Intellectual Hazard and the Design of Financial Stability Regulation
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Description
This paper considers the problem of intellectual hazard in the optimal design of financial stability regulation. Intellectual hazard is the tendency of behavioral biases to interfere with accurate thought and analysis within complex organizations. Drawing on concepts of intellectual hazard, we argue that financial stability regulators should be staffed by persons other than individuals serving in central banks, finance ministries, or bank regulators. Otherwise, instead of providing new information, these systemic risk regulators will simply recycle old information, contributing little to the independent analysis of the situation and leading to a potentially damaging complacency that the problem is being managed. Unfortunately, the systematic risk regulatory bodies that have been proposed or constituted to date are staffed by people from existing governmental bodies, and accordingly cannot be expected to provide the independence of viewpoint that is necessary for the effective functioning of these bodies. The financial crisis of 2008 revealed fundamental flaws in the world financial system’s ability to process information pertinent to risk. Few in industry or in government truly understood the serious threat to the stability of the system posed by the U.S. subprime mortgage securities and by the elaborate network of contracts, practices, and understandings that facilitated the packaging, marketing, and resale of these securities during the decade of the 2000s. Those who did identify the risks were not heeded. The consequence was the greatest financial disaster since the Great Depression of the 1930s - a perfect storm that descended on financial markets in 2008, nearly without warning, inflicting tens of trillions of dollars in financial losses; moreover, it still looms as a threat in the form of worries about the solvency of Greece and Spain, an enormous downturn in the U.S. commercial real estate market, and the potential for sovereign default by the American states of California, Illinois or New York. All good catastrophes generate proposals for reform, and the crisis of 2008 is no exception. Indeed, the volume of reform proposals is probably larger for this crisis than for any previous one, in part because of the severity of the downturn and in part because of the ready availability of media outlets in which these proposals can be vetted. One set of proposals, which has received considerable attention, and which is in the process of being implemented both in Europe and in the United States, is the creation of administrative bodies charged with the task of overseeing the stability of financial markets. It is not difficult to see the appeal of these proposals. They do not gore any oxen - creating a regulatory body charged only with overseeing financial stability does not threaten vested interests in the way, say, that a consumer financial protection agency does. They are cheap to implement, requiring only some appropriations for salary, staff, and office space. It appears that they can do little harm, and might do some good. By establishing these bodies, politicians can satisfy the single most important pressure facing them in this crisis - that they do something. But who should staff these agencies? This question, which at first glance may appear to be of secondary importance, is in fact central to their organization. An agency is only as good as the personnel who staff it, and if the people working in the agency do not have the right incentives to do the job right, the result could be worse than nothing. If people rely on these agencies accurately to identify threats to the world’s financial system, and they fail to perform this task, the results could be damaging, either because beneficial markets and institutions are stifled even though they do not pose a significant threat to financial stability, or because dangerous markets and institutions are allowed to continue in operation even though they do pose a threat. The complacent acceptance of flawed information is potentially worse than not having information in the first place. This paper examines the question of the staffing and design of financial stability bodies from the perspective of the theory of intellectual hazard. Part I outlines the concept of intellectual hazard as we have developed it in previous work. Part II applies that theory to analyze regulatory initiatives to create financial stability oversight bodies. We end with a brief conclusion.
Source Publication
Law and Economics of Global Financial Institutions: Third International Conference on Law and Economics at the University of St. Gallen; June 4, 2010 St. Gallen, Switzerland
Source Editors/Authors
Peter Nobel, Katrin Kehan, Anne Cathrine Tanner
Publication Date
2010
Recommended Citation
Miller, Geoffrey P. and Rosenfeld, Gerald, "Intellectual Hazard and the Design of Financial Stability Regulation" (2010). Faculty Chapters. 2015.
https://gretchen.law.nyu.edu/fac-chapt/2015
