Newsletter Sign-up

Recently, I had the opportunity to spend an afternoon with about 16 chief risk officers, chief compliance officers, and chief legal officers from financial-services firms discussing the implications that the various changes that financial regulation and government oversight would have on our businesses. The overriding theme was that the expectations for risk management and compliance activities were increasing significantly. It was clear that the general consensus in the room, and likely across other risk management and compliance professionals, was that the pendulum of regulation and government oversight had quickly swung from the lighter end of the spectrum to the heavier end -- and was not showing many signs of decelerating or starting to move back towards the middle.

As I participated in the discussion, I had a constant and nagging feeling that everything that we were discussing involved increased costs and expenses for organizations, with the primary benefit being "safety and stability". After the past few years it is hard to argue with those benefits; however, I then realized that it was the other "costs" that we're bugging me the most ... the "opportunity costs".

* The projects and investments that firms will forgo in order to fund their risk management and compliance efforts.

* The projects and investments that firms will forgo because either they are no longer permitted or they carry too high of a compliance burden under the new rules.

In the end, I am becoming increasingly afraid that the new rules and regulations will achieve exactly what they are trying to achieve: significantly increase the safety and stability of financial services firms -- or said another way, significantly decrease volatility of and variance between firms.

On the surface, decreased volatility and variance do not sound all that bad. However, financial services firms and the financial markets are not exactly manufacturing plants where the primary goal is to optimize for the reliable flow of consistent quality finished products out the factory door. Rather, financial services firms are more like highly competitive professional football teams that are constantly competing and pushing the boundaries of performance to win the next game and ultimately the Super Bowl.

Imagine if the NFL re-wrote the rules of the game to the point where it became nearly impossible for a player to get injured and where the standards on how teams could play were so prescriptive that teams were basically constrained to only running the ball up the middle, to the left or to the right. The games would look more like a lame game of tag and would frequently end in a 0-0 tie...welcome to a world of decreased volatility and variance!

In this safer and more stable world: the best players find somewhere else to play more competitively; the best coaches find something better to do; even the best referees leave because they would rather do something where they are able to exert some degree of judgment; and the number of fans drops quickly.

The outcome may not be all that different if we go too far in imposing rules and regulations in financial services. Just substitute bankers and traders for players, CEOs for coaches, regulators for referees and shareholders for fans.

The nature of volatility and variance is that the distribution of possible outcomes are made up of high highs, low lows, and everything in between. With the high highs come innovations and breakthroughs, however, with the low lows, come failure and catastrophes. Unfortunately, you often cannot eliminate the low end of the distribution, while keeping only the high end -- leaving you with a choice between instituting constraints to ensure a more certain mediocre outcome or allowing for more variable range of both positive and negative possibilities.

Daniel Kahneman, the Nobel Prize winning economist, characterizes this mindset as the "precautionary principle, which prohibits any action that might cause harm." Then quickly cites Cass Sunstein's point that an impressive list of innovations and breakthroughs would not have passed this test including "airplanes, air conditioning, antibiotics, automobiles, chlorine, the measles vaccine, open-heart surgery, radio, refrigeration, smallpox vaccine, and X- rays."

So much for that nagging feeling...now I am just outright depressed! Well, at least we still have professional football!

DAVID M. WONG is director of cross-asset strategy and planning at CME Group, the world's largest and most diverse derivatives exchange.

January 30, 2012

Copyright 2012© LRP Publications