In Modern Finance, Dumb is Better Than Smart

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Felix Salmon explains a bit more today about how JPMorgan managed to report a $2 billion trading loss on Thursday: it was almost certainly the result of a poorly conceived risk model that seemed like it should work but, in fact, didn’t pass the common sense test. At the end, I think he comes to exactly the right conclusion:

This is why Basel I turned out to be much more robust than Basel II. Your sophisticated platform needs to be built on a foundation of dumb rules: simple limits on how big any one position can get, on how much exposure you can have to any one counterparty, or in general on any trade which is based on the hypothesis that your desk is smarter than anybody else on Wall Street.

Those kind of rules won’t prevent all blow-ups, of course, but they’ll help. They would have prevented this one, and they would have put an end to Jon Corzine’s disastrous MF Global trades, as well.

The problem is that traders hate dumb rules, because they cap the amount of money they can make. And traders have enormous power at investment banks these days, because they make the lion’s share of the profits. That’s why it’s important that the CEO of an investment bank not be a trader. And certainly it’s crucial that the CEO shouldn’t have his own trading account and buy and sell from his Blackberry during meetings, as Corzine did. That’s just a recipe for disaster.

Yep. Dumb, blunt rules are the only kind that can work in the playpen of modern finance. We simply don’t understand the world well enough to pretend that we can regulate things in minute detail, and we sure as hell don’t have regulators who are either smart enough or can move fast enough to stay ahead of the rocket scientists trying to outwit them. That’s not just impossible in practice, it’s pretty much impossible even in theory. It’s just plain impossible.

But dumb-as-rocks rules about capital requirements and trading limits and collateral requirements and term structures? Yeah, that can work. In fact, Drum’s Principle (if Jamie Dimon can have a principle, so can I) is that financial regulations only work if they clearly cap the amount of money that traders can make. That’s one way you can tell whether new rules like Dodd-Frank and Basel III are working: if the financial sector keeps making as much money as ever, they aren’t.

Bottom line: financial regulations are only effective if they’re so dumb that traders simply can’t maneuver around them. Those are the kinds of rules we need.

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