Mr. Volcker Is Wrong
Stephen A. Boyko
May 21, 2010

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In "Mr. Volcker Is Wrong," Stephen A. Boyko argues that the U.S. capital market governance system needs repair.  He believes that the core structural flaw in how American capital markets are governed is that "risk" and "uncertainty" are treated as one and the same phenomenon.  Consider, however, that if there is complexity, there is uncertainty. Life is uncertain and that can't be "reformed" out of existence. Reality oriented regulatory reform requires that policymakers move beyond risk management to randomness governance of both determinate and indeterminate underlying economic conditions.  Trying to govern both risk and uncertainty with a one-size-fits-all deterministic regime is analogous to having one set of driving instructions for both the U.S. and U.K.  In a world of financial complexity, innovation, and bubbles, it is "randomness" that includes both uncertainty and risk that should become the main focus of capital market governance reform.  Mr. Boyko is the author of "We're All Screwed! How Toxic Regulation Will Crush the Free Market System." He has over forty years of financial services industry experience that include formulating regulatory policy for the National Association of Securities Dealers ("NASD") and providing a practitioner's perspective for the privatization of the former Soviet Union in the areas of corporate governance and regulatory development of the Ukrainian Capital Market.


Ending the idea that large financial institutions are too-big-to-fail is a top priority of President Obama’s regulatory reform efforts. However, market innovations and systemic changes have proven more difficult to overcome than anticipated. In spite of the administration’s reform proposals to reduce the scale of Too-Big-To-Fail (TBTF) banks, Volcker wrote in a January 30, 2010, New York Times op-ed that “keeping banks small . . . does not really seem feasible in today’s world, not given the size of businesses, the substantial investment required in technology, and the national and international reach required.”


As Volcker tries to reduce financial scale through regulation, it should be noted that it was the regulators who allowed many financial institutions to merge into TBTF status. Recall the S&L meltdown, where the indeterminate “asset” on the books of many insolvent S&Ls was “regulatory goodwill” – the regulator’s reward for acquiring an even more insolvent thrift.  Who could have foreseen the Resolution Trust Corporation’s (RTC) liquidations that occurred when minimum reserve requirements became illusory in a setting where capital consisted of vapor assets?


Regulation does not create competition. Rather, history has shown that regulation fosters large, unresponsive oligopolies. Regulation often has the unintended consequences of creating TBTF institutions via economies of scale to absorb regulatory overhead costs that serve as barriers to entry enabling the large banks to get larger. TBTF banks understand that regulation is a negatively defined business, “Thou shall not … except for.” A core competency of TBTF banks is to gain competitive advantages by obtaining an “except for” status. For example, although a 1994 regulation put a cap of 10 percent on the share of insured deposits that can be held by any one bank, regulators provided an exception to allow mergers for J.P. Morgan Chase, Bank of America, and Wells Fargo.[1] Current TBTF banks have prospered by competing in a regulated industry. As a point of reference, compare the growth of the appropriate financial governance sections of the Federal Register with bank capitalization. Adding more one-size-fits-all regulation may create unintended consequences that result in more TBTF financial institutions.


In practice, the regulated have proven better than the regulators at gaming governance. Hence, Goldman Sachs became known as “Government Sachs” and is viewed as the poster child of capital cronyism. In an era of re-regulation, either policymakers must become more proficient at promulgating regulatory constructs or they need to gain a better understanding of market incentives to increase competition.


Regulating TBTF can create a too-small-to-settle (TSTS) unintended adverse reaction. What happens when one-size-fits-all regulatory metrics create chaotic systemic randomness conditions caused by TSTS financial institutions acting in unison? To illustrate, the 1987 Market Crash was caused in large part by institutional, asset-allocators executing pre-programmed stop-loss sell orders, in concert, at specific price points for stocks and futures contracts. Similar to the collapse of the Broughton Bridge near Manchester, England in 1831, a financial equivalent of the now–standard practice of breaking cadence when soldiers cross a bridge was needed. Structures like the Broughton Bridge have many natural low frequencies of vibration, so it is possible for a column of soldiers, marching in step, to vibrate the bridge at one of the bridge’s natural frequencies. The bridge locks onto the frequency while the soldiers continue to add to the excursions with every step, causing larger bridge oscillations until unforeseen and unintended systemic failure occurs. [2] Segmenting regulation to fit the underlying economic environment of predictable, probabilistic, and uncertain regimes enables the market to break cadence. It provides a structural stabilization system to quell panic during periods of systemic distress since different regimes will be marching in different directions with different cadence. Thus, randomness segmentation is a precondition for a resolution mechanism.


Problematic scope that is Too-Random-To-Regulate (TRTR)


Mr. Volcker argues that financial institutions’ leveraged ownership or sponsorship of hedge funds, private equity funds, and proprietary trading should not be afforded FDIC insurance of customer deposits. This places bank capital at risk (emphasis added) in the search of speculative profit rather than in response to customer needs.” But, in a world of financial innovation and bubbles, it is uncertainty — not risk — that should be the randomness component of focus.


Uncertainty is different from, rather than a higher degree of, risk. This distinction was made famous by economist Frank H. Knight in his seminal book, “Risk, Uncertainty, and Profit” (1921). Risk refers to situations in which the outcome of an event is unknown, but the decision maker knows the range of possible outcomes and the probabilities of each. Uncertainty, by contrast, characterizes situations in which the range of possible outcomes, let alone the relevant probabilities, is unknown.[3]


Accordingly, capital market Too-Random-To-Regulate (TRTR) governance dilemmas are framed by three questions.


1.          Does uncertainty exist in the capital market to a material degree?

2.          If so, can it be regulated by one-size-fits-all deterministic governance?

3.          What metric(s) demarcate risk from uncertainty in the capital market?


These questions, in turn, engender the following responses.


1.          As there are innate complexities in the capital markets, the element of uncertainty always will be a part of complex adaptive systems.

2.          Absent randomness segmentation, indeterminate information cannot be processed effectively and efficiently by determinate metrics.

3.          The bright line that demarcates determinate from indeterminate underlying economic condition depends upon structure.


Reality is contextual, but because context is colored to a large extent by perspective, structure matters. “Structure” was a critical element in subprime contagion as mortgages were pooled into securities. These securities were then held in special purpose vehicles (“SPVs”). SPVs were funded by rolling over short term commercial paper with an off-the-books credit guarantee from a large bank. SPVs attempted to take risky assets — mortgages — and turn them into risk-free assets in the form of short-term debt. Here is what this financial structure does instead: First, it turns a “smooth” risk, like equities, which are repriced routinely, into “earthquake” risk that either pays a steady stream or fails catastrophically and unpredictably.[4]


Changing from a determinate to an indeterminate domain is a discontinuous function. “Change” is defined in this context as the relationship between risk and uncertainty. When uncertainty becomes risk, that's learning or innovation—you have greater control over your underlying economic environment. On the other hand, when risk becomes uncertainty there is either confusion (too much information) or ambiguity (too little information). Should the uncertainty become unstable as in New Orleans when the levees broke, there is chaos.[5] In capital markets, the smooth financial risk function becomes chaotically discontinuous during the uncertainty of “Minsky Moments.[6]


It is not so much the riskiness of the structural processes related to proprietary trading, hedge fund, and/or private equity that is troublesome, but what component percentage of the instruments’ contractual randomness contained in the portfolio’s investments are of a “risky” or “uncertain” nature. The Volcker Rules proscriptively describe an adverse condition to create disproportionate regulation of the already regulated and fails to address the true danger. Rather than requiring the prospective disclosure of the uncertainty attendant to an investment, regulation too often kicks the can down the road by retrospectively defining uncertainty in terms of the regulator’s reality (i.e. S&L goodwill, credit default swaps etc.) and not the market’s reality.


Systemic errors create false positives for Volcker TBTF and TRTR strategies


Today’s challenge is to rethink capital market governance to provide real change to the basic function(s) of financial intermediation and not simply to limit investment scale and scope. This involves doing the right things by avoiding systemic capital market mistakes of mischaracterization, misapplication, and misusage of best practice governance metrics. Segmenting one-size-fits-all, deterministic regulation is needed to correct the mischaracterization error that conflates risk and uncertainty. More information and more precise information correlation are needed. This is consistent with Senator Dodd’s contention that posits at “every point in the chain of events that led to the financial crisis, there was a crucial information deficit.”[7] This gap was caused by the misapplication of rule-writing metrics based on insufficient, non-correlative information that proved to be illusory as to regulatory knowledge. Finally, the resultant misuses of bailouts created false positives that systemically institutionalized speculative credit risk and caused the Volcker Rule TBTF and TRTR strategies to work in opposition to each other.


Mischaracterization of the underlying economic environment by conflating risk and uncertainty resulted in mispricing subprime debt. Best-practice financial regulatory reform must differentiate determinate from indeterminate economic domains.


Determinate - Indeterminate Differentiation










Not Measurable


Market bright line




Firm bright line

Positive cash flow

Negative cash flow


Management metrics

·      Insure

·      Diversify

·      Hedge

·      Warrant

·         Greater scale

·         Greater control

·         Slower throughput

·         Greater knowledge


As demonstrated by the above table, there are four ways to manage uncertainty that include: combining uncertainties through larger scale, increasing control of the situation, slowing throughput, and increasing knowledge.[8] The subprime financial crash illustrated that, while current capital market governance is almost exclusively deterministic, Treasury Secretary Paulson’s remedies relied heavily on uncertainty metrics by:


  1. Using greater scale to propose a $700 billion RTC-type pool for troubled assets,
  2. Banning short selling for more than 800 financial institutions from September 19, 2008 until October 9, 2008 to exercise greater control over bear raids, and
  3. Slowing throughput by re-instating the up-tick rule.


For there to be a reversal of the troubling trend of more frequent and larger systemic crashes, there needs to be an accurate characterization of the underlying economic environment. This requires the Volcker Rules to move beyond risk management metrics to segment the underlying economic conditions into predictable, probabilistic, and uncertain regulatory regimes.


Misapplication results from improperly using a proper regulatory tool such as information transparency. The result is rule-writing—a condition that is a proscriptive description of an undesirable situation. It is ad hoc policymaking that Band-Aids over a current problem of the capital market. Rule-writing expects buy-in from society by describing an undesirable situation and legally prefacing it by saying “don’t do this.” Former SEC Secretary Jonathan G. Katz commented that when “the SEC adopts a rule, it believes it has solved whatever problem it is addressing. … The solution is to rethink the rulemaking process. Instead of assuming, as lawyers do, that rules are self-effectuating, the SEC should adopt a scientific approach.”[9] But rule-writing is exactly what the Volcker Rules do. Much like Sarbanes-Oxley, the Volcker Rules’ over-reliance upon commands and controls constrains governance robustness.


The Volcker Rules’ TBTF and TRTR metrics are limited in developing regulatory knowledge that is needed to address today’s global market realities. Regulatory knowledge involves the evolution of data, to information, to knowledge. Data is empirical evidence that is mutually exclusive and collectively exhaustive. The MECE principle of mutually exclusive and collectively exhaustive is a grouping principle which says that data in a group should be divided into subgroups that comprehensively represent that group (no gaps) without overlapping. [10]


Data is then formatted to become information. Information is an operating-range concept that strives for balance to avoid too much formatted structure, “confusion” and too little formatted structure, “ambiguity.” A key objective of Senator Dodd’s reform proposal is to remove confusion to make investment information more understandable. Much has been made about complex financial products that were made available to green mortgagors being red flags. But without increasing investor product knowledge, additional regulation such as the Consumer Financial Protection Agency (CFPA) merely “dumbs-down” the consumer base at the expense of market efficiency. Similar to reducing the cost of auto insurance by passing drivers’ education, investors who become financially knowledgeable reduce the cost of compliance and increase market efficiency.[11]


It should be noted that excessive data formatting causes investment document confusion. This is the result of ambiguity stemming from the lack of differentiating risk from uncertainty in the one-size-fits-all legacy regulatory system. The lack of information correlation restricts regulators’ ability to connect compliance dots (e.g., Madoff) to develop either descriptive (profiling) or predictive (formulaic solutions) governance knowledge. Thus, the timing and sequencing of regulatory reform suggests that market segmentation of determinate from indeterminate underlying economic environments take precedence.


Misusing the wrong financial tool created price discovery difficulties where probabilistic mark-to-market values were derived from an indeterminate mark-to-model metric. Misusage of financial innovation enabled financial intermediation to happen where it would not have happened previously … [I]nnovations like securitization lowered borrowing costs for most consumers. But financial innovation is good only if it enables an economically productive use of money that would not otherwise occur. To make the world better depends on someone else having found a useful way to employ money. [12]


Professor Stanley Liebowitz of the University of Texas posited that the single most important factor in home foreclosures was negative equity. “NINJA[13]” and “LIAR” loans improperly gave property rights to renters. A moral hazard is created whenever investor rights exceed investor responsibilities enabling unsophisticated investors to receive a regulatory subsidy to expand the scale and scope of their investment activity. Liebowitz demonstrated that the presence of such loans also misdirected policymakers’ focus toward the wrong variables to control the adverse consequences of the subprime crash. [14]


The boom period of the subprime financial crash saw the product demand and market assumptions to be mutually reinforcing. In theory, TRTR investors were provided greater customer protection from a TBTF financial institution credit enhancement. The TBTF financial institution, in turn, received greater capital adequacy from the sale of high-margin, high volume TRTR investments. TRTR vapor investments were overly complex. Their prospectuses were difficult to understand given that deterministic metrics were used to describe indeterminate investments. Difficult-to-understand TRTR credit enhancement required an easy-to-recognize TBTF financial institution guarantor to make the sale.




The Volcker Rules attempt to limit financial institution scale and scope. Its Glass-Steagall Lite regulatory objective is to minimize conflicts of interest between leveraged-bank private equity, investment banking, hedge fund, and proprietary trading activities and their clients’ government insured deposits.


The question remains, do the Volcker Rules properly address TBTF and TRTR issues? I think not. The Volcker Rules cannot reverse history to the conditions that existed before November 12, 1999 when the Gramm–Leach–Bliley Act repealed the last remnants of Glass-Steagall.


The conflation of “risk” and “uncertainty” exacerbates capital market structural problems thus accelerating the troubling trend of larger and more frequent economic dislocations. While Mr. Volcker’s credibility and insight provide a good starting point from which to begin regulatory reform, the issue is whether it is more preferable to solve the “symptomatic problems” of scale that is TBTF and scope that is TRTR, or whether it is preferable to fix the “market” by segmenting the underlying economic condition in terms of predictable, probabilistic, or uncertain governance regimes.


The Volcker Rules are a set of financial controls designed to reduce randomness of vapor investments such as credit default swaps and capital adequacy of TBTF financial institutions. Controls historically have resulted in either a supply shortage in terms of less quantity or quality of services or black markets evidence by transfer pricing or asset stripping. Once an investment process reaches a critical level of demand, regulation does not stop it. Rather, regulation just determines where it is transacted and how much it costs.


The preferred reform strategy is to fix the market by segmenting the legacy, one-size-fits-all, deterministic governance. Why? There is more precise information correlation to limit prospective bailouts from systemically institutionalizing credit risk attendant to speculation.[15]

This is consistent with Christopher Dodd’s Senate proposal to provide better information. Since the Volcker Rules do not address fundamental structural problems, its non-correlative rule-writing metrics cause TBTF and TRTR strategies to work in opposition to each other.




[1] “Banks 'Too Big to Fail' Have Grown Even Bigger,”  David Cho, Washington Post Staff Writer 10/28/09


[2] We’re All Screwed,” Stephen A. Boyko, p 24.

[3] “Risk, Uncertainty, and Economic Organization,” Peter G. Klein, Mises Daily, October 22, 2009 http://mises.org/daily/3779.


[4] “Lessons from the Financial Crisis,” John Cochrane, Regulation Winter 2009-2010, Cato Institute, p 35.


[5] We’re All Screwed,” Stephen A. Boyko, p 61.


[6] A Minsky moment is the point in a credit cycle or business cycle when investors have cash flow problems due to spiraling debt they have incurred in order to finance speculative investments. At this point, a major selloff begins due to the fact that no counterparty can be found to bid at the high asking prices previously quoted, leading to a sudden and precipitous collapse in market clearing asset prices and a sharp drop in market liquidity.


[7] How Chris Dodd's Financial Regulatory proposal solves the problem of information, but not of regulators by Ezra Klein, Washington Post, 3/17/10

[9] “Rules Are Not Sacred, Principles Are”, Jonathan G. Katz, Wall Street Journal, August 8, 2006.


[10] Wikipedia.


[11] We’re All Screwed,” Stephen A. Boyko, p 76.


[12] “Finance: Before the Next Meltdown,” Simon Johnson and James Kwak, Democracy: a journal of ideas, Issue # 13, Summer 2009. http://www.democracyjournal.org/article2.php?ID=6701&limit=1000&limit2=2000&page=2


[13] NINJA is an acronym for “No Income, No Job or Assets.”


[14] New Evidence on the Foreclosure Crisis: Zero money down, not subprime loans, led to the mortgage meltdown, Stan Liebowitz,  WSJ July 3, 2009



Mr. Liebowitz is professor of economics and director of the Center for the Analysis of Property Rights and Innovation in the management school at the University of Texas, Dallas.


[15] Lessons from the Financial Crisis,” John Cochrane, Regulation Winter 2009-2010, Cato Institute, p 35.



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