Too Big To Understand

One thing that has undergone hyperinflation in recent years is the length of financial regulations:

Too Big To Understand

The Dodd-Frank regulatory hyperinflation crowds out those who cannot afford teams of legal counsel, compliance officers, and expansive litigation. Dodd-Frank creates new overheads which are no challenge for large hedge funds and megabanks armed with Fed liquidity, but a massive challenge for startups and smaller players with more limited resources.

As BusinessWeek noted in October:

The law requires Hedge Funds to register with the Securities and Exchange Commission, supply reams of sensitive data on trading positions, carefully screen potential investors, and hire compliance officer after compliance officer.

So, is this expansion in volume likely to improve financial stability? No — the big banks are bigger and more interconnected than ever, which was precisely the problem before 2008, and they are still speculating and arbitraging with very fragile strategies that can incur massive losses as MF Global’s breakdown and more recently the London Whale episode proves.

Andy Haldane laid out the problem perfectly in his recent paper The Dog and the Frisbee:

Catching a frisbee is difficult. Doing so successfully requires the catcher to weigh a complex array of physical and atmospheric factors, among them wind speed and frisbee rotation. Were a physicist to write down frisbee-catching as an optimal control problem, they would need to understand and apply Newton’s Law of Gravity.

Yet despite this complexity, catching a frisbee is remarkably common. Casual empiricism reveals that it is not an activity only undertaken by those with a Doctorate in physics. It is a task that an average dog can master. Indeed some, such as border collies, are better at frisbee-catching than humans.

So what is the secret of the dog’s success? The answer, as in many other areas of complex decision-making, is simple. Or rather, it is to keep it simple. For studies have shown that the
frisbee-catching dog follows the simplest of rules of thumb: run at a speed so that the angle of gaze to the frisbee remains roughly constant. Humans follow an identical rule of thumb.

Catching a crisis, like catching a frisbee, is difficult. Doing so requires the regulator to weigh a complex array of financial and psychological factors, among them innovation and risk appetite. Were an economist to write down crisis-catching as an optimal control problem, they would probably have to ask a physicist for help.

Yet despite this complexity, efforts to catch the crisis frisbee have continued to escalate. Casual empiricism reveals an ever-growing number of regulators, some with a Doctorate in physics. Ever-larger litters have not, however, obviously improved watchdogs’ frisbee-catching abilities. No regulator had the foresight to predict the financial crisis, although some have since exhibited supernatural powers of hindsight.

So what is the secret of the watchdogs’ failure? The answer is simple. Or rather, it is complexity.

Big, messy legislation leaves legal loopholes that clever and highly-paid lawyers and (non-) compliance officers can cut through. Bigger and more extensive regulation can make a system less well-regulated. I propose that this is what the big banks will use Dodd-Frank to accomplish.

I predict that the regulatory hyperinflation will make the financial industry and the wider economy much more fragile.

15 thoughts on “Too Big To Understand

  1. Okay. You are really on to something here. To quote Richard C. Young editor of Young’s Investment Newsletter, here is what needs to happen:
    1. Cut the corporate tax rate to 10%.
    2. Cut the dividend tax rate to 0%.
    3. Cut capital gains and estate tax rates to 0%.
    4. Kill ObamaCare dead.
    5. Kill Dodd-Frank regulations on the financial system.
    6. Implement a national plan to get us off foreign oil, starting with big incentives for Compressed Natural Gas (CNG) for all fleet vehicles.

    And there’s more….but where does one start with a Congress, Senate, and President who do not listen to the will of the people or, for that matter, to common sense?

    • 1. There should be no corporate tax.
      2. Dividend tax rate should be high enough to off-set zero tax on earned income [up to
      3. Capital gains ” ” ” ” ”
      4. Eliminate government and insurance company involvement in health care…period.
      5. Eliminate the financial system.
      6. Eliminate the energy cartels.

      Sounds like Mr. Young is another something for nothing scam artist.

    • Abolish taxes and government and litigation and just pay for services you used. We have the technology now and with global competition to provide health education security services we don’t need a government.

      Fixed it for you.

  2. Having read most of Sarbanes Oxley, why haven’t CFO’s been penalised for the GFC issues?

    A total waste of resources and time!

  3. Re Dodd-Frank and Chris Dodd & Barney Frank: can’t repeat too often that these two political crooks, along with their conspirators in congress, their Democratic political hacks appointed to head Fannie and Freddie, and Wall St. cronies, collapsed the global financial markets in 2008.

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