THE TEMPTATIONS OF MODERN FINANCE A Critical Yet Sympathetic Analysis of U.S. Financial Policy

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THE TEMPTATIONS OF MODERN FINANCEA Critical Yet
Sympathetic Analysis of U.S. Financial Policy

• David A. Westbrook
• The University at Buffalo
• The State University of New York

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An Influential Statement of the Problem

• Former Chairman of the Federal Reserve Alan
  Greenspan told the U.S. Congress that the modern
  risk management paradigm held sway for decades
  but the entire edifice . . . collapsed in the
  summer of last year.

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Without a Paradigm . . .

• How do we begin thinking about financial
  regulation?
• How do we begin to address the current crisis?
• How do we conduct financial regulation going
  forward?
• Most broadly, what do we believe about the
  relationships between government and markets?

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A Global Question

• Markets are global
• This is an intellectual crisis with a
  non-national frame
• As evidenced by my talking to you today ?

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Three Eras of Financial Policy

• The Era of Transparency
• The Era of Portfolio Management
• The Era of Constructed Markets (that I hope is
  being born)

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The Temptation of Finance

• Finance gives individuals and institutions tools
  with which to confront the future.
• Financial markets present their own dangers.
• Finance is therefore tempting (but sometimes we
  should give in to temptation).

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Transparency

• Transparency approaches to financial regulation
  respond to marketplace danger by giving investors
  information.
• Much financial regulation particularly the
  mandatory disclosure regime of the securities
  laws in the United States is based on
  transparency.
• Information truth is difficult to achieve.
  Actual disclosure regimes cannot live up to the
  ideal of transparency.
• Put all your eggs in one basket and watch the
  basket!

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Portfolio Management

• Based on theoretical work done in the 1950s
• Understands investment in terms of risk embraces
  risk.
• Marketplace danger is managed through strategies
  of diversification and hedging
• Dont put all your eggs in one basket

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Portfolio Management is

• Synthetic
• Speculative
• Virtual
• Modern
• Social

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Needle TowerKenneth Snelson, 1968Hirschhorn
Museum and Sculpture Garden, Washington, D.C.
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Needle Toweraluminum stainless steel60 x
20 x 20 feet18.2 x 6 x 6m
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Transparency vs. Portfolio Management

• Marketplace danger is ignorance
• Addressed through information
• Assumes a (naively) descriptive function of
  language
• In U.S., roughly 1933-1974

• Marketplace danger is risk
• Addressed through construction of sound portfolio
• Assumes a (naively) contractual and analytic
  function of language
• In U.S., roughly 1974- September 2008

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Weaknesses of Portfolio Management

• Diversification does not work against systemic
  risk
• Models may not represent reality (but be legally
  binding all the same)
• Integration of portfolios tends to increase
  uncertainty (and hence counterparty and even
  systemic risk)

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Tragic Structure of Current Crisis

• Crisis results, in immediate sense, from success
  and global adoption of portfolio management.
• At deeper level, crisis results from the
  antagonism between incommensurate virtues, those
  of transparency and portfolio management.
• Financial regulation like much of politics is
  business of managing such tensions, and as such,
  incapable of perfect solution.

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Managing Temptations (and the Resulting Crises)
through Law

• Recent decades have seen, at the heart of
  financial regulation in the U.S., a superficial
  understanding of law, and therefore of markets
• Financial regulation might be vastly improved by
  understanding that markets are constituted by
  law.
• It is wrong too simple to think of law merely
  as a response to financial markets. Markets
  are always already legal.
• Markets are a form of social organization, and in
  that sense, inherently political.

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Some Recent Oversights (Tough Lessons)

• Corporations do not self-regulate.
• Contract terms are not perfectly determinate,
  especially under conditions of insolvency. The
  precision of pricing models are therefore limited
  in principle.
• Privity (the inability to obligate third parties)
  imposes fundamental limitations on disclosure and
  hence transparency.

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General Lessons for Financial Regulators in the
Era of Constructed Markets

• Financial regulation should be unapologetic,
  because good minds may disagree about the
  essentially political question of how markets
  should be constructed.
• Market failures (and regulatory failures) are to
  be expected.
• Bureaucratic judgment is inescapable, and
  responsibility should be taken.

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A Few Specific Thoughts About Responding to
Crisis

• Even when supporting an industry, care must be
  taken not to throw good money after bad, and give
  undue support to badly run institutions
• Safety may be sought in separation (often legal
  or artificial) of risks, even though unnecessary
  as a matter of financial theory.
• There is safety in a diversity of institutions,
  analogous to biodiversity.
• Scale. Too big to fail is one thing too big to
  rescue is another.

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Intellectual History, Then and Now

• Financial policy has been naïve about the nature
  of language, and the social.
• Financial policy has not thought seriously about
  the laws at its core.
• It is time for financial policy to take the turn
  to interpretation that has marked the rest of the
  humane sciences.
• Thus the turn from the era of portfolio
  management (modeled on physics) to constructed
  markets implies a parallel turn to a more
  interpretive understanding of financial
  scholarship.

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Conclusion

• In a time of interconnected discourses, not least
  of all financial confidence, worldly philosophy
  can and should become a far friendlier
  enterprise!