We are currently facing one of the most challenging economic crises of our lifetimes — and the finger-pointing has begun. There is plenty of blame to go around, with homeowners, mortgage brokers, commercial and investment banks, rating agencies, insurance companies and investors all involved in the care and feeding of the U.S. residential real estate monster and its ugly downfall. However, in the final analysis, we may conclude that financial calamities are an unavoidable aspect of modern capitalism, a consequence of the interactions between hardwired human behavior and the unfettered ability to innovate, compete and evolve. But even if crises cannot be avoided, their disruptive effects can be reduced significantly by ensuring that the parties are bearing the appropriate risks. This is best achieved through greater transparency, particularly with respect to financial institutions in the hedge fund industry that have imploded.
Real disaster comes not from losing money — which investors and their portfolio managers have been doing since the dawn of financial markets — but from not being properly prepared for it.
One successful model for studying blowups is the National Transportation Safety Board, an independent government agency whose primary mission is to investigate accidents, provide careful and conclusive forensic analysis and make recommendations for avoiding such accidents in the future. In the event of an airplane crash, the NTSB assembles a team of engineers and flight-safety experts who are immediately dispatched to the crash site to conduct a thorough examination, including interviewing witnesses, poring over flight logs and maintenance records, and sifting through the wreckage to recover the flight recorder and, if necessary, reassembling the aircraft from whatever parts remain to determine the ultimate cause of the crash. Once its work is completed, the NTSB publishes a public report summarizing the findings, including specific recommendations for preventing similar future accidents.
The work of the NTSB is one of the major factors underlying the remarkable safety record of commercial air travel. For example, it is now routine practice to spray airplanes with de-icing fluid just prior to takeoff when the temperature is near freezing and it is raining or snowing. We can thank NTSB Aircraft Accident Report AAR–93/02 for this procedure. But it did not come cheaply. It was paid for by the lives of the 27 people who did not survive the crash of USAir Flight 405 on March 22, 1992.
The NTSB also establishes itself as the clearinghouse for all information related to an accident and communicates frequently and regularly with the press to provide as much transparency as possible to an undoubtedly anxious public. Compare this approach with the sporadic and inconsistent messages that were communicated to the public regarding the current financial mess, which may well have magnified the dislocation that ensued in stock and money market funds this fall. The Treasury and Federal Reserve Board can hardly be faulted for not providing polished presentations of every aspect of their deliberations — public relations has never been a significant component of their mandate. But in times of crisis, when emotions run high, it is particularly important to communicate directly, truthfully and continuously with all stakeholders, no matter how bad the news.
Financial crashes are, of course, considerably less dire than airplane crashes. However, the current financial crisis, and the eventual cost of the Paulson plan, should be sufficient motivation to create a “Capital Markets Safety Board” dedicated to inspecting, reporting and archiving the “accidents” of the financial industry. By maintaining teams of experienced professionals — forensic accountants, financial engineers and lawyers — working together on a regular basis over the course of many investigations, a number of new insights, common threads and key issues would emerge from their analysis. The publicly available reports from the CMSB would yield invaluable insights for investors seeking to protect their future investments from similar fates and would naturally drive managers and financial institutions to improve their safety records.
It is unrealistic to expect that market crashes, manias, panics, collapses and fraud will ever be eliminated, but we should avoid compounding our mistakes by failing to learn from them. Financial markets do not need more regulation; they need more effective regulation.
Andrew W. Lo is Harris & Harris Group Professor at MIT Sloan School of Management and chief scientific officer of AlphaSimplex Group, a Cambridge, Massachussetts–based asset management firm.
