November 19, 2009
Open Financial Regulation
Posted by Erik Gerding

I've written a number of posts on my research so far that applies Open Source concepts to risk models and to improving securities disclosure. We should also turn the lens on financial regulators and explore ways in which greater transparency can ensure regulators are more effective at their jobs.

The examination of financial institutions appears to be incredible intensive (I needed a flash drive to store the examination manuals for the FDIC for my research files). But regulatory forbearance has long been a concern in banking law. In other words, how do we know those manuals are being followed; sometimes regulators may not blow the whistle on problems at a financial institution for various reasons, including career preservation.

Because of the opacity of examinations, we don't know when regulators are refusing to do their job or when they make mistakes. This problem is compounded as the business of banking (or insurance or investment banking) has become more complex. Consider how difficult it is for any regulator to audit any single firm's financial condition or modeling let alone to spot systemic risks caused by homogeneity or blindspots among the models of numerous institutions.

Greater transparency of the examination process would allow the many minds of the marketplace to backstop regulators and uncover both errors and forbearance. Again, this borrows heavily from ideas in Open Source software.

Note that greater transparency would have restored the public and market's confidence in some of the major crisis management decisions of the past year - such as why Bear and AIG were bailed out and Lehman was allowed to fail. We can engage in academic arguments forever about the wisdom of the bailouts, but so far we have had to trust the regulators. Similarly, how do we know that those vaunted stress tests of banks were valid?

Please note that I do not advocate Congressional oversight of monetary policy. That is a downright horrible idea. I'd substitute a few bluer adjectives for "horrible" were this not a family blog. But there is a huge difference between making regulations - including monetary policy - transparent to the marketplace and to the public and giving control over the interest rate punch bowl to a group that faces reelection every two years.

There are legitimate arguments that immediate transparency may contribute to panics and banks runs. There are also limitations to the "many minds" argument, as Adrian Vermeule (Harvard) has written about. In economic terms, many minds can sometime devolve into herd behavior whether rational (information cascades) or irrational.

But there is little reason why we can't at least have post hoc transparency.

Finance, Financial Crisis, Technology | Bookmark

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