from Andrew Lo.

The functional approach to studying financial institutions and regulation begins with the observation that there are six functions of the financial system–a payments system, a pooling mechanism for undertaking large-scale investments, resource transfer across time and space, risk management, information provision for coordinating decisions, and a means of contracting and managing agency problems. Because functions tend to be more stable than institutions, regulations designed around functional specifications are less likely to generate unintended consequences.

Thanks to David Warsh for the pointer. Lo has a number of interesting proposals, including the creation of a “risk balance sheet.” His point is that accounting statements are historical snapshots, but they don’t say much about the susceptibility of the firm’s finances to possible future events. I would caution that the Risk Disclosure Problem is not easily solved.

James Martin, the guru of information engineering, claimed that within a firm, the data entities are more stable than the business processes, and the business processes are more stable than the organizational structure. So if you’re a bank, there will always be entities such as “customer,” “account,” “interest rate,” and so on. The business process may change–you can introduce online banking for example. And you can always do a re-org–you could put transaction processing under “customer relationship management” or under “operations.”

A lot of the regulatory “turf wars” that take place in Washington are based on organizational structure–this agency regulates banks, that agency regulates futures markets, and so on. The higher level of abstraction–business processes–is too difficult a concept. The concept of data entities takes abstraction still higher.

When I was at Freddie Mac, we tried to use information engineering, but it was too difficult. The result is that we were stuck with a variety of systems that did not talk with one another very well. I suspect that in the real world this is often the case. This suggests another reason to have limited expectations for regulatory reform.