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Wednesday, 10 October 2012

Regulatory Omniscience is A Fictional Conceit

Who Guards The Guards?

If you’re a regulator you’re likely to be conditioned by motivated reasoning: you should want more stringent regulation because, after all, that’s what you get paid to do.  You’ll base the need for more rules on reasoned analysis, but your analysis will be directed by your incentives.

Regulators are human; ergo, they’re subject to behavioural bias. Quis custodiet ipsos custodes?

One Step Behind

“Who guards the guards” is a phrase derived from the Roman satirist Juneval who regarded all women as inevitably inclined to adultery and all men as inevitably designed to help them; and as the guards were men then they’d need their own guards, ad infinitum.  As a cynical view of human nature this probably evens beats today’s economic mantra of self-interest.

In fact there’s an inherent issue at the heart of regulation in financial markets.  If you truly believe that markets work, that supply and demand is governed by the decentralized invisible hand then you would have a hard job believing that a centralized regulatory body would be able to control the behaviour of market participants.  And much of the time this is exactly what we see; regulators struggling to keep up with the ever-changing challenges of some of the best funded and smartest people around.

Stupid Is As Stupid Does

There’s more than a faint whiff of the Dunning-Kruger effect, the idea that some people are too dumb to know that they’re dumb, about regulatory attempts to stem an impossible tide (see: Don't Lose Money In The Stupid Corner).  Of course regulators are smart people but if markets are truly unknowable then they’re fooling themselves.  This is what Leonid Rozenblit and Frank Keil called the illusion of explanatory depth – we systematically overestimate our ability to understand complexity.   The Dunning-Kruger effect would predict that the people who are most likely to choose careers as regulators are those that think they’re capable of managing market behaviour: ergo the people least likely to be good at it.

The idea that regulators are inclined to regulate because that’s what regulators do is linked to the concept of motivated reasoning.  Here’s Slavisa Tasic on Are Regulators Rational? (abstract only):
“When deliberating upon regulatory action, regulators would be expected, under the influence of motivated reasoning, to bend their thinking towards more stringent regulation that increases their own discretionary powers and control over markets. Importantly, the claim based on motivated reasoning is not that regulators’ taste for excessive regulation is the product of brazen attempts to increase self influence, as public choice theory would have it … We do not follow incentives but reason – however, reasoning itself is directed by incentives. On a meta-cognitive level, we are not aware of the existence of relevant motives that influence our thinking.”
Tangled webs comes to mind.

Biased And Don’t Know It

The fact that regulators are biased but don’t think they are has been at the top of a number of commentators’ minds recently.  The generous bailing out of the wealthy by governments acting on behalf of the impoverished many is, in this reading, not a act of corruption or cronyism but is the outcome of biases acting on regulatory processes.  Regulators and the regulated are drawn from the same pool of people; they act in the greater interests of their group because they genuinely believe it’s the right thing to do.

What with groupthink, motivated reasoning and smart-but-dumb participants it’s hardly surprising that regulations fail and that everyone fails to learn the lessons of the past, that fixing local issues by enhancing regulations won’t solve the problem.  Consider JP Morgan’s recent Whale trading fiasco where they managed to lose a few billion dollars through trying to implement an all-too-complex hedging strategy intended to fall outside of the latest regulations.

The question, therefore, is what do we do about this; if enhanced regulation will always fail it would be wise, you’d think, to stop digging that particular hole.  In fact we can go further and argue that some, highly popular, regulatory actions such as protectionism and special interest group subsidies are positively harmful – but they continue to be mooted and are all-too-frequently implemented.

Bias All The Way Down

In Psychological Bias as a Driver of Financial Regulation David Hirshleifer adds to the potential array of biases that afflict regulators – salience effects, omission bias, scapegoating, reciprocity norms, overconfidence, availability cascades and so-called ideological replications (the idea that certain ideas propagate, aka memes).  The effect of this array of biases he labels the psychological attraction theory of regulation, which argues that some beliefs about regulation exploit these biases to generation popular attention and support.

So, for instance, he argues that regulations to stop price gouging and usury may actually harm the people they’re intended to help.  Denying the poor access to loans that they badly need may be guided by good intentions but has bad outcomes.  And none of this needs be due to selfish intentions: regulations are most likely to be popular if they reinforce popular beliefs, such as the idea that short-termism is always bad.

Reforming Regulation

To counter this Hirschleifer argues that we should aim to build inertia into our regulatory systems.  Inertia has the effect of slowing down changes and, as many changes are inspired by irrational short-term reactions to specific events, this would improve the overall regulatory environment. As Stephen Choi, A.C. Pritchard and Anat Carmy Wiechman describe in Scandal Reinforcement at the SEC, the publicity frenzy around the dubious practice of options updating:
“We test the hypothesis that the SEC responds to the salience of financial wrongdoing in determining its enforcement priorities, using media coverage as our proxy for salience. Our findings are generally consistent with that hypothesis.  Our study shows that the backdating investigations crowded out alternative investigative possibilities, but only after the media put a spotlight on the practice. Moreover, it is reasonable to conclude that the investigations foregone were likely to have more substantial impact than the backdating investigations that were pursued.”
Regulators are all-too-human and just as afflicted as the rest of us by behavioural issues; maybe more so in some cases.  It is perhaps time that we stopped focussing on the outcome of bad market behaviors and started looking at the reasons behind it.  Attempting to block every market abuse – and sometimes even creating new market abuses to block – is not overly beneficial.  Setting core principles rather than insisting on slavish rule-following which all the smart people promptly set their minds to overcoming would be a more sensible approach.

Regulators are not only not omniscient, but they are often inevitably incompetent.  The Romans recognised the pointlessness of setting guards over their unfaithful spouses – modern policymakers should take note and act accordingly.

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1 comment:

  1. The best idea I ever read was the proposal that consumers of financial products purchase insurance from a specialised provider.
    That way the insurer is incentivised to analyse the risk and the consumer can judge the riskiness by the size of the premium.