October 17, 2008
Regulatory Rule #1: Don’t Panic
Posted by Mike Guttentag

Suppose that you were running an agency charged with overseeing financial markets, and you were concerned that a situation similar to the October 1987 crash might reoccur.  What regulatory measures would make sense? 

Two recommendations seem obvious.  First, insure that back-office systems are sufficiently robust to function smoothly even when securities prices move up or down dramatically.  Second, avoid taking action in response to concerns that on any given day security prices are too high or too low (clearly not advice that Bernanke and Paulson are following).  I would also contrast this “don’t panic” advice with Professor Stephen Schwarcz’s proposal in recent articles that a “market liquidity provider” be established to purchase securities when their prices “fall below intrinsic value.”

First, Schwarcz, as with Partnoy, should be given accolades for presciently addressing many of the issues regarding volatile markets and systemic risk that are now at the forefront of US economic policy decisions.  (Equally prescient was Lawrence Cunningham, whose 1994 article, “From Random Walk to Chaotic Crashes: The Linear Genealogy of the Efficient Capital Market Hypothesis,” also considers many of these issues).  Schwarcz’s articles, “Complexity as a Catalyst for Market Failure: A Law and Engineering Inquiry” (August, 2008: ssrn abstract: 1240863), and “Systemic Risk”, Georgetown Law Journal, 97, 193 (2008) are of particular relevance to the discussion of how much regulation is advisable during a crash. 

In his “Complexity” article, Schwarcz draws a parallel between financial markets and complex physical systems.  Schwarcz goes on to describe how feedback loops in financial markets can cause a “downward spiral” in prices.  Schwarcz’s analysis in this article is similar to my explanation of how portfolio insurance can create an upward sloping aggregate demand curve, which could create many price equilibriums, and, in turn, a feedback loop between a decline in share prices and a decline in the demand for equity securities.

Notwithstanding the similarities, our recommendations as how to address the dynamic nature of securities markets are quite different.  One of the strategies that Schwarcz’s considers is the formation of a public entity “to act, if needed, as a market liquidity provider of last resort” (page 40).  This entity’s role would differ from the Fed’s role of acting as a central banker in that this entity could purchase different types of securities on the open market.  According to Schwarcz, “a market liquidity provider could invest in securities of artificially falling financial markets – markets in which the price of securities falls below the intrinsic value of the assets underlying the securities…” (page 41).  Schwarcz suggests that this market liquidity provider might act when “prices are artificially low.” 

But recommending a market liquidity provider rests on the inference that if prices for risky securities are driven by complex, non-linear systems, then high volatility provides evidence that prices are swinging above and below their “intrinsic value.”  Such a conclusion does not recognize the extent to which market gyrations may also be caused by the existence of multiple-equilibriums.  Markets can be in equilibrium at dramatically different price levels, even on the same day, and, in such circumstances, there is no justification for a regulator to intervene to restore “true” value.  For example, in October 1987, once the dynamics were in place that created an upward-sloping demand curve for equities in a relevant price range, there was little for a sensible regulator to do other than make sure that markets functioned smoothly enough to handle the fireworks.

It may make sense for a concerned regulator to determine beforehand whether there are flaws in the inputs to the system that create undesirable instability, but this is very different than coming in after the fact to reestablish “true” values.

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