do, it is too late to add fire protection. What free-market economists interpret as interference with Adam Smith’s invisible hand may, instead, be a mechanism for protecting ourselves from our own behavioral blind spots.

4 thoughts on “Systemic Risk, Hedge Funds, and Financial Regulation

  1. These were my takes. I think that they’re similar approaches:

    Tuesday, November 4, 2008

    “He calls for a regulatory system based on “principles” rather than “rules.”

    Via Deal Book on the NY Times we get “Stephen Schwarzman’s Seven-Step Program”:

    “In an opinion piece in The Wall Street Journal’s Nov. 4 issue, Mr. Schwarzman maps out seven principles he believes should guide any regulation of the financial system. In many of them, he uses the opportunity to criticize the current regulatory framework in the United States, describing a “hodgepodge” of fragmented agencies and laws that make a “fetish of compliance with complex regulations.” He expresses concern that the latest debacle on Wall Street will inspire a thicket of new rules that choke off innovation.”

    Here’s my comment:

    “He calls for a regulatory system based on “principles” rather than “rules.” He writes:

    If we are to sweep a vast array of financial institutions into the net of a single regulator, then that regulator has to be able to regulate not by promulgating a blizzard of ever more complex rules, but by enunciating a set of guiding principles. If these principles are coupled with strong disclosure and oversight, they will give the regulator the flexibility needed to cope with an ever-changing financial landscape, and to provide a clear direction for the regulated institutions.”

    I agree with this:

    This is the real problem with regulation. These investors can be very clever people, and are adept at shifting the terrain. That’s why regulation always seems to be correcting the last problem.

    The solution is either to regulate or supervise risk, especially any investment that shifts risk to a third party or magnifies risk. In other words, broad principles.

    However, have you ever noticed that some of these recommendations being bandied about are as simple disclosure and transparency, traits one would think a decent human being would try and exemplify as a matter of course.

    — Posted by Don the libertarian Democrat

    “The dismissive response, Mr. Lo said, was not really surprising because Wall Street was going to chase profits in the good times. The path to sensible restraint, he said, will include not only better risk models, but also more regulation. Like others, Mr. Lo recommends higher capital requirements for banks and the use of exchanges or clearinghouses for the trade of exotic securities, so that prices and risks are more visible. Any hedge fund with more than $1 billion in assets, he added, should be compelled to report its holdings to regulators.

    Financial regulation, Mr. Lo said, should be seen as similar to fire safety rules in building codes. The chances of any building burning down are slight, but ceiling sprinklers, fire extinguishers and fire escapes are mandated by law.
    “We’ve learned the hard way that the consequences can be catastrophic, even if statistically improbable,” he said.”

    The recommendations made are fine:
    1) higher capital
    2) a clearinghouse
    3) better regulation

    I’ve already agreed with and talked about all of them. However, the regulations need to be based on human agency and not simply measurable factors. That’s why I believe only simple and broad principles can work in this forthcoming regulation. Otherwise:

    “Innovation can be a dangerous game,” said Andrew W. Lo, an economist and professor of finance at the Sloan School of Management of the Massachusetts Institute of Technology. “The technology got ahead of our ability to use it in responsible ways.”

    This is just another way of saying that if the regulations are too specific, investors will find a way around them. You need a set of principles that can funnel riskier investments into a screening process where they can be examined. The actual amount of government regulation should be based on that assessment. Unfortunately, that will be done by human agency, and has its own set of conditions and risks. There’s no simple answer.

  2. “Why are fire codes necessary? In particular, given the costs associated with compliance, why not let markets determine the appropriate level of fire protection demanded by the public?”

    This is no way to make your point about deregulation. Attempting to apply supply and demand logic to the issue of fire protection is absurd. It does not make the point you want it to make at all.

    Financial regulation and safety are two completely different issues.

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