Two of my recent research interests are the ways in which technology contributed to the financial crisis and the ways in which it can help prevent future crises.

In one article, I've written about how financial regulators directly delegated (or outsourced) vast responsibility for regulating financial risk taking to the computer-based risk models of financial institutions. These models were used to market and price loans to consumers, price asset-backed securities and derivatives, provide credit ratings, and manage financial risk for large institutions. In some cases, regulators refrained from regulating, trusting that these models accurately assessed risk.  In other cases, they actively delegated core regulatory responsibility to models - most notably under the Basel II Accord. Basel II permits national bank regulators to allow certain large banks to set their own capital requirements according to internal models.

Ken Bamberger (UC Berkeley) has a great paper on the same theme called "Technologies of Compliance." Ken takes a broader view and finds that private sector compliance technologies are assuming risk regulatory functions in other areas including Sarbanes Oxley and privacy protection.

But Ken and I may have slightly different take on several points.

First, in terms of how this delegation occurred, I tend to focus a little more on industry pushing to use their own technologies in lieu of traditional risk regulation. I think this explains Basel II.

Second, I may be more skeptical about the motivation of industry in using models.  Many financial risk management models can be prone to gamesmanship.

Third, I focus more on the errors and limitations in industry models. As I noted earlier, the problem is not that some of the underlying finance theories - like Black Scholes -- are "wrong"; it is that these theories have embedded assumptions and limitations that are often overlooked. Models cannot be used uncritically.

Fourth, I have serious reservations about the incentives and capacities of regulators to audit these models (a topic I'll address in a subsequent post).

I catalogue some of the ways in which risk models failed in the current crisis.  I also explore some of the remedies for these failures.  If regulators continue to rely on private sector models to regulate risk, we need to require greater transparency of both these risk models and the auditing of these models by regulators.  I borrow concepts from the Open Source movement in software on the theory that "many minds" can both debug these models, spot sources of systemic risk, and police regulators.

A full open source approach might undermine the incentives of the private sector to generate good risk models.  So in many cases, I see this as an ideal of disclosure. But there are two exceptions.  First, I advocate fairly comprehensive disclosure of rating agency models.  Rating agencies essentially enjoy a government regulation-created oligopoly that will be difficult to undo.  Because of this oligopoly power, we have less to worry about undermining proprietary rating agency models.  Second, I argue that if banks elect to set their capital requirements under Basel II using their own internal models, they need to fully disclose these models to the marketplace.  This may create a disincentive for banks to exploit Basel II and use internal models to set capital requirements.  But I don't believe Basel II works in the first place.  

I'll be exploring some of the potential applications of Open Source ideas and other ways in which technology can improve securities regulation and banking regulation in subsequent posts.  I welcome comments on the paper.

Administrative Law, Finance, Financial Crisis, Legal Scholarship | Bookmark

TrackBack URL for this entry:
https://www.typepad.com/services/trackback/6a00d8345157d569e2012875af15e9970c

Links to weblogs that reference Open Source Approaches to Financial Regulation: