Stressing the Test (at the risk-free rate)

The Fed exists to resist the declining rate of profit. It regulates the money supply to resist deflation and inflation, having then the interpretation of transacting full employment with price stability, utilizing its regulatory authority.

Using its regulatory authority has predictable patterns that resist moral hazards: most notably unemployment (due to deflation) and rising prices (due to inflation). Both hazards measurably affect income, which determines the risk of default going forward.

Pricing the risk going forward is referred to as an arbitrage argument, and the formula for determining the future-forward price is, F(t,T) = S(t)\times (1+r)^{(T-t)}, which is used to settle the argument at the due date (T-t). This effectively models the risk going forward, and it fully assumes that the price exists (is determined, essentially) at the risk-free rate (1+r).

The risk-free rate is the comparative differential (the basis–the identity element) from which the argument derives and is thus resolved in the form of a “derivative” value. This is what formulates the risk in derivatives markets, which are over-the-counter markets, privately enterprised using proprietary models, managing the risk to make a profit (a capital gain) for the user, like insurance companies.

Insurance companies literally bank on the risk-free rate to stay solvent. The risk-free rate (which is nearly zero on the dollar) is the “full faith and credit” of the Federal Government. It is a Treasury Department function. The Fed and the Treasury then form the regulatory authority, forming a public-private enterprise, regulating the systemic-risk proportion. The measurable object is to control for the moral hazard, which in a court of law or equity is to measure the harm done to yield a benefit.

To measure the probable risk going forward (to form a regulatory argument), the Treasury conducts stress tests. These are models that simulate the probable risk, conducted by an interagency committee called FSOC.

The Financial Security Oversight Committee exists to resist a nuisance value. The object is to prevent “attainment” value (the moral hazard that does harm to yield a measurable benefit).

Today, for example, a Federal District Court judge ruled that the FSOC’s model (which has the force of administrative law, operating with executive authority deriving from legislative action) is arbitrary. The model, the judge said, assumes the world is coming to an end and MetLife, an insurance company (a “SIFI”), is a victim of regulatory authority (government oversight by committee, which is not exactly a free market).

MetLife filed suit against FSOC for its SIFI designation, which means it can be regulated like a TBTF bank. If it is not regulated like an investment bank, then there is every incentive to apply investment-bank practices under the name of being an insurance company, which is referred to as regulatory arbitrage.

(Also keep in mind here about Thomas Hobbes. He is a pre-Enlightenment philosopher who argued the king is naturally regulated by his subjects, and he said they should set up a learned cadre of elites to advise them, existing with natural authority, kind of like FSOC.)

Whether or not insurance companies, like MetLife, can operate like investment banks to manage risk (and do a lot of harm) presents a systemic risk that (guess what!) Glass-Steagall (in one little paragraph!) worked to prevent.

Do what Bernie Sanders says he will do (and Mrs. Clinton says she will not do!) in priority and we will be well on our way to deconsolidation of the risk that effectively controls for the moral hazard.

Vote For Sanders!

(What financial-security oversight has to do with whose wife is being insulted by whom, or who has been manhandled by campaign staff on the trail, or whose rhetorical style is too unrefined for presidential politics… I don’t know! I guess I don’t have the imagination to put it all together. I guess I’m missing out on all the fun!)


About griffithlighton

musician-composer, artist, writer, philosopher and political economist (M.A.)
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