Tuesday, May 1, 2012

The Difficulties of Dodd Frank

Financial regulation is such a pain...

There's been some recent news on how slowly Dodd Frank is being put together.  From the Financial Times, we see that most of the rules have missed their deadlines by a long-shot.  the original Polk report also notes that:

Of the 398 total rulemaking requirements, 108 (27.1%) have been met with finalized rules and rules have been proposed that would meet 146 (36.7%) more. Rules have not yet been proposed to meet 144 (36.2%) rulemaking requirements.
This certainly isn't good news for the face of financial regulation.  In the face of so much opacity, it's not too hard to imagine that finance will become even more difficult.  Even though the Volcker Rule is short and cute, it's most certainly not simple.  There are attempts to gain exemptions for investments such as venture capital, and it even may be a violation of NAFTA trade rules.  If all these crucial issues hang in the balance, this may worsen uncertainty and information uncertainties within financial markets.  And given that information asymmetries are the source of many of the frictions within financial markets, the uncertainty from this piece of regulation will probably have a short-term destabilizing effect on markets.

The way that the law creates short term opacity seems to create a Second Best argument against the policies advocated by Taleb that, in theory, would help reduce market fragility.  While financial markets in a whole would benefit from Volcker Rules that separate proprietary trading from commercial banking, the way that the rule is implemented may cause it to worsen problems.  The law also poses an interesting conundrum for those who advocate rules based on heuristics, because how do you design them to be specific enough to be appropriate for the market, yet also broad enough to capture all the possible destabilizing issues?  Moreover, the possibility of policy error in the writing of the laws is huge.  What if one of the exceptions is the exception that creates a new financial product that causes the next crisis?  The fundamental issue is that we would never know until we become the turkey and suffer through the next unpredictable crisis.

Then where do we go from here?  Although financial regulation may have slipped from public awareness, it's more important than ever to ensure that our financial system is diverse and robust (maybe even antifragile?) to shocks.  Regulation must also focus on the payoffs and maybe assets of the banks, which are observable, rather than the banks' methodologies or trading strategies.  A rather elegant way to do it would be to impose a Pigouvian tax on financial monoculture, for which firms that tend to follow the market are penalized vis a vis firms that can consistently go opposite the market.  While there may be measurement issues that prevent that policy from being a full-fledged way to stop all crises, this kind of thinking about the payoff will be increasingly important when information and probabilities become more opaque.

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