Regulating complexity in financial markets.

• Author: Schwarcz, Steven L.

Table of Contents I. Introduction II. Complexity Can Cause Market Failures A. Complexities of the Assets Underlying Investment Securities and of the Means of Originating Those Assets B. Complexities of Modern Investment Securities C. Complexities of Modern Financial Markets III. Addressing Market Failures Resulting from Complexity A. Addressing Information Failures Arising from Uncertainty B. Addressing Failures Arising from Nonlinear Feedback and Tight Coupling C. Addressing Failures Arising from Misalignment D. Regulatory Lessons IV. Conclusions I. Introduction

In a recent article, I examined financial-market anomalies and obvious market and regulatory protections that failed, seeking insight into the subprime financial crisis and its subsequent devolution into a larger global financial crisis. (1) The crisis, I argued, can be attributed in large part to three causes (2): conflicts, complacency, and complexity. (3) This Article focuses on the third cause, complexity, which I regard as the greatest financial-market challenge of the future. (4)

Complexity in financial markets does not necessarily "arise for complexity's sake, nor from a desire to obfuscate." (5) Rather, it arises in response to "demand by investors for securities that meet their investment criteria and their appetite for ever higher yields" (6) and in order to facilitate the transfer and trading of risk to those who prefer to hold it, promoting efficiency. (7) For example, more complex securities can offer investors the opportunity to gain exposure to new asset types and markets--such as foreign currency, commodities, or residential mortgages--in turn enabling them to earn higher returns and more precisely hedge risk. (8) Complex securities issued by special-purpose vehicles and backed by pools of financial assets (9) also enable firms to raise low-cost financing by accessing the ultimate source of funds, the capital markets, without going through banks or other financial intermediaries. (10) Complexity thus can add efficiency and depth to financial markets and investments.

Nonetheless, complexity can also impair markets and investments in several interrelated ways. Part II.A of this Article examines how complexities of the assets underlying modern investment securities and the means of originating those assets can lead to a failure of lending standards and unanticipated defaults. Complexity in this sense derives from the intricate combining of parts, creating complications that increase the likelihood that failures will occur and diminish the ability of investors and other market participants to anticipate and avoid these failures. (11)

Part II.B of the Article examines how complexities of the investment securities themselves can lead to a failure of investing standards and financial-market practices. Complexity in this sense derives not only from complication, but also from the difficulty of valuation. Senior securities, for instance, can carry higher credit ratings than, and can be valued above, the ratings and value of their underlying assets. (12) Complexity deriving from complication and valuation difficulty can be thought of as cognizant complexity; things are just too complex to understand. (13)

Part II.C of the Article examines how complexities of modern financial markets can exacerbate these failures. For example, markets consisting of securities that pool together multiple classes of assets can create a "complex system" in which price volatility and liquidity are nonlinear functions of patterns arising from the interactive behavior of many independent and constantly adapting market participants. (14) This not only can produce cognizant complexity (15) but also a "tight coupling" within credit markets in which events tend to move rapidly into a crisis mode with little time or opportunity to intervene. (16) This additional nature of complexity is temporal; (17) in a complex system, signals are sometimes inadvertently transmitted too quickly to control. (18)

Finally, Part III of the Article analyzes possible solutions to these market failures. The failures have characteristics similar to those that engineers have long faced when working with complex systems that have nonlinear feedback effects, and indeed many characteristics of complex engineering systems are similar to those of financial markets. (19) This Part, therefore, examines solutions inspired by chaos theory, which helps to inform engineers about complex systems with nonlinear feedback effects.

Prescriptive regulation can begin to address existing market failures, but financial markets evolve so rapidly and often in such unexpected ways that prescriptive regulation can never address all potential failures. Prescriptive regulation also can sometimes create unintended, adverse consequences. Chaos theory addresses these dilemmas. Because failures are almost inevitable in complex systems, successful systems are those in which the consequences of a failure are limited. This can be done by decoupling systems through modularity, helping to reduce the chance that a failure in one part of a complex system will systemically trigger a failure in another part.

To this end, Part III examines possible solutions, including creation of a market liquidity provider of last resort to provide functional modularity by limiting the consequences of financial-market failure. The costs of such a market liquidity provider (which could be largely privately funded) should be relatively minimal, especially compared with the costs of a lender of last resort to financial institutions--the role played by the U.S. Federal Reserve and foreign central banks. Had a market liquidity provider of last resort been in existence when the subprime crisis started, the resulting collapse of the credit markets may well have been restricted in scope and lessened in impact. Furthermore, by stabilizing financial markets, a market liquidity provider of last resort could minimize the quandary, increasingly faced during the subprime crisis, of a lender of last resort being forced to lend to financial institutions deemed "too big to fail."

2. Complexity Can Cause Market Failures

   This Part examines various ways in which complexity can cause market failures.

   1. Complexities of the Assets Underlying Investment Securities and of the Means of Originating Those Assets

      The complexities of the assets underlying investment securities, and of the means of originating those assets, can lead to a failure of lending standards and unanticipated defaults. Consider first the complexities of the underlying assets, which can include mortgage loans and a wide range of other financial assets. (20) Each type of underlying asset requires a separate approach to modeling, including estimation of default risk, interest-rate risk, and prepayment risk (the risk that the borrower might prepay the loan balance at any time, thereby jeopardizing the asset's anticipated return on investment). (21) To further complicate matters, prepayment risk is correlated with interest-rate risk: when rates fall, borrowers are more likely to prepay; whereas when rates rise, borrowers are more likely to default. (22) These risks are also dynamic in that they fluctuate over time, and mathematical models that attempt to estimate the dynamic correlation are, at best, approximations. (23) Furthermore, as models become more sophisticated to take into account interest rate movements, they rely on an increasing number of assumptions and historical data which, if incorrect, will generate incorrect data. (24) When multiple asset classes underlie a given class of securities, modeling can become exponentially complicated.

      In addition to complex modeling, the terms and conditions of financial assets can also be complex. in the subprime crisis, for example, loan originators made mortgage-loan products more varied and sophisticated, and offered these products to a wider range of borrowers, purportedly in order to meet market demand. (25) These products included terms such as adjustable rates, low-to-zero down payment requirements, interest-only payment options, and negative amortization. (26) Because of this complexity, some borrowers did not fully understand the risks they were incurring (27) and, as a result, defaulted at a much higher rate than would be predicted by the historical mortgage-loan default rates relied on by loan originators in extending credit. (28)

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      The complexities of the means of originating these assets also can lead to a failure of lending standards. For example, the originate-to-distribute model of mortgage lending, (29) under which mortgage lenders would sell off loans as they were made, (30) is believed to have contributed to the subprime crisis. (31) Third parties--including government-sponsored enterprises such as Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac), direct government entities such as the Government National Mortgage Association (Ginnie Mae), and private investment banks--would purchase the loans and package them into mortgage-backed securities, or "MBS." (32) This "securitization" process increased the accessibility and affordability of mortgage lending by indirectly funding such lending through the capital markets. (33) Nonetheless, because the interests of the lenders were no longer aligned with the interests of the owners of the loans (the investors in the MBS effectively becoming owners of the loans), there is concern that the originate-to-distribute model fostered moral hazard on the part of the lenders, (34) resulting in lax lending standards. (35)

      An important question here is why the ultimate owners of the loans-the distributees, which in the subprime crisis were the parties buying the mortgage-backed securities (36)--did not impose on the originator the same strict lending standards that they would otherwise observe but for the separation of...