Fianacial Regulation: Black Box or Skinner Box?

Some of the most prominent features of pending financial reform support the problem to be solved.

According to congressman Barney Frank, for example, Chairman of a House subcommittee on regulation of capital markets, the size of the firm does not matter.

The debate is more about negotiating what the problem is rather than solving the problem. If the size of firms that are "too big to fail" is not the problem, then the problem reduces to the fear of failure.

Avoiding failure is a characteristic of small firms. Too-big-to-fail firms do not fear failure because they are too big.

The entire finreg debate avoids considering deconsolidation of the risk. Without transforming risk into small-firm alpha risk, the risk conserves in an aggregated gamma proportion.

The debate suggests we can turn a rogue elephant into a chicken in a Skinner box. Risky behavior can be operantly conditioned, turning the elephant into a big chicken, confronted with the risk of failure.

An elephant-sized chicken is not exactly the vision of reduced risk. This chicken is so big it is likely to go rogue, and when we try and kill the chicken it just gets bigger.

The regulatory "box" being constructed to modify the behavior of firms that are too big to fail will, according to behavioral economists, conserve the economy-of-scale coefficiency without systemic risk. Of course, the coefficiency (the risk/reward ratio) is the externalized accumulation of that risk.

Hypothetically, substituting the reward of systemic risk with the risk of failure will internalize the risk. Managing the externality--the risk getting bigger if failure does occur--will be by means of an orderly resolution authority. The coup will be burning down, but with an orderly evacuation of the chickens.

If an orderly resolution of failure means the corporate, and the margin, just gets bigger, what is the incentive not to fail?

Going from the black box to a Skinner box is to set us up for failure.

Left with mega firms and a mega government authority to manage them, we have nothing but a public and private entity of networked externality that is too big resist (too big to fail). The only available, operant, answer in this box is "yes!" It is the tyranny that we are supposedly trying to box out, by boxing it in.

The Skinner box makes the black box look good.