Tue, May 28, 2019

Toward a New Regulatory Physics

Regulators have generated waves of new requirements aimed at preventing another financial crisis. But a different tack will be needed for the dramatic changes the industry is likely to face.
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Ten years on from the financial crisis, many in the industry are asking whether we are better positioned to prevent the next meltdown from occurring. Certainly, important gains have been made. Checks have been established to help prevent the excesses of the past, with a very real regulatory and enforcement infrastructure to keep those checks in place. There is greater interaction among jurisdictions and between regulators and industry, even if there are still improvements to be made. And there is greater awareness across the industry of the collective responsibility for ensuring a stable financial system.

However, what has worked in the past may not be as effective in the future. I would argue that despite the progress that has taken place, our approach to regulation will need to evolve in order to meet the dramatic changes that are likely to unfold within the industry.

What has worked in the past may not be as effective in the future.

The regulatory methodology we have relied on both before and after the crisis has been to make the adjustments that prove necessary when the industry drifts off course or after a storm hits. Sometimes, if we’ve gone very far off course or after a particularly bad storm, those course adjustments can be quite extensive, as they were following the Great Depression of 1929 and after the 2008 crisis. And the fact is that the course corrections that regulators have made to the supertanker that is the world’s financial system have done a fairly good job of keeping global markets afloat over the decades, all things considered.

But this reactive strategy has two serious limitations. The first is that, given human nature, it leads to extended cycles of scandal, response, drift, deregulation, and then scandals anew. One of the lessons of the crisis is that these cycles impose real costs on industry, consumers, investors, and governments, inflicting a collective scar each time society passes through one. That would be reason enough to try to improve this state of affairs.

Towards a New Regulatory Physics

But the second reason is even more significant. The incremental approach to regulation is based on the assumption that the market is powered by certain inherent and rather static principles, not unlike the way the movement of all objects–including supertankers– is governed by Newton’s laws. It follows from this assumption that the fundamental purpose of new regulation is to strengthen the guardrails that keep markets on course and hewing to those principles. Three important examples of those principles are:

  1. Markets are naturally stable and efficient–and if they veer off course, we broadly understand how to correct them.
  2. There is an enduring social contract among financial institutions, their employees, governments, and society that prevents excess and damage.
  3. Corrections to the system may be expensive and imperfect, but they move us asymptotically toward the natural state of how things “should” be.

But if we learned anything from the crisis, it’s how easily those ideas are swept aside. The crisis showed (and the subsequent rise of behavioral economics clarifies) that people are irrational and greedy, that economies are riddled with structural weaknesses, and that governments are flawed and can be hesitant to act. As for a social contract, we saw how gain is privatized and losses are socialized. It turns out that the market is not inherently effective, resilient, or fair; those qualities exist only to the extent that they are built into the system.

Beyond those sobering lessons, we must also recognize that the financial world is on the cusp of a transformation that is potentially so fundamental that it is frankly absurd to think that we can manage the system by merely tinkering with it. However much change has taken place with the rise of globalization, the internet, and social networks, all we’ve really done in financial services so far is to make the financial networks of the twentieth century bigger and much, much faster. The real changes have yet to begin–changes that will be powered by the ever-rising expectations of educated and empowered middle-class consumers around the world and by the geometric scaling of technological innovation. Consider the possibilities, for example, when Amazon or Microsoft decides to fully throw its weight into the financial services arena. When that happens, the current corrective strategy will no longer be merely imperfect–it will be wholly inadequate, in the same way that Newton’s laws proved to be when physicists began to uncover the messy and less predictable ways that matter behaves at the subatomic level. For financial markets regulation to be prepared for the coming revolution, it needs to be governed by similarly new thinking.

As a first step toward that new thinking, I would suggest that we replace the three traditional market assumptions discussed above with the following: 

  • We Don’t Know From Where the Next Crisis Will Emerge
    The combination of globalization and technology will only accelerate the creation of new products, markets, and forces in ways that we cannot foresee. (Prediction, as the eminent physicist Niels Bohr once observed, is difficult–particularly about the future.)
  • Institutions Don’t Make Decisions–People Do
    The role of technology in driving change should not obscure the fact that, in the end, it is still people who decide how and when to use that technology. Indeed, regulators will never really be able to get their arms around the technologies that have been (and will be) unleashed. Instead, it is better for them to focus on the human elements of motivation, culture, and behavior.
  • Never Be Complacent
    The key here isn’t simply constant vigilance (which can result in a deceptive sense of security if you’re guarding against the wrong thing) but rather constant curiosity–asking questions, connecting dots, imagining possibilities. This can be a particularly difficult perspective to maintain when times are good. It is also likely to require a broader range of skills and perspectives on the part of regulators, augmenting current collective competencies with disruptive thinkers who ask different questions and who can envision different sets of scenarios.

The old market principles were anchored on certainties, and regulation was based on creating policies to strengthen the guardrails around those certainties. In contrast, the new principles that guide regulation going forward need to be based on uncertainties–in how forces interact, in people’s behaviors, in how the future will unfold.

The implications of this shift for both regulators and industry will be profound. Business, financial, and risk models will need to be rebuilt to better capture a more complex environment. Indeed, it will take considerable effort just to address the very question of how to define acceptable risk in the face of an expanded array of variables. Incentives and disincentives at both the regulatory and institutional level will have to be realigned to accommodate the greater uncertainty of the business environment in which managers and employees must make day-to-day decisions.These changes will not be easy, but they will be necessary. Hopefully, the end result will be financial markets with the agility that will be essential for future stability, and a dampening of the swings of the regulatory compliance pendulum that have absorbed so much of the industry’s energy in recent years.

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