Behavioral Psychology, and the Regulation of Systemic Risk

It seems every day or two either the House or Senate is passing another bill to regulate the rating agencies or the banks or the hedge funds or this or that (see for example Hedge Fund Symposium: the regulation question, which covers this daily).

From an economic perspective, regulation takes time, money, and effort. And frustration. Sarbanes Oxley was only one of many regulatory requirements that imposed an insufferable burden and resource drain on smaller companies. Not that regulation might not be good; but rather that it needs to be carefully considered before implementation. There's (unfortunately) a rush, now, to propose the latest regulation.

But it's much more fascinating to consider this from a behavioral perspective. If you were unfairly nasty to Jimmy yesterday, you feel guilty, and so today you're overly nice. In other words, you overcompensate.

Let's think of regulation, too, as being on a continuum. It's not black and white, but perhaps the sweet spot is somewhere in the grey area: between a complete lack of regulation (closer to where we were) and a totalitarian, 1984, government.

Here's an example: earlier this month Senate Banking Committee Chairman Christopher Dodd suggested that congress will consider creating regulators to monitor systemic risk. And House Financial Services Committee Chairman Barney Frank suggested that he plans to start the regulatory overhaul with legislation that makes the Federal Reserve the regulator for systemic risk.

Now you have to appreciate that systemic risk is quite something to monitor. Academics -- most notably MIT's Andrew Lo -- have been successful at describing systemic risk in research papers but gloriously unsuccessful in implementing strategies (within their own hedge funds) to mitigate against it or profit from it. And so the natural question: imposing the new regulation may be fine and dandy, but how exactly is the Federal Reserve going to monitor and buffer against systemic risk? Are we wasting money, creating jobs to merely collect superfluous data? My comment is that the Fed may do this perfectly well, but that the careful consideration of how they'll approach the task need necessarily come before the imposition of the new regulation.

Nassim Taleb goes further in his recent interview with Bloomberg Surveillance:

"You know, people claim that we didn't have enough regulation. No. We had regulation. It was just bad regulation and bad regulators.

... the system is becoming very fragile because of interlocking relationships ... you even lose the national aspect of things ... the whole world is becoming a large bank ... banks are incompetent at risk management, have always been incompetent at risk management."

Taleb seems to maneuver towards the same question, and the creation of systemic risk via globalization. But he would likely want to know:Will the Fed be better positioned to manage systemic risk for the entire system than banks' risk management divisions were able to manage their own risk?

Are we overdoing the regulation, now, as we had perhaps underdone it under Greenspan? Does overcompensating not simply create the opposite problem? (When companies are having to apply significant resources to compliance and regulatory controls, they are to an extent hindered from growing: ultimately the aim of any economy.)

Looking at this another way, regulation here runs counter to utility theory. Has the severe economic downturn been so powerful as to return our Senators and Congressman to their biologically-engendered loss aversion roots? Or is this purely a short-term solution, with loss aversion making way for greed and utility as soon as resources become less scarce?

Note: see Phil Pearlman's piece on the deeper nature of loss aversion, evolution and risk complacency, and how the resulting cognitive dissonance may affect one's trading tendencies.

UPDATE - Feb. 24, 2009: The American Enterprise Institute for Public Policy Research, in their piece "Risky Business: Casting the Fed as a Systemic Risk Regulator," had some harsh criticism for the Fed's ability to monitor systemic risk:

This Outlook examines the notion that the Fed should be the systemic regulator, pointing out that the agency has for many years had all the powers of a systemic regulator for banks and has failed to use them effectively; that supervising industries other than banking requires skills and knowledge that the Fed does not have and probably could not acquire in any reasonable amount of time; and that a role as systemic regulator would impair the Fed's independence and create conflicts with its more important function as the nation's monetary authority. Finally, this Outlook questions whether systemic risk itself can be defined--and whether the commonly accepted notion of systemic risk supports the creation of a systemic risk regulator.