This Is the End


Markets, Risk and Human Interaction

September 16, 2009

Regulation in Defense of Capitalism

Will regulation hobble capitalism? I think the opposite is true. Properly done, government regulation of the financial industry will move the industry closer to the capitalist ideal. By capitalism, I mean where those who take the risks and put up the money get the fruits of their labor. And, importantly, where those who take the risks and put up the money actually do take the risks, bearing the full costs of failure as well as success. As things stand now, we have a finance industry that is capitalist when things are going well and socialist when things are going poorly -- right-tail capitalist/left-tail socialist.

Capitalism means bearing the costs
I sometimes miss the rugged beauty of Utah, where I spent some of my pre-Wall Street years. From my house on the foothills of the Wasatch mountains, I could see the cliffs of Mount Nebo to the south, nearly fifty miles away. Ten miles north, the western face of Mt. Timpanogas, capped with snow into early summer. To the west, the sun reflecting on Utah Lake. Oh, and on the eastern shore of the lake, the black smoke billowing out the stacks of Geneva Steel.

Geneva Steel was built to produce steel during the war effort, and kept in operation until seven years ago. It teetered at the edge – and at least two times over the edge – of bankruptcy, closing for good in 2002. Left behind were assorted furnaces, presses and scrap metal sold to a Chinese steel producer, and a giant pond of toxic sludge.

Fortunately, we’ve learned a thing or two about toxic sludge in steel production. The steel producer, in this case the original parent of the Geneva plant, U.S. Steel, has to set aside a fund to pay for the clean-up. The sludge is part of the production process, and the clean-up is a cost of production, even though it is a cost that is not realized until many years down the road. As a result, steel costs are a little higher and the shareholders fare a little worse than if this longer-term expense were not forced onto the producers. The regulation that requires setting aside funds for the clean-up might be considered intrusive to the core values of capitalism. But it is the contrary. It is forcing the steel mills to recognize all of their costs rather than leave society to foot part of their bill.

Wall Street’s toxic sludge
Wall Street has its own forms of toxic sludge, longer-term costs and negative externalities from products and strategies: The increase in the risk of crisis that comes from the opacity of complex derivatives; the fat tail risk of positions that are short credit or liquidity; negative gamma trading strategies, strategies that in various guises are like naked call writing, making money most of the time, but on occasion failing spectacularly; the forced deleveraging and liquidity crises that come from high leverage.

These costs are easy for the Wall Street capitalist to ignore, because unlike the sludge pond behind the steel mill, they are not visible until they finally hit. Indeed, they are not even deterministic. They might hit or they might not – so what we have in financial markets is invisible and probabilistic toxic sludge. Which makes sludge-producing strategies all the more popular with banks and traders, because if you can do things where you don’t have to bear some of the costs, the odds are better you will turn an apparent profit.

The limited liability assault on capitalism
The banks and trading firms don’t have to bear these costs because of the widespread use of limited liability. Limited liability creates a ‘heads I win tails you lose’ relationship. The template for limited liability is the corporation, a template that has been copied to create the trader’s option and short-term compensation, paid out before the full costs of a product or strategy are manifest.

If I want to get the most value out of limited liability, I will gravitate toward fat tailed and complex businesses, where most of the time I pump money out with regularity, but face some prospect of a catastrophic loss. How catastrophic? The bigger, the better. It doesn’t matter to me how bad things get once they have passed my liability limit. And the larger that catastrophic case, the more costs I am passing on, and thus if a general risk-return relationship holds, the more return I will get as long as the catastrophe is kept at bay.
Put in other terms, I will look for businesses and strategies that produce the highest level of costs that I can slough off, that will be unrecognized by others. Is this the direction Wall Street has gravitated? Are the exposures of traders and banks biased toward taking credit risk, being short liquidity risk, and short gamma? Do they prefer the complex to the simple? Do they push leverage as far as regulation allows?
Regulation and capitalism
Regulation that exposes this and forces the trader or bank to absorb these costs makes the markets more true to capitalist ideals. Capitalist regulation forces the producers to recognize all of their costs. It undoes the harm to capitalism that comes from limited liability and its kissing cousins, the trader’s option and short term compensation deals. The flip side is that with capitalist regulation, no one can take on more risk than they are capable of absorbing. Which means requiring higher levels of capital on the one hand, restricting leverage on the other, which in turn means reduced capacity to generate high returns.

The aspiring capitalists among us will decry such regulation because it invariably makes our lives harder; we can’t make as much money. But if the reason is that the regulation is now forcing us to bear all of the costs of our enterprise, then we are feeling the pain of having the socialist trappings removed, and entering into a more robust capitalist regime.


  1. From Provo to there is a cultural shift. Keep writing. Love your work.

  2. Do we scold or praise the mother who restrict her son from eating like there is no tomorrow?

    Do we scold or praise the father who, when teaching his son/daughter how to drive, admonish them when they get reckless?

    Do we scold, or praise the teacher who sets clear rules of discipline in the classroom, so everyone has a chance to begin to learn?

    The answer is obvious, isn't it?

    Therefore, pray tell why this basic common sense logic, shouldn't apply to Wall Street?

    I rest my case.

  3. Great framing, great piece.

  4. I agree with what you are saying, Rick, don't see how anybody can dispute the argument. However, in practice it's a bit harder. It boils down to how you measure the cost of cleaning the sludge. The key is to measure it as the potential for sludge is being generated in the good years, not years later when you are already bankrupt. You have to do so, otherwise you are lying to your shareholders and overstating profit.

    But here is the thing. In the past people thought they were reserving plenty of money for the potential cost of the sludge. For all the complex books of all the banks there where were model reserves being taken precisely for this. Banks had hired expensive qualified professionals, many of them with PhDs like yourself, to periodically evaluate whether the reserve amount was adequate, and the amounts were largely thought to be "conservative". Better judgement at the time would have shown the contrary (wasn't that complicated if you understood the math, the product and the market and had some common sense). But, in my case I still find it difficult to make some of the PhD guys take their heads out of the math and think about the real world for a second.

    Everybody now knows that reserves weren't anywhere near enough, but, again, back to the original question, is there a correct way of measuring reserves before it's too late? What do you think? I incline to think that there is no correct answer and no practical solution. More common sense and better understanding of complex finance would help, but I don't think it's going to happen any time soon. Key decision makers in banks didn't udnerstand complex finance then and don't uderstand it now. Therefore, from a regulation perspective, I prefer more drastic approach to the issue of complex finance, such as reserving all PL and only slowly accrueing it over the life of the deal, no matter how good it may look at inception, or something along these lines.

  5. Fantastic.

    I think the big mistake of the current administration is to do too much while the reality is by making some sensible nudges that keep parties on the straight and narrow we can correct for the mistakes made in the latest excess and not mess up capitalism or democracy...


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