We Don’t Have All the Answers: A Regulation Warning

Last week, I attend a conference co-hosted by the Chicago Federal Reserve Bank and the European Central Bank. The topic was the role of central banks in financial stability, and many of the papers presented were focused on how to improve macroprudential regulation. I was struck by the confidence of the presenters (there were roughly 40 or so 15 to 20 minute presentations) in their belief that “now we’ve figured it out” and can design the right regulations to create financial stability. One—just one—of the academics suggested that instead of talking about how we are preventing problems in the future were should figure out the problems of today. And a few expressed some skepticism in the ideas others put forth. But no one stood back and said, maybe it is impossible for us to now have all the answers, just a few years after the crisis.

One of the ideas behind Dodd-Frank was that by granting regulators more powers they could prevent problems at financial institutions. The general consensus is that the legislation really didn’t end the too-big-to-fail problem. But behind that, the law was essentially backward looking. It put in place a lot of rules that may or may not have prevented the financial crisis in 2007-2008, but that was in the past. The next crisis will be of a different character, come from a different place, and quite possibly evolve out of the regulations recently promulgated.

The failure of MF Global is evidence of this. A key part of the story of MF Global’s collapse is that they did a terrible job tracking their own finances. In fact, they lost hundreds of millions of client cash not to bad trades but in bad book keeping. Most of the money has been found, but it has let to the CFTC taking industry wide action. Dealbook reported last week:

Federal regulators have ordered an audit of every American futures trading firm to verify that customer money is protected, a move that comes after roughly $600 million in client funds were discovered to be missing from MF Global, the bankrupt brokerage firm once run by Jon S. Corzine.

The Commodity Futures Trading Commission, the federal regulator searching for the missing money at MF Global, will audit many of the nation’s largest futures commission merchants, according to a person briefed on the decision. Exchanges like the CME Group will examine smaller firms to ensure they are keeping customer money separate from company money, a fundamental rule on Wall Street.

What is interesting about this is that there never was a thought given to verifying that futures traders were keeping track of their customer’s cash. In all the backward looking regulation, this had never come up. Because it was a future problem.

Now, we could argue about whether or not the CFTC needs to be checking in on firm’s ability to track its own cash. If they fail to do so there is some liability on the shoulders of investors in picking the right place to keep money, and there will be legal liability toward any firm that leverages its client money for trading its own book. But the point here is that the CFTC didn’t think to regulate this until it became a possible problem.

This will always be the nature of depending on regulation. That is not to say there should be no rules. That doesn’t even necessarily say that Dodd-Frank’s rules were bad (though they were). But it does make a point that rises above partisan politics—depending on backward looking regulation is not going to lead to financial stability.

Every brilliant academic who presented at the Chicago Fed-ECB conference should be able to discern this. Though at at certain point, your own brilliance may lead you to believe you can John Nash the world and see the matrix floating by. In this case, understanding the Hayekian knowledge problem becomes critical to recognizing the limitations of humanity and the value of accepting a more market driven world of failure and success that depends on personal liability and not societal supports to achieve a false sense of stability.