1. Markets are always smarter than regulators.

Too much regulation spurs bad innovation. If regulation is onerous, costs of adherence are high, and firms perceive a shift in competitiveness, then expect markets (the good guys and the bad guys) to find ways to circumvent it. Also, much of the day-to-day function at Regulators is focused on magnifying-glass level examination of details; whereas the need here is to have a broader macro-perspective of how “it” all fits together, where “it” is much more than any regulatory form, any individual bank and even the banking system.

2. Are the right products regulated? In the right way?

What is a ‘standard’ derivative, in the context of the move to exchanges and clearing-houses? Standard derivatives didn’t cause the crisis at any individual institution. At a systemic level arguably they did, in the volume and liquidity sense. Complex and exotic products, not regulated because nobody has figured out how, are often the serious offenders.

3. There is as yet no way to measure the overall health, and level of systemic risk, in the market.

Ex-ante, who knows what systemic risk is. Regulators are currently unable to even pull together a comprehensive view of the market. And if we do get a market-level aggregate report, when is the light going to turn from orange to red. Some absolute level decided by the Fed? At the level of each instrument? At the change of the light, will the Fed via individual regulators go back to firms and demand action. What action? And so, are we about to see a hitherto undefined conflict between regulation of an institution versus regulation of the market as a whole?

4. National regulators do not talk to each other, not enough, not effectively

One key lesson from the recent crisis seems to be that risk and flows and financial markets are global, whereas most regulation is national and often nationalistic. This brings another central point to the discussion, a single regulator versus a committee of them.

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Posted by Jaidev Iyer, MD, GARP at 9:20 AM 2 comments

A New Regulatory Regime, and no perfect solution for a problem that is not well defined

Do not envy Tim Geithner. There is simply no chance to get it all right all at once – in form, content, and effectiveness. And the critics have it too easy. Some will call new regulations as not far reaching enough and unable to guarantee against future financial meltdowns. Others will want to preserve complete freedom of the derivatives markets and howl about the baby versus the bathwater. And all will wring hands about market constraints and cost.

Do remember that derivatives before they went toxic, were good creative ways to hedge exposures, to isolate asset allocation decisions from risk decisions, to synthetically overcome barriers to market access. Till parts of the market went rogue, and we had too much of a good thing. And, we also found out that self regulation is a myth in competitive markets in the face of “let’s make revenues Monday, manage costs on Tuesday, and oh let’s do get a Risk report on Wednesday; everybody else is doing it”.

Most will agree ‘some’ incremental regulation is needed. What it will look like, how much of it, and how effective it will be has yet to be defined. The challenge is of course in the balance – we want just the right amount to curb bad innovation, to stifle system-wide blowups, and with incentives for organizations to institutionalize solid risk management principles.

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Posted by Jaidev Iyer, MD, GARP at 11:20 AM 11 comments