Thursday, August 5, 2010

Taleb With a Telling Anecdote on the Regulatory Mess

Nassim Nicholas Taleb weighs in on the regulatory mess in our financial system through a curious tale of being approached while at Davos with the following (legal) proposal to avoid FDIC regulations:
[He] tried to sell me a peculiar investment product. It allowed the high net-worth investor to go around the regulations limiting deposit insurance (at the time, $100,000) and benefit from coverage for near unlimited amounts. The investor would deposit funds in any amount and [the] company would break it up in smaller accounts and invest in banks, thus escaping the limit; it would look like a single account but would be insured in full. In other words, it would allow the super-rich to scam taxpayers by getting free government sponsored insurance. Yes, scam taxpayers. Legally. With the help of former civil servants who have an insider edge.
Got it? I left out the name of the salesman for this scheme for shock value, because it was none other than ... Alan Blinder, a former Vice Chairman of the Federal Reserve Bank of the United States.

So, in case anyone was left wondering, government officials apparently don't feel any regret/guilt/sense of impropriety about crossing over to the other side -- going from regulator to regulatee -- and profiting off the knowledge/connections gained while enforcing financial rules.

But Taleb makes one other must-ponder point dear to my heart:
... the more complicated the regulation, the more prone to arbitrages by insiders. So 2,300 pages of regulation [i.e., the current financial reform bill] will be a gold mine for former regulators. The incentive of a regulator is to have complex regulation.

Second, the difference between letter and spirit of regulation is harder to detect in a complex system. The point is technical, but complex environments with nonlinearities are easier to game than linear ones with a small number of variables. The same applies to the gap between legal and ethical.
I've repeatedly said on this blog that the answer to our financial system's regulatory woes is not a rules-based approach of trying to anticipate every situation, of trying to plug every hole, of trying to cover every contingency in this or any other possible world. It's impossible to do. We need to look at more flexible solutions, such as principle-based regulation with teeth. We're foolish to head back down this path of growing a new regulatory bureaucracy that is doomed to fail as smart financiers parse out endless loopholes.

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