Financial Regulation: Theory of Wealth and Finance

1
Tsinghua University Course on Financial
RegulationLecture 1/08

• Financial Regulation Theory of Wealth and
  Finance
• Andrew Sheng
• Adjunct Professor,
• Graduate School of Economics and Management
• 17 September 2008

2
Lecture Series

• Lecture 1 Origin of Wealth Traditional vs
  Complexity Theory
• Lecture 2 A Macro-History of Chinese Governance
  (2007)
• Lecture 3 Theory and Practice of Governance
  (2007)
• Lecture 4 Leadership in Regulatory Environment
  (2007)
• Lecture 5 Money, Property Rights and Markets
  (2006)
• Lecture 6 Practice of Financial Regulation
  (2006)
• Lecture 7 A Property Rights Framework (2007)
• Lecture 8 Practice of Bank Supervision (2006)
• Lecture 9 Asian and International Financial
  Markets (2006)
• Lecture 10 The Regulation of Listed Companies
  (2006)
• Lecture 11 Consolidated Financial Regulation
  (2007)

3
Content

• The Questions ????
• Evolution is inter-linked process
• Traditional Economics(?????)
• Complexity Economics(??????)
• Social technology Business Designs
• Economic evolution is adaptive learning process
• Wealth is fit order (???????)
• Organization
• Financial markets Complexity Economics
• Government and Markets
• Contradictions, Theory and Practice

4
The Origin of Wealth Evolution, Complexity and
the Radical Remaking of Economics????????????????

• Eric D Beinhocker,McKinsey 2005Random House,
  2007

5
Origin of Wealth

• The economy, the market and government are all
  social institutions.
• The economy is a marvel of complexity. Yet no one
  designed it and no one runs it.(?????????)
• Beinhocker argues that wealth creation is a
  simple, but profoundly powerful, three-step
  formula - differentiate, select and
  amplify(????????), - the formula of evolution.
  (?????). This is the same as the process that
  drives evolution of species, ie Darwin Origin of
  Species.

6
The explosive growth in human wealth
World GDP per Capita
7,000
2.5 million BC to 2000 AD
3,500
0
0
-2,500,000
-1,250,000
Year
First stone tools
Human-gatherer lifestyle
7
The Questions

• How is a complex and highly structured economy
  created?
• How does the economy work in a self-organized and
  bottom-up way?
• Why has the complexity and diversity of the
  economy grown over time?
• How does complexity and wealth correlate?
• What role does financial regulation play in the
  economy?

8
Objective of this Course

• Teach you how to think about problems
• Financial Regulation is tool of Social Governance
• Markets and Governments are co-existing(??)
  (sometime competing) systems of Social Governance
• Because reality is complex, people use theories
  to think about reality for decision-making
  purposes
• But theory is often wrong, hence we must
  understand the contradictions of theory and real
  world. Regulation is Practice!

9
Economic evolution is the result of three
interlinked processes - Richard Nelson

• Evolution in technology - 1750 coincides with
  Industrial Revolution(????)
• Co-evolution(????) between Physical Technology
  (PT) and Social Technology (ST - ways of
  organizing people to do things)
• Business design (BD) encompasses its strategy,
  organizational structure, management processes,
  culture and a host of other factors. Business
  designs evolve over time through a process of
  differentiation, selection and amplification(?????
  ???), with the market as a final arbiter of
  fitness.
• It is the 3-way(??) co-evolution of PT, ST and BD
  that accounts for the patterns of change and
  growth in the economy.

10
Traditional Neo-Classical Economics(??????)

• Definition
• the set of concepts and theories articulated in
  undergraduate and international graduate-level
  textbooks.
• the set of concepts and theories that
  peer-reviewed (???????)surveys claim,or assume,
  that the field generally agrees on.
• Critique of Traditional economics by physical
  scientists
• the mathematical techniques and equations used is
  outdated, Newtonian vs Einstein.
• the assumption of perfect rationality that people
  know everything and all information is
  unrealistic.

11
A critique to Traditional economics

• Two golden rules for the use of assumptions
• the assumptions must be appropriate for the
  purpose of the models,
• the assumptions cant affect the answers of the
  models.
• Two laws of thermodynamics(???????)
• First, the energy is neither created and nor
  destroyed and is otherwise known as the
  Conservation of Energy Principle,(??????)
• Second, the entropy (??),a measure of disorder or
  randomness in a system, is always
  increasing.(?????)
• The traditional economics only borrowed the first
  law from the physics, but missed the second law.

12
Five Big ideas that distinguish Complexity
Economics from Traditional Economics
Complexity Economics
Traditional Economics
Open,dynamic(???),nonlinear systems,far from
equilibrium
Closed,static (???),linear systems in equilibrium
Dynamics
Modeled individuallyuse inductive rules of thumb
to make decisionshave incomplete
informationhave errors and biaseslearn and
adapt over time
Modeled collectivelyuse complex deductive
calculations to make decisionshave complete
information,make no errors and have no
biases,have no need for learning or
adaptation(are already perfect)
Agents
Explicitly model interactions between individual
agentsnetworks of relationships change over time
Assume agents only interact indirectly through
market mechanisms(e.g.,auctions)
Networks
No distinction between micro- and macroeconomics,
macro patterns are emergent result of micro-level
behaviors and interactions (????)
Micro- and macro economics remain separate
disciplines (??)
Emergence
The evolutionary process of differentiation,
selection,and amplification provides the system
with novelty and is responsible for its growth in
order and complexity.
No mechanism for endogenously creating novelty,or
growth in order and complexity.
Evolution
13
The Economy is an open, dynamic and complex,
adaptive system???????????

• TE Economy is closed, stable and reverts back to
  equilibrium(??????????)
• In reality, the economy is member of universal
  class of open systems, that grows and is
  irreversible. ????
• Three ingredients of Dynamic systems
• Stocks and flows?????
• Feedback loops,????, including positive and
  negative feedbacks ?????????
• Time delays.????
• Because social behaviour is interaction of
  different games by different players, it is
  nonlinear and self-organizing.?????????.

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Rationality

• Two problems justifying perfect rationality(????)
• First, it doesnt necessarily follow that if
  everyone else is behaving in some other way, one
  should be the lone perfectly rational person in
  the crowd.
• Second, perfect rationality is not a good
  normative model,???? because even if people
  wanted to act this way, they actually cannot.
• Bounded rationality(????)
• Chicago psychologist Herbert Simon people make
  decisions based on limited information and
  resource constraints (bounds)

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Inductive vs Deductive Rationality???????????

• Those who tell stories rule society
• We process information through induction (??) and
  deduction(??), then we form patterns(??).
• 2 aspects of inductive pattern recognition(???????
  )
• Relating new experiences to old patterns through
  metaphor and analogy making
• Not only good pattern recognizers, but also good
  patterns completers
• Pattern recognition and story telling are
  integral to humans cognition.
• Real people simply dont form preferences, judge
  risk, or make decision in the way traditional
  theories describe.
• Traditional Economists admit the validity of
  criticisms against perfect rationality, but they
  still use it because of lack an alternative.

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Non-Rationality as Human errors and biases

• Common errors and biases shared by normal people
• Framing biases (????) decision based on how
  question is framed
• Representativeness(??) does todays event
  represent big picture?
• Availability biases(?????) decide on what
  information is available, not on what can be
  found
• Difficulties judging risk how much to spend to
  prevent risk?
• Superstitious reasoning(????) random?? vs cause
  and effect(??)
• Mental accounting(????) money is treated in
  different compartments

17
What do people want?

• Advertising Rule SMS Sex, Money and Status
  ?, ?, ??
• Wealth therefore is a representation or
  derivative of mans drive for reproduction or
  survival of species.
• Therefore, social growth is all about behaviour
  of human beings for survival and growth of
  species(??).

18
Markets and Organizations are complex networks
connecting people
Densely interconnected network ???????
Hierarchical network ????
19
As Systems grow more complex, decay and
corruption sets in growth cycle between
simplicity and complexity

• Big is badcomplexity catastrophes(?????)
• The number of connections per node has an
  important effect on the behavior of a network
• The number of interdependencies in the network
  grow faster than the network itself.
• Complexity catastrophes
• dense interdependencies in a network (Kauffman)
• Less adaptable as they grow
• Example bureaucracys growth with tenacity of
  weeds(????) (Parkinsons Law) (?????)

20
Technology Evolution

• Two features in the technology development
• No technology is developed in isolation
• Technologies are inherently modular (??)
• Necessary conditions for evolution
• A design space ????
• Code the designs into a schema ??
• Schema reader????
• Modules and systems of modules??????
• Constraining factor of interactors ?????
• Fitness function?????

21
Evolution through fitness (survival via trial and
error)

• Fitness is result of an algorithmic process(????)
• The creation of order from randomness?????????
• The discovery of fit designs
• Continuous adaptation
• The accumulation of knowledge
• The emergence of novelty(??)
• Growth in resources devoted to successful design
• Reasons why evolution can find fit designs
• Evolution employs parallel search
• Evolution creates a spectrum of jumps on the
  landscape
• Evolution is a continuous innovation

22
Game Theory Economics (cooperate or defect)
???????

• The prisoners dilemma(????)
• non-zero sum game,
• Present us with a conundrum (both lose or both
  win)
• Coordination problems

Prisoner B
Deny
Confess
Judgement
Prisoner A
(1,1)
(4,0)
Deny
Confess
(0,4)
(2,2)
23
Interactive Learning is Tit for Tat Strategy
????.

• Four strategies for an agent only remember one
  move back
• Always defect(??)
• Always cooperate(??)
• Tit for tat (always do what your opponent did)
• Anti-tit for tat (always do reverse)
• Tit for tat strategy
• First move is to cooperate,from then on repeat
  last move its opponent made
• Who wins is nonsensical question survival is
  winner, e.g. Friendly but tough wins in highly
  cooperative environment, and Iron Fist (??)does
  well in non-cooperative environment.

24
PT ST BD Organization for Business
Strategy, Structure, Implementation, Outcome

• A business
• A person or an organization group of people,who
  transform matter,energy,and information from one
  state into another with the goal of making a
  profit.
• A firm
• One or more business controlled in common by a
  person or a group of people
• A module
• A component of a business plan that has provided
  in the past,or could provide in the future,a
  basis for differential selection between business
  in a competitive environment.

25
Markets vs Command Economies
Entrepreneurs vs Bureaucrats

• Over the history humankind evolved 2 methods of
  economic selection
• Big men Leaders
• The problem is that the big man will interfere
  the process of business plan selection,distort
  the fitness function and slow down evolutions
  speed.
• Markets
• Both a ancient and recent invention
• Business selection is decided by its customers
• Resources are devoted to venture that makes best
  use of it.

26
Economies swing from command to market back to
command

• Visible hand of corporate(?????)hierarchies make
  far more economic decisions than invisible hand
  (?????) of market called by Adam SmithAlfred
  Chandler in the 1970s.
• Typical Business Plans also true for
  Bureaucracies
• The market environment Context
• Strategy
• Products Services Output
• Operations Processes
• Marketing and Sales Information/data feedback
• Organization structure lines of authority

27
Dialectical(????)theories portray change - not
rest - as an economys permanent stateEd Kane
(2000)

• Alfred North Whitehead??????????
• The art of progress is to preserve order amid
  change and to preserve change amid order
• Market Behaviour under Asymmetric Information
• In a situation of order, disorder wins in a
  situation of disorder, order wins.
• In a situation of simplicity, complexity wins
  (make more derivatives) in a situation of
  complexity, simplicity wins (run!).
• Regulation is reflexive it affects the
  regulated and regulator is also affected through
  mutual interaction!

28
Economic evolution ?????

• Orgels second ruleEvolution is clever than you
  are.
• Comparison
• Perfect efficiencyTraditional Economics
• Relative efficiencyComplexity Economics
• Market can never be perfectly efficient, just as
  the engine of a car never be made 100
  thermodynamically efficient.
• Three important observation connecting
  evolving,complex economy with the origin of the
  wealth
• ?the process of creating economic value are
  inherently irreversible,
• ?our whole economic life feeds on low entropy(?)
• ?products and services are order-creating
  activities,but not all order has economic value.

29
Nicholas Georgescu-Roegen (G-R), Entropy Law and
Economic Process (1971)

• Economic process is all about using energy to
  turn low entropy materials and information into
  highly ordered products and services.
• G-R has three conditions for value creation
• Irreversibility
• Entropy value creating transformations reduce
  entropy locally and increase entropy globally
• Fitness such activities produce goods or
  service that are fit for human purposes.
• If physics cannot escape Second Law of
  Thermodynamics, neither can economics. There is
  no free lunch????? its takes energy to
  transform something and it is irreversible.
  Therefore evolution is continuous and behaviour
  is always changing.

30
Wealth Creation is producing what people want

• Order
• Order versus disorder is relative to something
• Order is in the eyes of the holder.
• Seven major categories US consumers spend on
• ?housing
• ?transport
• ?food
• ?life insurance and pensions
• ?health care
• ?clothing
• ?entertainment,media and communications

31
Wealth is fit order ????

• All wealth is created by the thermodynamically
  irreversible, entropy-lowering process,
• The act of creating wealth is act of creating
  order,but not all order create value,
• Economic and biological wealth both are system of
  locally low entropy, patterns of order evolving
  over time under the constraint of fitness
  function,
• Economic and biological wealth both are forms of
  fit order.(?????)
• The economy is ultimately a genetic
  replication???? strategy. In physics, order is
  the same as fit information, in other words,
  knowledge. The origin of wealth is knowledge.
  ?????.

32
Complexity, Evolution Knowledge

• Complexity economics put the creation of
  knowledge at the heart of the economy,
• Evolution is knowledge creation machine - a
  learning algorithm (????),
• All the order and complexity,all the
  knowledge,was created and assembled by the
  simplest of recipes differentiate,select,replicat
  e and repeat(????????,???)
• Wealth is knowledge. Its origin is evolution.

33
Why do organizations exist? a society of minds
????

• Four reasons
• ?incomplete contracts, - ????
• ?holdup problem ????
• ?a structure for cooperation to endure over long
  periods ????
• ?a vehicle for collective learning ????
• Three levels to examine complex adaptive systems
• ?the level of individual agents ????
• ?the structure of organizations ????
• ?emergence - ??

34
Architecture of Organization determines Fitness

• 3 components of a social architecture
• ?the behaviors of individual people in the
  organization,
• ?the structure and process aligning people and
  resources in pursuit of goals
• ?the culture from the interaction of people and
  their environment.
• Organizations are goal directed,
  boundary-maintaining,(????)and socially
  constructed system of human activity.

35
Companies compete through Innovation? But many
fail.

• Companies dont innovate, markets do
• Market is highly dynamic, but most companies are
  not,
• The change in the economy is driven more by the
  entry and exit of firms than by the adaptation of
  individual companies,
• Market create more surprise and innovations than
  companies,
• Strategy makes long-term commitments resulting in
  competitive advantage,
• Strategy is a portfolio of experiment??????, a
  population of competing business plans, rather
  than a single plan built on predictions of the
  future.

36
Culture is norms evolved over time for social
groups

• Ten norms(??) contributed to successful companies
• Performing norms(??????)
• Performance orientation
• Honesty
• Meritocracy ????
• Cooperating norms(??????)
• Mutual trust
• Reciprocity ??
• Shared purpose
• Innovating norms(????)
• Nonhierarchical
• Openness
• Fact-based
• Challenge

37
Adaptability to change ?????

• Reasons for poor adaptability of organizations
• Individuals
• ?a bias toward overoptimism,(????)
• ?a bias toward loss aversion or risk
  aversion,(????)
• ?difficulty to change the way we construct our
  mental models,(????)
• ?punctuated equilibrium nature of change tends to
  favor rigid leadership styles than flexible
  ones.(??)
• Structure ???
• ? Deep,densely connected hierarchies(????)
• ? Constraint space of business plans and path
  dependence in resources(?????????)

38
Financial Markets

• Ecosystems(??????) of expectations
• 3 salient facts that weaken traditional financial
  theories
• First,a lot of evidence shows that the real-world
  investors are nothing like perfect rational
  rather boundedly(???) and inductively
  rational(????) ,
• Second, markets dont follow random walk
  (????)but a complex adaptive path,
• Third, markets arent effective in the
  Traditional Economics sense, but are highly
  effective in an evolutionary sense.

39
Finance Perfect Markets and Traditional
Economics

• TE has evolved many tools and models used in
  Finance Theory, such as Random Walk, Markowitz
  Asset Management, VaR models etc. All have
  proved defective under current market volatility.
• Market efficiency is a relative term as financial
  markets are an evolving ecosystem of competing
  trading strategy(???????).
• Market is effective in processing information.
• Root causes of business cycles and stock price
  movement
• Behaviour of the participants
• Institutional structure of system
• Exogenous inputs(???????) into the system

40
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42
Technical Arbitrage increases Volatility
Fundamental Traders Fail to Arbitrage Technical
Pattern
43
Complexity Theory Implications for Finance

• Widely used methods for calculating cost of
  capital are wrong e.g CAPM
• Challenges use of absolute standards e.g. IFRS,
  Basle II, which may add instability because of
  one-way view
• Questionable to use stock options for
  principal-agent(????) incentive alignment
• Challenges super-capitalism(??????) what is real
  goal of society and corporations?

44
Complexity Theory Implications on Government and
Public Policy

• Government as fitness function shaper,
• Two different types of government actions
• ?Policies that get government involved in the
  differentiating, selecting, and amplifying
  Business Plans and interfering in the economic
  evolution,
• ?Policies that shape the fitness environment
  and leave Business Plan selection and
  amplification to the market mechanism.

45
Dialectic Materialism and Social Contradictions

• ??????????????,????????????????????????????????
  ?????????????????????????????????????????????
• ???(1937?8?)
• Dialectics look at problems from a relative and
  comparative angle.

46
Financial Regulation the Contradiction between
Theory and Practice

• ?????????,????????????????????????????????,???????
  ?????????,?????????????????????????,????,????????,
  ??????????????,????????????????????????????,??????
  ?????????
• ???(?????????-??????) ???(1937?7?)

47
Preliminary Thoughts

• ??????????,??????,?????,??????,????????.
• ???????,???,???,???,????
• How different is this from an Adaptive,
  Learning, Evolving Socialist Economy?
• Chinese Development by Opening Up, Learning,
  Adapting, Competing, Cooperating is truly
  Complexity Economics!
• Regulation has a role in Complexity Economics
  because Regulator is Reflexive and has major role
  in shaping social behaviour in accordance with
  policy objectives!!

48
Thank You
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