The weekends G-20 ended with a few broad presses releases. I read one that was released under the header ‘Declaration of the Summit on Financial Markets and the World Economy’ which came from the White House. I suspect others were similar. A significant focused of the statement was on improving the rules of the financial game. A valid goal given that the quality of games has much more to do with the rules than the players.
Some of these improvements such as increased transparency through standardization of the accounting practices are a good idea. This would be useful because it helps people communicate and thus allow more players into the investment management (capital allocation game) making the game more robust. But standardization of methodology, risk management, and strategy in investment management creates rigid capital markets that are likely to have dire consequences. An example of bad standardization is the rating agencies. The idea that they need to be held to the highest standard is missing the point. Even if the rating agencies were extremely professional in their analysis they would still be dangerous to the system because the investment process would be extremely un-diversified. (For finance geek, think about the fact that a crossover index exists or simple trading strategies based on predicting rating changes – which are not particularly challenging). Another source of rules that weaken financial system diversification focus on ideal risk management methodologies. A degree of reasonableness can be mandated such as minimum capital levels (or more conceptually maximum leverage) without encouraging correlated (un-diverse) capital market but if specific rules are handed down expect correlation to rise. (Don’t be convinced that a golden standard exists because the process of risk management is reflexive; you need to be aware of what others are doing and if everyone is doing the same thing you’d likely want to stay away from that method (or front run it, meaning to trade in front of it)).
Rather than have a golden rule create a competitive environment full of robust capital pools. Meaning focus the rules of the financial system on providing information for investors and eliminate rules that push investor away from the thought process of allocating capital (such as using rating agencies or the prudent man rule).
The principles of diversification that are commonly recognized in portfolio construction should be used when creating robust capital markets but their usefulness does not stop, in fact the principles of diversification should be used consistently throughout our daily lives when making decision in a uncertain world.
