Is the SEC fighting last year’s war?

December 23, 2010, 3:00 PM UTC

Richard Bookstaber, adviser to the SEC on risk, discusses how to regulate it, how Wall Street ran amok, and what needs to happen to make markets work.

By Nancy Miller, contributor

Richard Bookstaber

Richard Bookstaber, veteran Wall Street risk manager and hedge fund manager, made a splash on the eve of the financial meltdown with the publication of Demon of Our Own Design, a book that warned the markets had grown too complex and were headed for a crash. Last year, Bookstaber left Wall Street to join the Securities and Exchange Commission as Senior Policy Adviser in the newly formed Division of Risk, Strategy, and Financial Innovation – a job he calls the most fulfilling of his career. In what spare time he has, Bookstaber trains in Brazilian jiu-jitsu, pens a broadly read blog, and during his New York-Washington commute is working on a novel that explores the limits of human knowledge.

He recently sat down with Fortune to reflect on his first year in a regulatory role.

Like many Wall Street professionals, your career began in academia.

At MIT my goal was to be in developmental economics. I wanted to save the world. I started doing courses and I realized there was an absolute disconnect between economic theory and what was happening in the world. I saw what mattered was infrastructure — building roads, creating communication networks, enabling entrepreneurs to borrow money for their businesses. Developmental economics didn’t have anything to do with that. But finance did.

Today, Main Street sees Wall Street as a rampaging behemoth that benefits only itself. How did that happen?

Start by looking at the huge structure that exists in finance and ask: What is that about?

First, the main function of finance and Wall Street generally is to provide capital. Now, the people who provide capital will do it more willingly if they have the liquidity to get out of their obligations by selling to other people. So you add the markets for trading to provide that liquidity. Go one step further. When people buy and sell securities they are taking on risk. So to address that, Wall Street offers instruments to help with hedging and risk management. You end up with derivatives and the like.

All of that is reasonable. But the next step is where things start to get into trouble. Those in finance start to realize that it’s hard to make money in a competitive market. They look for ways to get an edge. And to do that, they try to create informational asymmetries and institutional barriers.

And this is the point where derivatives started to be designed for gaming the market rather than to meet the demands of risk management, to allow institutions to lever when they weren’t supposed to lever, avoid taxes, trade in markets that they weren’t supposed to trade in.

Last year the SEC hired you to monitor your former stomping grounds. What kind of changes are you implementing?

I have spent a lot of time on the Dodd-Frank legislation and now on its implementation. And within the SEC I am working on a team to create more of a process-oriented approach for the examination work, a process that can take inputs, do analysis and generate outputs that provide information and insight to better arm the examiners — doing the sort of thing for the exams that quantitative methods can do for trading.

How would this improve things?

The first step in risk management is getting the data. You can’t manage what you can’t measure. Step two is to create a process for analyzing that data and, as issues occur, learn from those issues to refine that process.

What is the hardest part of securities regulation?

If you find a valve in a nuclear power plant that isn’t working right and replace it, the valve is not going to try to fool you into thinking it’s on when it’s really off. In the market, traders will try to fool you. In other words, there’s a realm of feedback and gaming that can occur in the financial markets that doesn’t occur in an engineering system. That makes developing rules much more difficult for Wall Street than for safety in engineering.

When you observe the market, the very fact that you are observing it as a regulator almost guarantees that the people in the market will react as a military adversary and develop the best defense against it. They will try to find ways around it. And, as I said in my testimony before Congress, derivatives are the weapon of choice for gaming the system.

You’ve said that regulations risk adding a layer of complexity. Should we change our regulatory system to be principal-based rather than rules-based?

The key point is that, whether rule- or principle-based, rather than looking at the regulation itself, it’s more important to look at the system and understand in what way the system is structured that makes it difficult to regulate.

And that gets back to themes in my book about complexity and tight coupling.

If you make the system more transparent and simple then regulators have a chance to observe what’s occurring and the time required to respond accordingly. That makes the regulation more effective.

But some people warned a housing bubble was forming well before 2007 and the powers that be ignored their voices. How will things differ now?

That is an issue of governance. When I was in charge of risk management at Salomon Brothers, the big issue wasn’t so much finding the outsized risk as it was making sure that somebody took responsibility for reducing it and then verifying that it was done.

The last two steps are the most difficult. Nobody wants to take the step of doing something about an outsized risk because that’s costly. Taking off a trade that you think will work has both transaction and opportunity costs. So it’s tough for a regulator to step in and say cut that out so the risk doesn’t slam the economy. The CEO may say, “I can’t believe you increased our financing cost or made us reduce our exposure. Because of you, we had to walk away from revenue!” The regulators are caught in a counter-factual argument. If they do their job and as a result the potential crisis doesn’t happen, then it looks like all they did was to unnecessarily tamp down profit opportunities.

You are part of an interagency group on systemic risk. Does systemic risk pose the greatest challenge to regulators?

Everyone says systemic risk is a hard nut to crack. But I don’t think systemic risk is hard; at least monitoring systemic risk is not difficult. Nobody can hide risk of that magnitude. It’s there to be seen. As I already mentioned, it is taking action that is difficult.

It’s true we just had a near systemic failure. But it’s the only one that has occurred in our lifetime. We are putting steps in place to deal with it, but I question whether we are too focused on fighting last year’s war.

For most people, on a day-to-day basis, what matters most is the notion of market integrity, to be able to raise money for businesses, to be willing to put money in the market. To do that, investors have to feel that they are protected. This is the true blocking and tackling that is critical for a functioning of our economy.

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