Crescenzi: FinReg—Fewer Unknown Unknowns

In 1921, famed economist Frank Knightsaid that uncertainty is a risk that can't be measured. This concept is known as a Knightian Uncertainty.

When faced with uncertainty, people disengage demonstrate elevated levels of caution. An example of this is the way that financial markets behaved after Lehman fell in September 2008.

Back then there were many Knightian Uncertainties: Who held toxic assets? How many bad assets sat on the balance sheets of banking institutions? What were these toxic assets worth? Put simply, there were many unknown unknowns. Markets behaved accordingly, with riskier assets performing poorly and U.S. Treasuries the preferred asset class.

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Bankers, corporations, and investors have contended with many unknown unknowns regarding the future structure and regulation of the financial system.

For banks, the uncertainty has likely contributed to the contraction in lending, because banks could not be sure of both their future revenue prospects as well as the sort of regulations and capital requirements they would be subjected to.

Now, with financial reform set to be implemented in Washington, there will be fewer unknown unknowns.

This will contribute to a healing of the U.S. credit system. Moreover, the November election is likely to lead to more balance in the House and Senate, which means that the worst of the regulatory cloud and government involvement will soon pass. This could rally risk assets if this viewpoint becomes popular.

Still, challenges remain.

A global standard on capital requirements, as well as liquidity and leverage ratios will take quite some time to be set.

In addition, the populist fervor that shaped the current regulatory framework is still strong. Moreover, although banks are more capitalized than they were two years ago, they are likely to remain cautious about lending in this uncertain climate, especially given the focus on government balance sheets worldwide.

Bankers and investors alike understand that nations have reached the Keynesian Endpoint, where the last balance sheet has been tapped.

It is no longer easy for governments to borrow money to boost spending to support economic growth because investors are no longer tolerating fiscal profligacy.

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Tony Crescenzi is Senior VP, Strategist, Portfolio Manager Pimco. Crescenzi makes regular appearances on financial television stations such as CNBC and Bloomberg, and is frequently quoted across the news media. He is also the author of "Investing from the Top Down," "The Strategic Bond Investor," and co-author of the 1200-page book "The Money Market."