Obama wants to end chance itself
America’s wars have become increasingly abstract. Instead of fighting the British, the Germans or the Vietcong, we’re fighting drugs, poverty and terror. Now we have declared our final war against risk itself.
Last week, President Obama launched the opening salvo in our new war against risk with a 89-page description of financial reform. Financial firms would be regulated so they could never again fail. Financial markets would be more transparent so they could never again cause losses. The government would have a broad range of new powers, of course; after all, this is war.
Obama praised his own proposal as being “by all accounts … a commonsense, reasonable, non-ideological approach.”
He was already wrong on one thing. It is not by all accounts. Hi there. I disagree.
My father and I recently argued in a research article that any regulation of risk actually increases risk. Moreover, any objective regulatory algorithm to measure and manage risk capital will always result in independent banks simultaneously choosing to invest in securities that appear to be low-risk based on the particular algorithm, but which in fact have higher risk. We proved this both mathematically and empirically, and it holds for any regulation where the measure of risk is objective. In other words,
Obama’s proposal is doomed to fail. What’s worse is that the introduction of new regulations will only increase the probability and severity of future financial crises.
Does that mean we are doomed to a life of chaos, that risk has won?
There are two ways out of the risk-increasing regulatory morass, and they both work by making risk management a subjective rather than an objective process. One way is to fully nationalize all financial firms. We can then just focus on finding good quality regulators to run them. They will be able to make subjective decisions about each bank’s portfolio and lending decisions without the handcuffs of an objective rule. Perhaps this is Obama’s ultimate goal. But of course then risk does not disappear but merely lies in wait as economic and financial decisions get made for political purposes, and any tiny loss can become a collapse of the entire system, since they are all integrated.
The only other possible solution is a complete deregulation of all financial entities. That would mean shutting down the Federal Reserve, America’s central bank. It would also mean ending the FDIC, federal deposit insurance. When you put money in a bank, you would have to be confident in that bank, just like when you invest money in a stock, you have to be confident in that stock. A bank is nothing more than a company that takes your money, hands out long-term loans and tries to repay you on demand.
This is not as radical as it seems. Indeed, perhaps counterintuitively, allowing risk to reign free would reduce the cost of risk. In a free market, when a bank fails, only that bank fails, dragging down, at worst, a handful of others that depended on it. The system remains. The possibility of a financial crisis lessens.
We have tried the approach that has been billed as commonsense and middle-of-the-road. We may disagree whether we should nationalize or deregulate everything but one thing is clear: on the issue of risk, you don’t want to be standing in the middle of the road.
Dr. Phil Maymin is an Assistant Professor of Finance and Risk Engineering at NYU-Polytechnic Institute. The views expressed are his own.
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