Traffic regulations have become more constraining as technology grows ever more sophisticated. In finance the opposite is true and progress has been measured by the suppression of previous regulatory safeguards and the complete absence of a new framework with which to replace them. To extend the analogy of the automobile it is as if whoever has the desire, can drive any vehicle while creating their own rules and according to any route. Is this the path we want to be taking?
What possible overlap can exist between motor vehicles and the primarily virtual instruments of the financial world? While the connection is by no means obvious, an analogy can indeed be drawn and an exploration of its dynamics will result in a number of profound insights into contemporary life.
At the most fundamental level the circulation of goods and individuals on one side mirrors the flow of capital on the other and together they form two of the main pillars of the edifice used to support modern society. Both have seen their relative importance grow following a long and winding trajectory in the case of the former and in a frenzied rush toward the future for the latter.
Both sectors have arrived at an advanced level of technical sophistication even while the rhythm of this evolution has been at two divergent speeds. They both have a major impact on daily lives across all segments of the population.
Together they have the potential for significant levels of disruption and the consequences can be painful: in the case of automobiles they are plainly physical while in the other they are obviously economic. The resulting disruption however ignores any semantic distinctions and can rapidly reverberate to impact a broad cross-section of society.
Both occupy privileged positions on government policy agendas.
The more easily understood half of the analogy is unquestionably the automobile as they are so common in our daily lives. It is illuminating to step back and observe how society has largely mastered the delicate balance between individual freedom and collective security in this domain. Clearly there is a lesson to be learned here.
The picture presented by the financial world is, by comparison, mysterious and poorly understood, not least by many of the ‘experts’. Nevertheless, the sector can lead us to a number of useful insights if we know where to look.
The automobile industry has taken a highly technical approach to development producing vehicles that have attained ever higher levels of performance moving hand in hand with the expansion of the infrastructure to carry them.
At this stage it is relevant to identify a number of pertinent points that will be of continuing relevance further on:
• motor vehicles are subject to the laws of mechanics which demand equilibrium between such properties as force, inertia, and friction;
• development is subject to physical limitations;
• imperatives of industrial production have created a need for standards and tools of measurement
From its very inception the automobile created a number of risks and public authorities moved swiftly to limit the liberty of “pioneers”.
The very first car driven by a gas powered engine appeared in 1884 and as early as 1893 drivers in France were required to obtain an authorization granting the dual rights of ownership and permission to operate a vehicle. It wasn’t long before a separation was created, first with the appearance of the vehicle registration, known as a carte grise, in 1896, and the first driver license in 1899.
The next step was to create some rules of the road, many of which predated the existence of the automobile—the law of traffic keeping to the right for instance dates from 1804 in France—and by 1921 a comprehensive framework was created with the first edition of a highway code.
The regulations distinguished different classes of vehicles as well as drivers; bus drivers for instance are subject to higher standards than say private car owners.
Regardless of class however the highway code defined a framework for common individuals driving standard vehicles; the road network was not designed to accommodate the aspirations of a Formula One driver trying to draw the quintessence from the latest Ferrari.
And of course, enforcement was required for the new regulations with patrols pre-dating cars and appearing as early as 1851 in France.
The spread of road accidents created conditions under which insurance became necessary and while coverage was at first voluntary it soon became mandatory, and has matured into a system designed in the interests of collective safety. Authorities are concerned primarily with protecting the interests of victims. Drivers at risk only to themselves are free to ruin themselves as long as no other drivers are harmed in the process.
Drivers need a reliable way to find their way and the first road signs began to appear at the turn of the previous century.
Road networks grant unrestricted access to drivers willing to follow some basic laws and are familiar to all. There is little tolerance for rule breakers however and we cannot simply hop over the highway median to take a cross country short-cut or drive around town in a tank.
Finally, international conventions were signed to facilitate the occasional need for drivers and their vehicles to cross frontiers.
This series of historical landmarks in the development of the automobile is a reminder of the ways in which policymakers have adapted to demands to allow for the efficient movement of vehicular traffic.
Cleary the system has increased in complexity as it has matured. Driver competence is more rigorously tested, and rigidly defined, than ever before and the bar is being pushed ever upward in terms of car safety standards.
A parallel development has been an increase in surveillance by the authorities.
We can observe that the evolution of motor vehicles has almost by definition been tied to increased regulation. The controls are designed less in the interest of limiting access, (although regimes of this nature do exist in places), and more in the spirit of allowing for traffic to circulate freely with a minimum of risk.
The primary tools at the disposal of policymakers have been:
• a near monopoly on infrastructure;
• control of access to the aforementioned infrastructure as well as the rules by which it is governed;
• vehicle safety standards;
• vehicle and driver licensing requirements.
When we observe financial networks it is also becomes evident that the massive development of infrastructure is intimately bound to increasingly sophisticated technical expertise. The main differences lie in:
• the speed of the evolution ;
• the absence of physical limits on potential growth ;
• complexity; reaching even an approximate understanding of financial networks is close to impossible and even those responsible for ensuring their proper functioning are slaves to the system in possession of a narrow view that is by definition never more than partial;
• little reverence for the laws of mechanics which demand equilibrium between such properties as force, inertia, and friction; in the financial domain, tensions rooted in such forces have figured little into calculations on overall system stability as the bubble and its eventual bursting have amply shown;
• the near absence of standards and tools of measurement that are understood by all;
In regards to specific rules (or the regulatory framework as a whole), the entire philosophy is divergent and stands in stark contrast to that which governs traffic.
The financial system has never been free from the heavy hand of regulatory bodies and they have primarily concerned themselves with exercising control, as opposed to ensuring the overall health of the markets, as can be seen by their tendency to:
• exert a “royal” prerogative over the flow of money ;
• insist that traffic flow over defined networks in order to maximize control;
• control the economy by directing credit into specified channels;
• protect individual consumers.
Following the crash of 1929, financial regulation in the United States was given a complete overhaul:
• specialization was encouraged; lines were drawn and bankers were no longer insurers, nor the reverse; American banks became explicitly defined by role and according to state;
• the safety of deposits was guaranteed through the creation of the federal deposit insurance and reserve requirements were established for member institutions;
• protections were placed on personal savings.
Some notable differences arose in the approaches taken on opposite sides of the Atlantic. In France, as in much of continental Europe, regulatory regimes reflected a certain level of public mistrust toward financial institutions and a desire to ensure effective state control over their operations (exchange, credit, etc.). Americans placed greater emphasis on protecting the interests of consumers as illustrated by their strategy to create smaller institutions as they would be easier to monitor and their errors would have a limited impact on the financial system as a whole. This led to a decentralized American banking system and spurred the creation of specialized circuits through which business could be conducted away from the eyes of the regulators.
A heavy handed system endured up to the 1980s when regulations were weakened as a result of the confluence of two parallel trends:
• as in many other sectors of the economy the state began to withdraw and regulatory constraints were lifted as faith was placed in the power of the market to regulate itself;
• information systems underwent a period of exponential growth allowing increasingly complex operations to take place almost instantaneously and in seemingly limitless volumes.
Governments for the most part excused themselves from the business of infrastructure and it is a minor miracle it did not collapse under the weight of saturation.
To gain access to the network market actors were required to fulfill the technical requirements for transmission, if not the funds could nevertheless move freely, at least in the developed West. Extending the traffic metaphor we could say that regulatory norms related only to the actual construction of road networks and vehicle safety standards. As far as driver requirements and vehicle performance were concerned anything was permitted.
A more open system loosened the rules on specialization and barriers to entry for the most part crumbled. While a Formula One driver might push up against physical limits for financial interests the very notion of limits became irrelevant.
Financial folly reigned and whereas automobiles are subjected to rigorous road safety tests before hitting the road toxic Madoff-style investments faced no such scrutiny before being dumped on unwitting customers ; while markets create new opportunities to operate “under the table” in car manufacturing it is required that everything be above board.
In relation to the traffic metaphor we have entered a world where practically anyone with the desire can engineer a new vehicle to be driven by anyone, whether licensed or not, and according to rules made up as the car moves down the road cutting across traffic whenever it might seem opportune.
In such a world signposts become redundant and it would be an understatement to say that the rating agencies have clearly shown their limitations.
Governments while paying lip service to deposit insurance, or other similar schemes to protect small investors, have actually invested the bulk of their energy on bank rescue packages in the hope that financial institutions will then come to the aid of the victims that they created themselves.
Clearly, there has been a fork in the road and we see two sectors on evolutionary paths that have become fundamentally opposed.
On the roads, the growth in traffic has moved hand in hand with stricter regulation placing what can at times seem an unusually heavy burden on drivers all of which has allowed for increases in volume to correspond with less and less accidents.
In the financial sector, the burden of regulation has all but vanished, for both actors and the products they distribute, resulting in runaway growth that eludes any measure of control and produces more and more accidents.
Plotting a parallel course between the evolutionary paths can only take us so far however towards illuminating our dilemma. Could it nevertheless provide some insight for the diverse range of interests currently tasked with drawing up the financial roadmap for the future? While steps have so far been modest it pays to remember that liberty should never be confused with anarchy.
Post Scriptum: We could pursue our discussion further by adding tax regimes to the equation. Policymakers were swift to realize the potential of the automobile as an instrument for fiscal policy as it represents a means by which substantial revenues can be generated for the state without the need for complexity or the risk of major economic repercussions. Financial markets are ripe with potential of an at least equal scale but “financiers” have demonstrated remarkable efficiency in resisting these measures by convincing governments otherwise.
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