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The Fat Tail and the Barking Dog: Complexity Theory and the Looming Failure of Financial Reform

February 7, 2011

Photo by Jason Tester. Some rights reserved.

This is an 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 process 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.

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

Let’s do start with normative politics, however – the interests that influence electoral, legislative, and regulatory outcomes – because that is where our minds naturally locate a zone of comfort. From there, we can then descend into the rabbit hole of complexity theory, 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

With the recent 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 – he has not received less than 70 percent of the vote in any Congressional election since 1992. For this reason, he can be dismissive of Sarah Palin and the Tea Party, cagy about gun control, favorably disposed toward President Obama’s leadership style, an advocate for international debt relief for poor nations, and opposed to negotiations with the genocidal leadership in Sudan.

Bachus is no moderate, however. He says he can identify no fewer than 17 socialists serving in the US House of Representatives. He also accused comedian Bill Maher of treasonous behavior for mocking the quality of US military recruits in 2005. 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 famously said last fall, “In Washington, the view is that the banks are to be regulated, and my view is that Washington and the regulators are there to serve the banks.” Bachus also has gained notoriety for rapid-fire market trades – rare for elected federal officials – that netted him more than $160,000 in 2007.

When chaired by Barney Frank, the previous House Committee on Financial Services website offered an informative, but politically nondescript, face for the Democratic Party financial reform agenda. The website promoted Democratic policy initiatives but was otherwise remarkably nonpartisan. It is difficult to find any mention of the Republican Party at all on the site.

Spencer Bachus does not pull his punches on the new HCFS website. As redesigned by the Republican majority, the website is no longer 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, memorialized in Section 619 of the Dodd-Frank legislation, amends the Bank Holding Company Act of 1956 to prohibit 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 such as Goldman Sachs and Morgan Stanley rushed in 2008 to become bank holding companies in order 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.

The Volcker Rule is not popular with large banks or with Republican politicians (and actually with many Democratic politicians). Bachus has opposed the Volcker Rule in communications with Treasury Secretary Timothy Geithner (who is himself no fan), 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 possibly harm the ability of non-financial companies to engage in legitimate hedging of commodities for business purposes.

Republicans such as Massachusetts Senator Scott Brown successfully loosened the provisions of the Volcker Bill as a condition for supporting the Dodd-Frank legislation. Bachus and other Republicans have further threatened to stall regulatory implementation of the Volcker Rule through relentless oversight hearings of relevant agencies and by trimming the budgets of these agencies.

Barking Dogs and Fat Tails

While Bachus is perhaps (but perhaps not) 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 very much 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. On the surface, it matters which dog barks the loudest and longest. 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, interpolations, 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, the reality is that 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 (and, subsequently, of his JWM Partners hedge fund in 2009) provide evidence to complexity theorists such as Taleb 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, as envisioned in the mind of its creator, 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 (or “Glass” as it was called back then) was not a complicated piece of legislation. All of 37 pages in length, the law was declarative and simple, as the paragraph below indicates. To any bank dependent upon the Federal Reserve for access to funds for lending: Thou shalt not speculate.

Each Federal reserve bank shall keep itself informed of the general character and amount of the loans and investments of its member banks with a view to ascertaining whether undue use is being made of bank credit for the speculative carrying of or trading in securities, real estate, or commodities, or for any other purpose inconsistent with the maintenance of sound credit conditions; and, in determining whether to grant or refuse advances, rediscounts or other credit accommodations, the Federal reserve bank shall give consideration to such information.

The broadened scope of federal lawmaking and rulemaking in the past 75 years has guaranteed that politics would make it impossible to return to the golden age of Glass-Steagall and make a mess of the Volcker Rule. Volcker proposed the ban on proprietary trading as an alternative to of the use of regulations to determine which financial institutions would be too big to fail. 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

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”, and it is in these exceptions where we must acknowledge the complexity, not just of the modern, global, computerized financial system, but of the regulatory framework charged with managing its risks. Immediately thereafter, still on Page 1, the Council introduces an impressive amount of bureaucratic noise:

However, to ensure that the economy and consumers continue to benefit from robust and liquid capital markets and financial intermediation, the Volcker Rule provides for certainĀ  “permitted activities” that represent core banking functions such as certain types of market making, asset management, underwriting, and transactions in government securities. These permitted activities – in particular, market making, hedging, underwriting, and other transactions on behalf of customers – often evidence outwardly similar characteristics to proprietary trading, even as they pursue different objectives, and it will be important for Agencies to carefully weigh all characteristics of permitted and prohibited activities as they design the Volcker Rule implementation framework.

At this paragraph indicates, one need not worry about the banks. They have already provided for their needs and they will take care of themselves. As Dodd-Frank, and the Volcker Rule, find their way into the concrete details of agency regulation, financial institutions will quickly learn how to 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 for us 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 – the consequence of pressure from financial institutions – 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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