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bernanke
November 2008 
financial regulation
Posted on Oct 30th, 2008
by 
Vivek
Vivek
I read two excellent books recently: both by former traders. One is the Black Swan by Nicholas Taleb the other Traders, Guns, and Money by Satajit Das. Both are notable for being written before this crises and predicting almost exactly what happened in some cases to the level of specific firms. They also do a good job of describing the new and 'innovative' things that have been happening in the world of finance. Its interesting reading; quite eye opening on a lot of bizarre practices (many of which seem to be essentially ways of skipping out on taxes and evading regulation). While before the ever intensifying sub-prime crises they were both kinda shouting in the wilderness I suspect people are listening a lot more closely nowadays.
Anyways all of this got me thinking a bit about how the worlds financial system is regulated (or as it turns out not so much)
At work I develop algorithms for MRI scanners and by now I'm quite used to heavy levels of regulation. Before an algorithm or piece of machinery can be sold in the real world we're required by the FDA to go through a vast gauntlet of tests and clearances. This can be hard work at times, but its hard to argue against it. You don't just randomly try new technologies on human beings. You build mathematical models, you do animal studies, you test on small populations, you carefully list and test assumptions being made. The alternative would be unthinkable.
Occasionally even the most rigorous of processes can fail. There are cases where drugs that are meant to heal hurt due to inadequate models and mistakes in the clinical trial process. Change and innovation are not simple things
But these case are few and far between compared to the number of truly useful and helpful medical technologies that people develop. You don't see the
wholesale chaos and absurdity that is the case in the financial system. And lets be honest, the processes and regulation that ensure quality and safety are a big part of that. Its funny, if a doctor tried out a new and untested drug on you without telling you, she would probably lose her medical licence and be open
to vast lawsuits and potential jail time. Yet apparently the money you put into bank deposits can be used as part of wild experiments in securitization without consequences, validation, or previous testing. I guess its not as 'mission critical' as your health, but imho peoples savings are a rather significant thing
and not necessarily the right 'volunteer' for exotic financial experimentation.
I suspect I'd have to look long and hard to find someone who thinks healthcare products don't really need testing or regulation, yet somehow finance is able to skip all of this.
So why can't we require financial institutions to submit new algorithms, packages, whatever to a regulatory authority before, not after use.
How about this
1. Before any new derivative technique or financial contract can be used in the real world it has to be evaluated by an independant body (like the FDA) that would decide
a. if it has value, b. what sort of protections need to be placed around it.
The obvious problem here is that just because you disallow something in one country doesn't mean financial whiz kids can't go set it up in another loosly regulated haven. The defense against this would be:
2. If an uncleared technique is being used by some third party in a different country,
financial institutions from say the USA are not allowed by law to have any financial transactions with that company or any company it deals with. This prevents contagion scenarios and loophole attempts.
At first glance #2 might seem a bit draconian. But in the real economy these sort of requirements are the norm. For example: if a company decides to manufacture parts for a CT scanner in Mexico or India, but wish to sell the completed device in the USA they need to follow FDA norms at that plant. Often manufacturing companies will even add additional international norm requirements (ISO 9000, CMM, etc) when outsourcing work. This has been a normal and accepted part of globalization for the simple reason that quality requires certain global norms. Maybe Benanke, Paulson, and co could learn something here.
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