and overconfidence
in economic regulation

From formal rules to wise men and global sheriffs

Trust is crucial in economics and finance, but it should not be based
on illusions, including over-reliance in administrative rules.

The subprime crisis has shown that economic regulations do not
always vaccinate against crises.
They tend to be bureaucratic and built on past issues, barring any
anticipation of new situations that might arise.

Competent watchdogs, with enough power, are needed as radars
to see farther.
Any power - whether of global organizations or of the markets - needs
a global counter-power.

person Trust is a crucial economic and finanial factor.
   But trust should not be illusion
              and over-reliance
Legal and administrative rules that are supposed to protect
people and society are often:
  • too complex intricate, always changing and non transparent
Here the "cognitive overload" might strike and make those
rules inapplicable
and an obstacle to evolutions. Complication
tends to bring confusions and add to the possibility of loopholes
and perverse effects as seen below.

Better have a few fundamental principles, and powerful
and smart supervisors as seen also below than
an impenetrable

  • built on past past issues more than on anticipation
of what could go wrong on the future.

This can make them easy to circumvent, not always enforced
and also soon obsolete as innovations took over and changed
the picture of the related activities.
Such regulations can do more harm than good (
effects, moral hazards...) once they get overridden by somber
realities and conjurer tricks.

Regulations, however needed they can be, are not
enough to bring trust.

Over-reliance in their formalism and intricacies
can be illusive and
easily crumble as victim of
unforeseen realities.

ependent and effective signal vigilance might
be even more important
than intricate rules

When blind regulations bring
perverse effects, even crises

The temptation, after a crisis like the subprime crisis, is to create new
and stricter regulations.
A paradox, as one of the causes of the crisis was a ...regulation.
The capital adequacy rules for banks gave them the incentive to
transfer loans, above all dubious loans, from inside to outside
their balance sheet
They were repackaged as financial securities and contracts (by
using techniques such as "securitization" and "financial options")
via shadow financial "vehicles"and sold to funds and to ...other
banks usually.

This opened the door to subprime loans, miraculously changed 
into apparently safe investments
that met the solvency
regulation criteria
, like hashed rotten chicken turned into pheasant
This is how bank balance sheets artificially complied with it.

A mountain (or ocean, choose your allegory !) of those toxic
assets (estimated at 3 trillion US dollars or more) was created,
until people understood that their value was dubious to say the
least and they became unsalable therefore illiquid.
Then the crisis broke out!
And it was fed by other norms or regulations:
rating agencies usages, "mark to market" accounting rule...

What to do?

More regulations?

What to do to avoid such a crisis in the future?
Regulate those financial instruments?
Adapt and harden the capital adequacy rules (it is what is being
done by the way, with a specific attention to "systemic banks") ?

Who can really think that regulating what caused a past
anomaly will avoid the next anomaly
, which can be totally

What is more, when one reason of the crisis were loophole /
moral hazards
created by regulations and norms.
Hazards that most financial authorities where
blind blind to,
as were the cases of

* not only various global and general official bodies (not all of
   them,  let
us be fair) that tend to be eaten by two cancers:
and clans

* but also most other organizations and businesses that lived
in their geographical and / or professional
insurance, markets, investment funds, not
   to forget public finance public treasuries, central banks ...).

Too complex intricate regulations (instead of simple principles) cannot
be really complied to. Compliance to a maze becomes a farce.
=> Such rules get tacitly relaxed, which prepares the next crisis.

Or clear simple principles

and smart and courageous sheriffs?

The right solution can only be one that can avoid such myopia.
It means to have:
  • Some general transparency, safety and ethical principles
instead of a maze of rules that get soon obsolete and bring
  • Those principles to assess poachdelictuous behaviors might be:
  • You shall not rig the market (creating bogus transactions)
  • You shall give all information (transparency),
  • but also avoid buy / sell recommendation
(cf. the expert issue).
  • You shall not rig information
(the whole subprime business was done behind an
apparently scientific smoke screen)
  • You shall put enough of your own money,
not just betting with other people's money
  • Smarter watchdogs,
They would act as radars able to anticipate what new
forms the biases would take,
what new excesses (in pricing,
volumes, returns,
overleverage...) are building up.

Those overseers need
not only to use a digital dashboard but:

* to have an anticipative minds and investigating qualities,

* to have a legal authority as legal counter powers to the
   financial industry.

* to manage a sizable and competent staff and powerful and
flexible technical means as a kind of scientific financial
* to work on the basis of international cooperation.

See more details in the next section
"what about those supervisors?"

The example of Canadian supervisors (and in some degree
the French ones) who prevented their banks to fall into the
excesses seen in the subprime crisis, should be taken into

What about those supervisors?

The King Salomon and Elliot Ness lineage
Those supervisors would form a kind of World Financial
or at least a World Financial Authority.
  • Those Salomon-type wise judges, should be recruited 
among the best professionals and researchers.
Effective supervision needs a wide experience of the
game so as to detect what happens in the restaurant
=> For that purpose, they would be not only
* nosy and suspicious.
* attentive to "weak signals",
* and imaginative in order to anticipate what
professionals are inventing or
   going to invent
to distort the system,

Btw, who is interested in the liquidity danger brought
by ETFs which portfolios
are made of virtual assets ?
  • Their mission would be to have general principles respected,
not intricate regulations.
Here we see some similarity, but in another area, with the
ssion of the European Court of Human Rights
  • They should be very well paid and rewarded
because of their competence and performance, but also in
order to be "incorruptible".
  • They should have full global authority
as global sheriffs or magistrates, whatever way to call

Taking into account that in global markets frauds tend to
be global also.

They would not be ordinary bureaucrats who are happy
to see that the rules are not broken on the surface, or
when they understand the biased game, have no power
to stop it.

What are needed are not just bean counters but also
Elliot Ness's squads
Of course without the prohibition pretense ;-).
With extensive technical and human resources.
paid informers and undercover agents as
financial crime is as high a menace as terrorism or
drug dealing

And as a legal court, they should have the authority to
decide sanctions
when the principles stated above
are violated.
  • And what is crucial, take a monk-like commitment
not to be influenced
Notably by the
sillymad general mood and the belief that
markets always know better, even when they enter
behaviors (market bubble or crash), an
ion the efficient market theory instilled in some
weak (and greedy) minds.
  • In fact they would be "behavior observers"
and "system dissectors" more than number crunchers.

Better remember Montesquieu:

The way to avoid that a power (we can apply it to the power of
markets) becomes an absolute power is to develop independent
democratic counter-powers.

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M.a.j. / updated : 26 Sept. 2015 
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