Funding the Academic War on Financial Reform

Jan 26, 2012Wallace Turbeville

mortar-board-and-money-150Wall Street is funneling money toward error-riddled studies that stand to muddy the important conversation about implementing Dodd-Frank.

"The moon so long has been gazing down
on the wayward ways of this wayward town
my smile becomes a smirk, I go to work" - Cole Porter

Over the holidays, I finally watched the film Inside Job and was struck by the final section highlighting the corruption of academics by the financial services industry. It was a good thing that I had waited so long to drop the DVD into the player. Real life experience had provided important context.

A year ago, I became deeply involved in the issue of position limits and the effects of trading structures on commodities prices. As time wore on, the regulators made clear that any action beyond the bare bones, historic approach would require academic studies supporting the policy. It was a political necessity. My colleague David Frenk and I undertook a study using the techniques of these experts and found statistically significant relationships between the boom/bust cycle in commodities prices and the structural trading practices of commodity index fund sponsors.

Many like-minded advocates warned of formidable hurdles in this effort, since so many academics were beholden to the financial services industry. I was a skeptic, having spent my career in investment banking and trading, shielded from the corruption of experts by a self-interested industry. I learned that an uncomfortably large percentage of study opinion is molded by venality. And I also understand the weight ascribed to the work of experts, with an astounding disregard for quality and even relevance. Eventually, the CFTC sponsored a two-day academic "battle of the bands" (our study was excluded since we are not academics), which led to nothing.

Decision makers enjoy the cover provided by expert studies using statistical methodologies. If a study uses math and accepted procedures to test the robustness of conclusions, it is imbued with a sanctity that can be critically important in a policy fight. Opponents are cowed by assertions about the economy and financial markets that are figuratively cloaked in white lab coats by use of statistics. The all-important questions of the subject matter and scope of the study and underlying assumptions too often go unchallenged, and conflicting interests are largely ignored.

The legitimate appeal of expert analysis is the assumption that the expert is ethically and intellectually committed to independence of thought and is capable of using rigorous and accurate techniques for measuring cause and effect. On the other hand, if the expert serves an interested paymaster, he or she can use this capability to most effectively rig the results and camouflage the deed. They assume the pop culture role of evil mad scientist, opposing the forces of justice. Who would have thought that the danger would come from regression analyses instead of death rays?

It is troubling when biased research is used to influence regulatory outcomes and to wobble the knees of members of Congress inclined to support sensible regulation. But a far more powerful use of biased studies has emerged. The primary legal challenge to financial reform regulation will assert an inadequate consideration of costs and benefits by the regulators. On this field of battle, expert analysis is a powerful weapon.

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Last week, I testified at a hearing before subcommittees of the House Financial Services Committee along with Simon Johnson and six advocates of the industry's positions. The subject was the economic cost of the centrally important Volcker Rule. Before the hearing, Oliver Wyman consultants, on behalf of industry advocate SIFMA, produced a study that measured the cost of the Volcker Rule in terms of the liquidity that would be "lost" if proprietary trading by banks benefitting from the Federal safety net were prohibited. Professor Johnson and I both submitted testimony that pointed out that the major assumptions of the study that were both illogical and assured a conclusion that costs would be large. (We both were economical in our critiques, recognizing that a full catalogue of errors would have challenged the attention span of readers.)

Perhaps we were able to head off the use of the study in oral presentations by the industry advocates. Professor Johnson later wrote a useful article on the study that might discourage further dissemination, but far more is required. Committee members cited it and it is still floating around in the ether. It will no doubt be used in many private conversations in which no one will challenge its veracity.

Late last week, I was asked to look at a new study produced by NERA consulting (as it turns out, a subsidiary of Oliver Wyman) prepared for an energy industry advocacy group. The study sought to measure the costs and benefits of energy traders being designated as "swap dealers." It was filled with errors and unfounded assumptions, even worse than the Volcker Rule piece. (For a critique see this report and the observations of Professors John Parsons and Antonio Mello).

Academics are a concern as well. Professor Darrel Duffie of Stanford published an article at the behest of SIFMA two days before the Volcker Rule hearing that was largely a discussion of his preference for increased capital over the Volcker Rule approach and expressed concerns about effects on liquidity. He appropriately recognized uncertainty about his concerns. Even more appropriately, he acknowledged that in lieu of compensation, SIFMA made a $50,000 donation to the Michael J. Fox Foundation. Nonetheless, the timing of his piece means that it will probably be conflated with the Oliver Wyman study by casual observers.

Costs and benefits will be an enormous subject as financial reform implementation grinds forward during this election year. Legal academics need to weigh in on the proper judicial approach to this issue. And economists and finance academics need both to act as watchdogs and to enlighten the discussion on both sides of the cost/benefit scale. SIFMA and their colleagues have vast resources available to challenge financial reform in the courts and in Congress. Bought and paid for studies must be challenged so they are not accepted as the truth.

Wallace C. Turbeville is the former CEO of VMAC LLC and a former Vice President of Goldman, Sachs & Co. He spent a year during the derivatives rulemaking process drafting more than 50 comment letters on proposed rules while working with Better Markets, Inc.

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