Sunday, September 27, 2009

The Fed's failure in end to end risk management

Another one in a series of risk management write-ups. (I guess this is becoming more and more common as this is my full-time job right now.) I came across a recent article in the Washington Post about the malpractices in lending practiced by subprime affiliates of large banks and the reluctance of the Federal Reserve to play an effective regulatory role. The article is here.

The article talks about how the Fed gradually withdrew in its regulatory responsibility on consumer finance companies as these were not "banks". The Fed reduced its oversight of these companies because it believed it did not have the right jurisdiction to regulate these companies. This was despite a considerable amount of evidence from individuals and other watch-dog bodies that were reporting egregious practices by these institutions. Another big factor that was playing at the time was the good old "markets self-regulate" belief (I was going to say theory and I corrected myself. Maybe I should say, myth.) but I am not going to spend too much time in this post on that.

Why did the Fed turn its head away from the problem? One of my hypotheses is too much of a reliance on "literalism". The Fed chose to literally interpret its mandate of regulating banks and decided to look no further - even though there were other institutions whose practices were exactly the same as what any bank would do. Literalism is a particular problem I have observed in the US. It is the strong objection to interpret a piece of policy/ law developed years ago in line with the world today. This problem is most commonly seen with respect to the US Constitution and its various amendments. But "literalism" is a problem when it creates blind spots in end-to-end risk management and ends up threatening the viability of the corporation or, as in this case, the entire financial system. An effective risk manager is expected to be proactive in identifying gaps in the end-to-end risk management and being open to taking on more responsibility, proposing changes to the system, as needed.

The other problem was that the Fed tended to be influenced more by grand economic theories and conceptual/ philosophical frameworks and decided to discount the data coming up from the ground. According to the article, the Fed tended to discount these pieces of anecdotal evidence as their place within a broader framework or their systematic impact was well-known. This is another problem often with smart people. It is a thinking that goes: I think and talk in concepts, abstractions and theories. Therefore, I will only listen when other people talk the same way. Now this is a problem which afflicts many of us, and therefore might be even borderline acceptable in everyday life. But this is fatal in risk management, where your job is to anticipate different ways in which the system can be at risk. An effective risk manager is expected to constantly keep her radar up for pieces of information that might be contrary to a pre-existing framework and have an efficient means of investigating whether the anecdotal evidence points to any material threat.

Finally, one important lesson that is worth taking way is that when it comes to human created systems, there is no one overarching framework or "truth". Because interactions between humans and institutions created by humans are not governed by the laws of physics, there are often no absolutes in these things. Many theories or frameworks could be simultaneously true or may apply in portions of the world we are trying to understand. Depending on the prevailing conditions, one set of rules may hold. And as conditions change or as the previous framework pushes the environment to one extreme, the competing framework often becomes more relevant and appropriate to apply. It is often practical to keep one's mind open to other theories and frameworks. Ideological alignment or obsession with one "truth" system only makes one closed to other explanations or possibilities.

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