Institute for Financial Transparency

Shining a light on the opaque corners of finance


Role of Financial Regulators in an Agent-based System

There are a number of reason I wish the Information Matrix was taught in Econ 101.  Close to the top of the list is it would raise the bar when it comes to talking about what financial regulators can be expected to do and what they cannot be expected to do.

Let me give you an example: the attempt to capture the endless complexity of interactions in the financial system through agent-based network modeling.  The idea is financial regulators will model the financial system, identify where too much risk resides and then swoop in before this excess risk triggers contagion and the domino like fall of participants in a network.

Why would anyone design a financial system that is 100% dependent on regulators correctly identifying who has the excess risk in a network and taking the steps to reduce this risk?

Having a single point of failure guarantees the financial system will fail.

Is it even remotely reasonable to think regulators are capable of assessing a network and identifying which market participant is exposed to too much risk and which of their exposures is the source of too much risk?

If you look at our current financial system design, you will find the combination of transparency and caveat emptor already addresses the problem of contagion.  Contagion is addressed because each market participant knows they are responsible for the losses on their exposures.  Hence, they have an incentive to use the information transparency makes available to limit their exposures to what they can afford to lose.  Limiting their exposures ends contagion and the threat of a network collapsing.

Market participants limiting their exposures based on their assessment of risk/return also happens to be the source of market discipline.  One of those features of the financial system you don’t want regulators meddling with.