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Next-Generation Regulation May Better Detect Systemic Risk

Policymakers can open their minds to a new kind of regulatory paradigm before the next financial crisis.

  • Jeffrey Kutler

Most memory spans — and terms of political office — are too short to fully grasp the grand sweep of historical cycles. But the legislators responsible for the massive Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 surely understood that they were dialing back a generation’s worth of regulatory loosening.

And yet there was also something haphazard, perhaps even irrational, about how Dodd-Frank and the regulations it spawned spiraled into thousands of pages of compliance complexity. As Securities and Exchange Commission member Michael Piwowar noted in a March speech, Dodd-Frank was “enacted before any of the official regulatory inquiries into the cause of the financial crisis had been completed.”

Today in Washington an administration and congressional majority of a very different mindset seek to remake, if not eliminate, such Dodd-Frank pillars as the Consumer Financial Protection Bureau; the speculative-trading restrictions known as the Volcker Rule; and the Financial Stability Oversight Council (FSOC), the multi-agency systemic-risk-monitoring body.

The next crisis will come, and the tables will no doubt turn again.

It doesn’t have to be this way. Policymakers can open their minds to a new kind of regulatory paradigm that Massachusetts Institute of Technology finance professor Andrew Lo spells out in his new book, Adaptive Markets. It’s a summation of developments in fields ranging from economics and behavioral finance to neuroscience and artificial intelligence — all influences on the adaptive markets hypothesis Lo proposes as a framework for finance that considers both rational and irrational behavior.

With due credit to several like-minded thinkers — notably University of Oxford and Santa Fe Institute complex-systems scholar J. Doyne Farmer, Bank of England chief economist Andrew Haldane, and Princeton University ecologist and evolutionary biologist Simon Levin — Lo argues that “the financial system is more like an ecosystem of living organisms than a mechanical system of inanimate parts, and we need to manage the system accordingly.”

Traditional market theories revolving around rational expectations and the efficient markets hypothesis have proven too static and mechanistic — owing too much debt to physics — to factor in the dynamism, uncertainties, and irrationalities of Lo’s adaptive markets.

“Most real-world economic phenomena simply look more like biology than physics; it’s very rare to find any economic ideas that conform perfectly to elegant mathematical derivations,” he writes. Biology and the adaptive hypothesis win out, Lo contends, because of “a single, powerful, unifying fundamental principle: Darwin’s theory of evolution by natural selection. Today physics has numerous contenders for a ‘theory of everything,’ but they’re of very limited use to economists.”

How does the adaptive theory translate to regulation?

“Biological systems offer many examples of highly effective regulatory mechanisms” such as homeostasis, which regulates body temperature, along with their reliance on feedback loops, Lo says. If financial crises are “positive feedback, like the squeal of a microphone, where small changes are amplified into large effects,” then that amplification must be counteracted by “more negative feedback throughout the system, and the feedback needs to be more adaptive to changing environments,” Lo writes.

Considering that regulators have behavioral biases and can make imperfect decisions, he says, “the adaptive markets framework includes regulators as part of the ecosystem, and a natural proposal is to develop adaptive regulation that isn’t prone to the same behavioral biases as human regulators.”

A case in point: countercyclical capital buffers, wherein capital requirements adjust automatically according to business and credit cycles.

Adaptive theory is starting to get noticed. It figured prominently in an October 2015 conference, Interdisciplinary Approaches to Financial Stability, co-sponsored by the Office of Financial Research (OFR), a Dodd-Frank-mandated arm of the FSOC; and the University of Michigan Center on Finance, Law, and Policy, which is led by law professor and former Treasury assistant secretary (and Dodd-Frank architect) Michael Barr. A few months later Lo and Levin ran a smaller workshop at the National Academy of Sciences in Washington, D.C. Levin saw that as “a beginning in establishing a dialogue between the complex systems community and the financial regulatory community toward the establishment of more adaptive approaches to regulation.”

Lo says “better measures of systemic risk” are crucial to financial ecosystem stability. Lo has contributed to the work of the OFR, which, in its support of the FSOC, has become an important repository of systemic-risk data and analysis. It would be abolished under the proposed Dodd-Frank corrective known as the Financial Choice Act. That would be maladaptive.