20 Feb The Impossibility of Capital Regulation

I’ve thought about this a lot. The more I contemplate the challenges of implementing a fair and effective system of capital regulation for credit risk, the more I appreciate its impossibility.

First, a fair and effective system of capital regulation for credit risk involves the measurement of moving targets.

This is hard. We can see the degree of challenge by the fact that through-the-cycle ratings and going-concern assumptions continue into the 21C. But no theory of non-change surpasses Zeno’s for brilliance and elegance. His paradoxes have lasted 2500 years. They are impossible to refute logically without modern methods of counting to infinity; yet even today they persist in the “Quantum Zeno effect.” It says that a quantum system’s dynamic motion can be hindered or stopped if the whole system is under observation. No doubt this is especially true when the waves are cash flows.

Second, academic finance offers an elaborate theory of pricing based on current price and randomness, but it treats information as an unexplained plug.

Paying bills is not a random act, and past behavior is very relevant to predicting future payment probability, but try fitting conditional probability, aka the Monte Hall problem, into our credit models, and you will hit the same wall Marilyn vos Savant did in 1990. She tried to explain why the odds don’t change with new information, only our perception of the odds, and received over 10,000 letters “correcting” her logic. The one from Edward Harmon, a then-PhD with the U.S. Army Research Institute, is particularly astute:

“You made a mistake, but look at the positive side. If all those Ph.D.’s were wrong, the country would be in some very serious trouble.”

Precisely.

Third, the real fix to all problems of risk measurement is adopting a standard yardstick and enforcing it.

This milestone is particularly challenging. Feet are older than homo sapiens, but the foot was only standardized in 1959.

At the end of the 19th Century, the U.S. began losing out in international trade to England and Germany because we cheated like heck on our commercial measures. Our National Bureau of Standards was formed in July 1901 and the work of enforcing them received a big boost under Herbert Hoover. The National Institute of Standards and Technology, as it is called today, still plays a critical role. They investigated 9-11.

Their mission is to promote “U.S. innovation and industrial competitiveness

…by advancing  measurement sciencestandards, and  technology in ways that enhance economic security and improve our quality of life.”

No doubt someone will protest that standard measures have zero relevance to risk grades in the bond market. Even after the Credit Crisis, when we collectively cheated like heck. No doubt someone else will argue that weight and height can be measured but that bond quality is too intangible. But money is pure metaphysics. Time, which links money to value, is the ultimate intangible. Productivity is powered by the clock.

Fourth, no one of our generation believes in the possibility of change, or fairness.

We are happy with our medieval credit system. And knowledge isn’t cumulative anyway, our financial models say so, so we can’t learn from our mistakes. Let’s leave the challenges of financial responsibility and economic justice to our children to fix.