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A Time for New Regulatory Thinking

It has been six years since the collapse of Lehman Brothers, and memories of the meltdown have yet to fade. Still, lest anyone in the financial industry forget, the unfinished business of regulatory reform and new compliance burdens serve as constant reminders.

Less remembered from those dark days are attempts at innovation and creativity of a very different sort from the financial engineering that got the industry and economy into so much trouble. While Congress and lobbyists haggled for two years over what became the Dodd-Frank Wall Street Reform and Consumer Protection Act, independent experts were urging more-radical departures in the way financial regulation is carried out.

They didn’t get much traction. Dodd-Frank and similar efforts amounted to traditional controls and supervision — just more of them. Now, long removed from the depths of the crisis, the time is ripe for what might be termed new regulatory thinking.

“I still believe it is important to pursue innovation of this kind,” says MIT Sloan School of Management finance professor Andrew Lo. He floated one particularly intriguing idea: that regulators look to the National Transportation Safety Board — the U.S. agency that investigates civil aviation accidents and severe ones involving ships, trains, cars and trucks — as a model for systemic risk management.

Lo laid out his logic in a 2010 paper co-authored with NTSB official Eric Fielding and MIT Sloan School fellow Jian Helen Yang: “The practice of independently and systematically reviewing failures — sifting through the wreckage and analyzing every step of an accident to determine its proximate and ultimate causes — can benefit every technology-based industry,” they wrote. “Over time and after a number of investigations, a clear and practical definition of a financial accident should emerge” and define the scope of a “financial NTSB.”

Looking back, Lo tells Institutional Investor that “there was a lot of positive reaction.” As unconventional as the proposal may have seemed — the NTSB, being purely investigatory, is not even a regulator per se — “the focus on safety appeals to everybody,” says Lo. The board has a stellar track record and reputation in part due to its independent status, having been severed from the Department of Transportation in 1974.

In the heat of the Dodd-Frank moment, a true regulatory paradigm shift wasn’t in the cards. Today, Lo has high hopes for the Treasury Department’s Office of Financial Research, the data-gathering arm of the Financial Stability Oversight Council, on which all the key regulatory bodies are represented. OFR is “the closest to carrying out the mandate” of identifying systemic threats through aggregation and analysis of multitudes of information, Lo says. However, ensconced within Treasury and reporting to a committee, OFR will have a “difficult challenge” achieving NTSB-like independence, he adds.

As it happens, a kindred regulation-reform spirit is working within the OFR. Richard Bookstaber, former hedge fund manager and author of the 2007 critique of financial innovation A Demon of Our Own Design, has been pushing the mathematical simulation technique of agent-based modeling as a way of mapping and gaining insights into complex systemic threats. Bookstaber outlined the concept in one of the earliest OFR working papers, in 2012, and co-authored one of the latest, “An Agent-Based Model for Financial Vulnerability.”

Chris Yapp, a scenario-planning specialist and former head of innovation for Microsoft UK, sees a useful paradigm in food-and-drug safety. As with transportation, government involvement in the pharmaceuticals industry has been notably effective, in this case through an emphasis on safe dosages. Applying that approach to, say, a mortgage portfolio, regulators might set a “nonlethal” limit at 15 percent of loans with a 4.5 or higher loan-to-income ratio, Yapp suggested in July in London-based Z/Yen Group’s Long Finance forum.

“Regulatory models are beginning to creak,” he says. “People will do well to borrow from other sectors.”

Assessing postcrisis “reinventions,” Bank of England chief economist Andrew Haldane wrote in August in Central Banking Journal, “The very definition of a resilient financial system is one that does not require active intervention.” But he went on to say: “Risks emerging in the financial shadows” call for a constant state of alert, and “regulatory fine-tuning could become the rule, not the exception.”

“A crisis is a terrible thing to waste,” says Lo — repeating a quotation originated by then-Stanford University economist Paul Romer in 2004 and appropriated by former White House adviser (now Chicago Mayor) Rahm Emanuel in 2008. It still holds, and there is still time.

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