Effective Regulation Requires Information Richness

For the last several years, we have been simultaneously enthralled and horrified as financial scandals and attempts to improve financial regulation have continued to unfold. As data practitioners, we know just how demanding the problems are. We appreciate the efforts of thousands of good, well-meaning people who are dedicating large portions of their careers to resolving the issues, especially in light of conflicting political demands.

But as investors, citizens, and taxpayers, we find the lack of progress troubling, to say the least. No matter where you sit on the political spectrum, the current financial regulatory system is simply not working. For example, we judge the recent Libor scandal an abject regulatory failure, even though one bank has paid a half-billion-dollar fine, and others are under investigation. A massive problem was not caught early enough, and it is unlikely that the damage will ever be undone. Worse, some five years after the onset of near financial collapse, we have no idea whether efforts to improve regulation have accomplished anything. There is no plain English explanation of what we get (and what we don't get) for our regulatory dollar — and at what costs, including costs both to banks and to the economy.

Almost all agree that nipping the offending behavior in the bud is far better than punishing offenders after the fact. The latter hurts customers, damages the financial system, and costs taxpayers. It is the essence of our complaint about the Libor incident.

Similarly, almost all agree that regulation should come at a low cost. But early detection and prevention is complex, and comes at a high cost. We simply cannot have both. It is critical that all involved come to fully realize this point.

We suggest a new way of thinking about regulatory effectiveness to help inform honest debate, crystallize the issues, and break the stalemate. Actually, this new thinking is not so new. It stems directly from cybernetics, quality control, and information theory, all with roots at least 60 years old.

The most important principle (with some restatement on our part) comes from Stafford Beer in The Heart of Enterprise: "The complexity of the regulator must match the complexity of the regulated."

Roughly one should read "complexity" as "richness of information." Obviously enough, any regulated financial institution is far more complex than any regulator could possibly be. So the regulator needs pertinent summaries of the regulated's business. In turn, the regulated needs to know what is required in terms that can be translated into action. This implies there must be high-quality communication between the various players. It also implies that the overall penetration and effectiveness of regulation is no better than the weakest channel.

There are many communications channels. Each must be designed and operated to provide the information required accurately, quickly, and concisely. Today's communications channels simply don't meet this standard. Indeed, poor quality has been a persistent, recurring theme in the financial crisis and has yet to be properly addressed. Poor quality means regulatory reports that are inaccurate or too complex to be understood. Ultimately, this undermines the entire effort. It is also the means by which those acting illegally hide their actions. Order-of-magnitude improvements are possible. Regulators must make dramatic improvement in this regard if they hope to be effective. If they do nothing else, regulators must demand that regulatory reports be of high quality, and they must verify that this is indeed the case.

Moreover, financial institutions are highly dynamic, complex, information-rich companies that operate in highly dynamic markets. Unless regulators build and operate high-bandwidth information channels that keep them abreast of changes in these markets and provide leading indicators of possible problems, they will become helplessly out-of-date with no hope of understanding — let alone preventing — the next crisis.

But these actions will make no difference if there is no transparency. As taxpayers, we have no idea what to expect from regulation: What problems should we expect a regulator to prevent? Which problems is it likely the regulator can catch and punish? Will the punishment act as a deterrent? Are today's regulations already out-of-date? Can we trust a balance sheet?

One consequence is there is no objective way to find a sensible middle ground. Regulators simply must provide clear answers to our questions, a fully transparent "report card" of how they're doing, and lucid discussions of possible courses of actions and the costs/benefits thereof.

To be clear, we do not expect regulators to be perfect — they have a very demanding job! We would find it most helpful if this report card fully acknowledged their own fallibility.

We know just how demanding building and operating high-bandwidth, low noise, right-sized communications channels is. Still, it offers the best hope of getting out of the current quagmire. No agency can avoid the cold, hard truth: Effective regulation requires information richness. It is best to design for it from the start.

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