develop systems to acquire the necessary risk information from the institutions, analyze that data and determine if new areas of risk are emerging

From Rick Bookstaber:

"The Regulator as Risk Manager versus Risk Monitor

I have recommended in various forums that we need a government-level market risk manager( I AGREE WITH THIS APPROACH. I CALL IT SUPERVISION. ). (See my House testimony (October, 2007) and Senate testimony (June, 2008), both linked via posts in this blog, and the Preface for the paperback edition of A Demon of Our Own Design). Such a role has also been recommended by the Treasury in the form of a market stability regulator.

I was discussing this idea yesterday with a colleague in government, and he mentioned that one concern for such a role is the potential for a concentration of power. Risk taking is at the center of the financial industry, and whether it is the Federal Reserve, Treasury or SEC, the ability to dictate risk limits puts this role in the position of controlling the industry’s profitability.

To answer this concern, it is useful to make a distinction between risk management and risk monitoring( SUPERVISION ). In the financial industry, be it in hedge funds or in banks, what is called risk management is really a risk monitoring function. The risk management team, headed by the Chief Risk Officer, oversees the aggregation and analysis of exposures( I SAY THAT THE SUPERVISION WILL MONITOR THE METHODS AND AIMS OF INVESTMENTS, ESPECIALLY ONES THAT TRANSFER RISK TO A THIRD PARTY OR MAGNIFY RISK. ). But it does not make decisions on the appropriate risk appetite for the firm, and it does not unilaterally set the risk limits or otherwise force the risk takers to hedge or reduce their positions. If the CRO thinks action is needed, the baton is passed up the chain of command to the firm’s decision makers. This might be the head of the trading division, the CFO, the CEO, or a risk management committee with these as its members. The decisions of how much risk to take, the limits to set, when to make exceptions all are made at this level.

A similar structure could exist for the risk management role within the government( YES ). The role of risk manager would be staffed by technocrats, in the positive sense of that word, who would develop systems to acquire the necessary risk information from the institutions, analyze that data and determine if new areas of risk are emerging( YES ). They would connect with their industry counterparts, the CROs of the various institutions, to understand areas of concern, to help identify common or emerging risks, and to constantly refine the risk management process. If a market crisis did occur, they would have all of the data at their disposal to revisit the risks to monitor and the limits to set. Think in terms of what the NTSB does when there are airplane accidents. All of this would lead to recommendations to a decision making committee, perhaps a subcommittee of the House or the Senate. ( I AGREE )

Don’t worry about too much back and forth with the decision makers. On a practical level, it would be rare for the government risk manager make one-off suggestions that this or that bank lower its risk beyond the risk targets that have already been established. More likely, the government risk manager would see that a number of banks are starting down a particular path, building up exposure to a new market or diving into a particular structured product space, and recognize that, while each bank’s actions might be reasonable on a stand-alone basis, there is too much concentration and potential systemic effect once the exposure is aggregated across the banks. ( A GOOD IDEA. )

And, by the way, no one can make such an observation in our current regulatory structure."

This qualifies as what I call Supervision, as opposed to Regulation, which focuses on narrow rules and then tries to figure out if anyone is breaking them. Regulation is a system that can very easily gamed by working around the rules and regulations.

"On the contrary, among the biggest supporters of both have been the world’s investors, at least insofar as their collective judgment "

Another good James Surowiecki post:

"Libertarians Against the Market

Tyler Cowen, in his ongoing effort to ensure that the government spends as little as possible in its attempt to stimulate the economy, cites approvingly a post by Arnold Kling arguing against a big fiscal-stimulus package, because the risks vastly outweigh the potential rewards (actually, Kling doesn’t really think there are any potential rewards from a stimulus plan). Kling enumerates those “risks” in a list. This is not a very useful list, because it contains absolutely no evidence for any of his assertions—he simply assumes the existence of his risks to be a fact—and no assertion about how likely any of these “risks” are, which makes it a little hard to do a cost-benefit analysis. Kling says that “on close examination,” the case for stimulus is weak, but, in this post, at least, he offers no such “close examination,” merely a laundry list of familiar (and unproven) criticisms of government spending.

The most curious thing about Kling’s post, though, is the way he closes—namely by complaining that even though he and his side “have logic on their side,” they will be “mocked and vilified in the media” for their opposition to a big stimulus package, and that that package will be pushed through as a result of “elite groupthink”—the same groupthink, in fact, that pushed through the Paulson rescue plan. The implicit assertion here is that the support for a stimulus package, as for the rescue plan, is driven by this élite group of interventionist economists and politicians, who are overriding what would otehrwise be commonsense economic policy.

What’s odd about this is that the support for the stimulus package, as well as support for the Paulson plan, hasn’t just come from liberal economists or Democratic politicians. On the contrary, among the biggest supporters of both have been the world’s investors( TRUE ), at least insofar as their collective judgment is reflected in market prices. As I showed yesterday, investors overwhelmingly supported the Paulson plan: it was only when it was killed, that stock prices really started their downward spiral( I AGREE ). And it was only after Obama unveiled his economic team and made clear how big his stimulus plans were that the market began its sharp recovery( I AGREE ) (the S. & P. 500 is now up twenty-five per cent since Nov. 20th). And as The Economist’s mystery blogger noted yesterday, anyone’s who’s paying attention to the stock market knows what would happen if Obama announced today that he was abandoning his plans for a major stimulus package:

Markets would plummet, with significant knock-on effects, based on the actual news that government spending would not nearly close the American output gap, but also given the signal that America was no longer committed to serious stimulus.( TRUE )

The point is that it isn’t just some group of pointy-headed Keynesians saying that a big stimulus package will be good for the economy: the collective wisdom of the market is saying the same thing( TRUE ). And it seems peculiar for a supposed believer in the efficiency and intelligence of markets—which, as a libertarian economist, I assume Kling is—to simply disregard what the market is saying in this case. In effect, libertarian economists are saying that they have a better sense of what’s good for the economy than the aggregated wisdom of investors does. And that makes them sound peculiarly like the Platonic economic planners that they typically decry( TRUE ).

There is no doubt that our Investor Class wants a government bailout large enough to stop both the Calling Run and the Proactivity Run. TARP and other various government actions have tried to stop the first, while the stimulus is an attempt to stop the second. Only explicit government guarantees and actions are believed to be sufficient enough to stop these runs. Leaving the two Runs to run their course could lead to extreme losses of wealth and jobs, large enough to effect social stability. This outcome must be avoided at all costs.

The Investor Class had no Plan B. They believed, quite correctly, that the government would have to intervene in a financial crisis. Investing has been done for at least the last twenty years with this understanding, as well as the understanding that government has an important role in funding and helping the Investor Class. They do not believe in limited or no government, and would have no idea to do business in such an environment. As Wittgenstein said, "If a lion could talk, we could not understand him". I say, "If the free market showed up, the Investor Class would not know how to do business in it". They are the ones with the money, not theoreticians.

In the future, we will need a LOLR and SOLR to undergird our financial system. The explicit conditions of these guarantees will be meant to prevent Calling and Proactivity Runs. This can work. In other words, the intent is to keep the government from having to actually spend money, by allowing time for financial knots to unwind at minimal cost and disruption. Only the government can do this. In order to keep moral hazard from being a consequence, a strict application of Bagehot's Laws and a strict regime of supervision, not regulation, which focuses on aims and methods, as opposed to relying on particular laws, can keep moral hazard from becoming a problem. For one thing, by the end of the process, the Investor Class members which need a bailout will essentially be bust. It will not be a pleasant experience for them, as opposed to TARP.

The current political culture is a result of compromises over time. It cannot be easily changed, and should not be quickly changed. But, over, time, the system can be made fairer and freer for most people. Starting out with the changes listed above would be an excellent down payment.

Regulations And Regulators

Terrific post on the NY Times by Gretchen Morgenson.

Point 1) The problem of regulators:

"And that has created the biggest problem for regulators right now: at precisely the moment they are entrusted with breathtaking powers, investors’ and taxpayers’ trust in them is at a nadir."

Of course, the SEC story earlier and handling of the Wachovia deal weren't great shakes for regulators either.

Point 2) The implicit government guarantee:

"There are a few straight talkers in the regulatory regime, of course. One is Gary H. Stern, president of the Federal Reserve Bank of Minneapolis and co-author of “Too Big to Fail: The Hazards of Bank Bailouts.” In a speech last Thursday, Mr. Stern expressed deep unease over the consequences of using taxpayer money to rescue big and reckless financial institutions.

“The too-big-to-fail problem, with which I have long been concerned, has been exacerbated by actions taken over the past year to bolster financial stability,” he said, according to his prepared remarks. While conceding that the recent lifelines were appropriate, given the circumstances, he said that “it is critical that we address ‘too big to fail’ because, if left unchecked, it could well be a major source of future instability.”

It seems to me that this problem has already led to instability.

Point 3) Regulations going forward:

"Mr. Stern’s solution is an approach he calls “systemic focused supervision.” It involves “early identification, enhanced prompt corrective action and stability-related communication.”

First, regulators would identify what Mr. Stern described as “material exposures between large financial institutions and between these institutions and capital markets.”

Read on.

In other words:

A. Identify problem bank.

B. Close It.

C. Tell the public why.

Of course, this solution relates to Point 1, since this system will necessarily rely on regulators. However, it's better to have Point 1 be a problem, from my point of view, than Point 2. It seems to me that it would be cheaper, and hinder the free market less than the consequences of implicit government guarantees, i.e., to big to fail.