Stability, Friction and Regulation

By Steven C. Ferguson

Financial Instability Abounds

Ever since the recent Bear Stearns (NYSE: BSC) bailout, financial news reports have been replete with discussions and plans of new regulatory measures aimed at providing financial stability and preventing further such financial crises. Congress, the G-7, Paulson and Bernanke, along with a host of pundits and politicians, have all weighed in on the Fed's present and future response to what some have even labeled as financial terrorism. Indeed it does seem we must save the suicide bankers with the CLOs strapped to their balance sheets to avoid collateral damage to the entire financial system and eventual collapse of the U.S. Economy. So far, while there has been much talk of Homeland Financial Security, nothing substantive has changed to protect Main Street from the twin threats of Greed and Risk.

And while it is irksome to consider the hypocrisy of unilateral laissez-faire policies, which apparently apply only during the greed and risk-ridden bubble inflation phase; while it is incredible to hear the hyperbolic hypotheses of what "would certainly" have befallen us had we let "free market" response prevail in the case of BSC; and while it is downright irresponsible to ignore the downstream and not-so-hidden costs of the Fed's morally hazardous monetary response to this credit crisis (how about the contribution to $119-a-barrel oil and hyperinflationary food riots for starters?! Someone should be yellin' to Yellen: "Inflation expectations are not anchored!"); these stark observations are not even required to substantiate the obvious need for more careful regulation of Wall Street investment bankers. Instead, systems theory provides the rationale rather directly.

Shaky Foundation

Given the theoretical premises upon which our financial system is built, it should come as no surprise to anyone that the system would easily become unstable, making its eventual catastrophic failure a very distinct possibility. In fact, the system itself appears to be constructed with (at best) what can be termed "bounded-input bounded-output (BIBO) stability." In such a system, a large disturbance, coupled with complex interactions between wealth stores and asset classes, could easily lead to unexpected and harmful price oscillations. We have observed as much in government bond yields last summer, equity prices for the better part of nine months, and especially in currency exchange rates of late. The reason for this instability is simple: the system lacks necessary friction in the form of prudential regulation.

The reason the system lacks such necessary and properly implemented frictional components is also simple: investment banks, central planners and various other regulation-averse beneficiaries with questionable motives would prefer to minimize or eliminate regulatory oversight. Even a cursory survey of the literature reveals how planners view any form of regulatory friction as deleterious, costly and even loathsome.

For example, friction is generally only included in economic models for the purpose of demonstrating rather contrived and costly effects. Mr. Bernanke views credit market friction as the mechanism for his sometimes dreadful "financial accelerator" hypothesis. Paulson's overhaul proposal evidently favors a very "light touch" where regulatory friction is concerned. Greenspan was often quick to reaffirm his view that "the costs of regulation exceed the benefits." (Of course, the reader will kindly ignore the cost of any ensuing bailout.) A technical paper written by the FRB in 2005 even suggests that reduced market frictional factors (i.e. regulatory provisions in housing loans), lending to consumers without strong collateral and related financial innovation which magically securitized risk, were all reasons for wonderfully diminished economic volatility! Yes, we can all see that now.

From all of these perspectives, it would seem as if the anticipated costs of regulatory friction, which would preemptively dampen oscillations in the financial machine, have never been objectively compared to the enormous expense of catastrophic cleanup when the machine spins out of control and crashes. It would seem that both planners and market participants need to gain a better appreciation of friction in order to see prudential regulation as friend rather than foe.

Friction is Your Friend

Friction can stabilize any system, including a financial system. For example, an automobile without shock absorbers would bounce over potholes in such a violent manner that it might rattle your fillings. Without much friction, we all know how easy it is to slip and fall on the ice. Combine low friction with momentum, and collisions between players in a hockey game become even more spectacular. The friction between the four tires on your car and road beneath them allows you to generate thousands of pounds of force for stable acceleration, braking and steering using a contact area about the size of an 8 ½ x 11 sheet of paper. At high speeds, without that friction, instability can lead to a deadly crash.

Though economies and capital markets are more complex machines which involve non-linear and time-varying human behaviors across industries, regions and even cultures, friction (i.e. prudential oversight) can likewise be employed judiciously to prevent excessive momentum (e.g. bubbles) and avert crash. Regulators and market participants must understand, appreciate and embrace necessary changes in order for self-regulatory supervision to be meaningful and effective.

Friction, Dissipation and Heat

Friction does not come without a price. Regulation does result in explicit costs, both in terms of money and time. However, the cost associated with a crash in capital markets and/or economies is significantly higher and of longer duration.

In physical systems, friction dissipates energy. Dissipated energy can take the form of heat or noise. When an automobile is braked in a stable manner using friction brakes, the rate at which energy is dissipated is controlled; heat is exchanged between brake pads and rotors, and between the tire and road, but the car itself is stable and safe. If friction is removed at the road or at the brake pads, the energy in the car is dissipated all at once. We call that an accident. Such a crash is also much more expensive, time-consuming and even irreversible.

It turns out that friction also creates heat both in capital markets and on Capitol Hill. The very discussion of regulatory reform generates heat. The effects of friction can even be observed directly in the U.S. Congress. We see it every day and especially in relation to the need for regulatory reform: nothing but hot air!

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