Monitoring the financial world

One of the recommendations of the US Government's recent proposal for revamping financial regulations was to create a “systemic risk monitoring” group that would keep an eye on the state of financial markets. This group would watch for hidden risks such as some of the mortgage-backed securities structures, credit default swaps, and unregulated, creative derivatives instruments. Despite the merits of such a group, the effort is probably doomed to failure, as the humans trying to monitor the complex world of investments fall prey to the same dangers the general investment public makes. There are three overriding issues:

Knowledge, ethics, action

First, the monitors need access to information - on individual companies, and aggregated over industries, nations, interest groups, and so on. Data is relatively easy to come by in the modern age. Transforming this data into useful information for detecting dangerous trends is a couple of orders of magnitude more difficult. Variations in measuring protocols, differences in methods and processes, all make creating valid information from data more difficult.

A second aspect of this knowledge problem brings in the ethical component. Who gets to know the inside information on important industries? How do they safeguard this information, and differentiate between what is proprietary and what is not? How can we be sure no one benefits from using this inside information to play markets? From the quality of the data provided or available, to the confidentiality and prudent use of the information, the way information is accessed and safeguarded is critical to the necessary trust and credibility of the group. These issues are extremely thorny, and will not be easily put to rest.

If we end up with many "insiders"(for example, Wall St executives, Wall St retirees, economists, central banks and so on) doing the evaluating, their motives for reaching the conclusions they reach will be suspect - conflict of interest will always be an issue. Each would have too much of an interest in maintaining the status quo and in keeping uninterrupted the operation of the existing system.

Aside from that danger, there is the danger of using confidential market information to colour their own investment decisions. The monitors will need information that is considered proprietary to the firms involved, and will have difficulty developing the trust required to achieve this end. The group’s reach should include terms of contracts and transactions that are above a certain size threshold, or that add up to significant portions of investment activity. These folks will have a legitimate interest in the financial health of firms that are parties to these transactions or markets. This may require access to operating results that the parties would prefer not to share. How will the overseers manage this access, and prevent information from leaking to the general investment world?

So the only way to achieve pure intent would be to recruit individuals from other lines of business whose skills and knowledge are related, but who are not actively involved in investing. Sweeping restrictions on what investment choices the monitors could participate in may be required.

Should this institution be viewed like the CIA - legitimately using illegitimate means to acquire information (hacking into computer systems, for example)? Or should there be strict boundaries and limits to its reach? These answers depend on the importance given to the results, and the level of trust we have in this potentially powerful institution.

I see so many problems with the approach that I don't think they can implement it without falling into some of the traps I've mentioned. I think the goal is a good one, but the tools, the confidential nature of business transactions, and the personal temptation to profit from inside information will inhibit results. Creating confidence in, and the credibility of, the group will also be a big issue.

Even assuming pure motives, the knowledge problem is still a considerable obstacle. Magnificent tools exist for collecting and aggregating data in the 21st century, but making information out of it is another story. It probably is a hopeless task but if it is I have concerns as to where that leaves us. Are the housing bubble that just burst, and the financial dislocations that then ensued, the largest in recorded history in terms of the size of the national or global economy? My impression is that they are. If these market distortions keep on getting larger before they burst, the repercussions of the next one could cause a lot more hardship around the world.

I envision a tier of researchers and information gatherers and analysts working within some fairly specific guidelines, and the committee adapting these guidelines to the current developments in the world of money and investments, and evaluating the results in terms of potential problems. I grant that things will pass them by that should be questioned - they won't anticipate the next problem much better than anyone else, but they might be in time to avoid catastrophic results.

The final issue is what this monitoring institution can do about problems it discovers. A bully pulpit is better than nothing. Enforcement provisions in the international finance realm will require broad co-operation between the institution and central banks, and agreement on the nature and magnitude of any potential risks discovered. If all of these obstacles can be overcome, such an effort would be worthwhile. In the meantime what sound like a very prudent idea faces serious challenges in its implementation.