Destructive Coordination

Abstract

An important goal of financial risk regulation is promoting coordination. Law's coordinating function minimizes costly conflict and encourages greater uniformity among market participants. Likewise, privately developed market standards, such as standard-form contracts and rules incorporated into widely-used vendor technology systems, help to lower transaction costs partly by increasing coordination.

By contrast, much of financial economics is premised on a world without coordination. Basic tools used to manage financial risk presume that changes in asset prices follow a random walk and individuals buy and sell assets independently. Thus, a bedrock premise of traditional risk management is that a portfolio manager’s actions affect neither the marketplace nor the trading decisions of others.

The result is a paradox: regulations and standards that benefit financial firms and markets can also impose unintended and significant costs - what I label “destructive coordination” - by inducing portfolio managers to act in unison and, in turn, affecting asset prices and eroding the core presumptions underlying much of financial risk management. Greater uniformity can increase the magnitude of a drop in the financial markets, a result that can have systemic effects.

Going forward, coordination’s benefits must be weighed against its costs, which are often less well understood. Expanding the scope of regulation beyond individual firms - taking into account the collective impact of coordination on the financial markets and the expectation of market participants - can help fill gaps in today’s regulatory framework. Financial regulators must also consider the role of market standards in promoting coordination, as individual firms are unlikely to have sufficient incentives (or information) to police them themselves.

Keywords: Dodd-Frank, risk, financial regulation, financial crisis, coordination, risk management, financial, financial market, systemic risk

JEL Classification: C71, D89, G18, G2, G21, G24, G28, K2, K22, L51