From transparency to intelligibility in regulating finance

As I've been reading coverage of the rolling financial crisis, it occurred to me again that one of the tools that I’ve recommended for managing complex regulatory systems - transparency - might be relevant, though with a tweak.

More than lack of transparency, a root cause of the melt-down seems to have been a lack of intelligibility. The constant refrain is that nobody understood the ramifications of the financial instruments they were creating, managing or (not) regulating.

I’ve explored this topic in the context of software development on this blog (the hard intangibles thread), and I'm now convinced that the cognitive constraints that lead to problems on large software projects apply in finance, too. As I blogged last August:

“The sub-prime mortgage debacle is a problem of cognitive complexity. A lack of understanding of the risks entailed by deeply nested loan relationships is leading to a lack of trust in the markets, and this uncertainty is leading to a sell-off.”

At that point I hesitated to draw the corollary: that limits should be imposed on the complexity of the intangible structures we create.

The current approach is that complex novel approaches are left unregulated, on the assumption that only “informed investors”, those who are supposedly smart enough to understand the risks, will be exposed to losses. We’ve learned that this is not the case: the informed investors are pretty dumb, and the rest of us pay for their ignorance.

I now think we should invert the regulatory presumption: the more complicated an instrument, the more firmly it should be supervised.

The hard question is how to measure the intelligibility of financial instruments in order to decide if they deserve additional scrutiny. The Mom Test for user interface design - "would your mom be able to figure this out?" – seems reasonable, but it’s hard to see how the SEC would use it in practice. A more commonly used equivalent, the Politician Test, doesn’t help either since the comprehension of politicians is a function of campaign contributions.

We’re left with algorithmic complexity: the length of the program required to specify the object. Financial wizards will surely plead commercial confidentiality in order to avoid disclosing their algorithms; but a private assessment by an impartial regulator need not lead to a leakage of competitive advantage.

The loss of paint on panel

At the end of Jared Carter’s poem “At the Sign-Painter’s,” he explains why he liked these men best of all the laborers he met, accompanying his father on his rounds:

For the wooden rod with its black knob resting lightly
Against the primed surface, for the slow sweep and whisper
Of the brush—liked seeing the ghost letters in pencil
Gradually filling out, fresh and wet and gleaming, words
Forming out of all that darkness, that huge disorder.

I felt nostalgia for the loss of finger-touch with stuff we make for a living. A sign maker now works with mouse and keyboard, tweaking pixels on a glass screen – no more “the slow sweep and whisper / Of the brush.” The signs themselves are made at many removes, the “fresh and wet and gleaming” paint now applied in the invisible sanctum of an industrial ink-jet printer.

Some few people still manipulate their work: chefs, the cutters of hair, surgeons, those who care for children and the sick. A blessed few, though not financially; except for surgeons, most are paid minimum wage.

The rest of us have to wrestle meaning out of the “huge disorder” with tools that are themselves intangible, information worker implements operated with plastic prostheses.

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The poem appears on p. 172 of Fifty Years of American Poetry, New York: Harry N Abrams, 1984. It originally appeared in Work, for the Night is Coming, 1980.