University of Houston Finance Professor Craig Pirrong questioned a policymaking assumption that better understanding of the workings of financial networks can enable regulators to make financial markets better and, therefore, prevent the next financial crisis. He cited mandatory clearing and rigid variation margin requirements as examples of regulatory measures that change the topology of a financial network to “make the network more tightly coupled, and therefore more vulnerable to precipitous failure.”
Professor Pirrong criticized policymakers who believe that they can reconfigure highly interconnected financial networks to make them safer, arguing that “[t]he very features – feedbacks, spillovers, non-linearity’s – that can create suboptimality also make it virtually impossible to know how any intervention will affect that network, for better or worse, under the myriad possible states in which that network must operate.” He concluded that:
. . .it is delusional to think that simplicity can be “imposed on” a complex system like the financial market. The network has its own emergent logic, which passeth all understanding. The network will respond in a complex way to the command to simplify, and the outcome is unlikely to be the simple one desired by the policymaker.
Lofchie Comment: Professor’s Pirrong’s financial network models demonstrate how complexity may thwart the most well-intentioned regulatory plan. A couple of related observations:
First, many elected officials and regulators are so invested in Dodd-Frank and the regulations adopted under it, that they deny its deficiencies or the problems it creates. See, e.g., Legislators Boast That Shrinking Size of GE Capital Proves Dodd-Frank Is a Success; FDIC Chair Gruenberg Asserts that Post-Crisis Reforms Strengthen the Financial System. Even to those who believe that Dodd-Frank is a better than bad piece of legislation, honest and critical examination would demand significant revision. No one can write a 2,000-page piece of legislation that would not benefit from a second draft.
Second, regarding an observation made by former SEC Commissioner Daniel Gallagher: FSOC’s recent report on risks to the financial system entirely (with the exception of one clause) missed Brexit. If this were the NBA, that would be the equivalent of missing Kevin Durant going to the Warriors.
Given the Professor’s warnings about the impact of complexity on any system, maybe a little more modesty and willingness to be self-critical are in order.