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 didnt 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
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
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 wasnt in the cards. Today, Lo has high
hopes for the Treasury Departments 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
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 Groups
Long Finance forum.
Regulatory models are beginning to creak, he
says. People will do well to borrow from other
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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