As regulation has become more complex, it has also become less effective - Haldane and Madouros paper

Speech of the Year. WSJ Editorial
A regulator, of all people, shows how complex regulations contributed to the financial crisis.
WSJ, September 11, 2012, 7:13 p.m. ET
http://online.wsj.com/article/SB10000872396390444273704577637792879194380.html


While Americans were listening to the bloviators in Tampa and Charlotte, the speech of the year was delivered at the Federal Reserve's annual policy conference in Jackson Hole, Wyoming on August 31. And not by Fed Chairman Ben Bernanke. The orator of note was a regulator from the Bank of England, and his subject was "The dog and the frisbee."

In a presentation that deserves more attention, BoE Director of Financial Stability Andrew Haldane and colleague Vasileios Madouros point the way toward the real financial reform that Washington has never enacted. The authors marshal compelling evidence that as regulation has become more complex, it has also become less effective. They point out that much of the reason large banks are so difficult for regulators to comprehend is because regulators themselves have created complicated metrics that can't provide accurate measurements of a bank's health.

The paper's title refers to the fact that border collies can often catch frisbees better than people, because the dogs by necessity have to keep it simple. But the impulse of regulators, if asked to catch a frisbee, would be to encourage the construction of long equations related to wind speed and frisbee rotation that they likely wouldn't even understand.

Readers will recall how ineffective the Basel II international banking standards were at ensuring the health of investment banks like Bear Stearns. The inspector general of the Securities and Exchange Commission, which adopted the Basel standards in 2004, would report in 2008 that Bear remained compliant with these rules even as it was about to be rescued.

Messrs. Haldane and Madouros looked broadly at the pre-crisis financial industry, and specifically at a sample of 100 large global banks at the end of 2006. What they found was that a firm's leverage ratio—the amount of equity capital it held relative to its assets—was a fairly good predictor of which banks ended up sailing into the rocks in 2008. Banks with more capital tended to be sturdier.

But the definition of what constitutes capital was also critical, and here simpler is also better. Basel's "Tier 1" regulatory capital ratio was thought to be more precise because it assigned "risk weights" to each category of assets and required banks to perform millions of complex calculations. Yet it was hardly of any use in predicting disasters at too-big-to-fail banks.

We've argued that Basel II relied far too much on the judgments of government-anointed credit-rating agencies, plus a catastrophic bias in favor of mortgages as "safe." Instead of learning from that mistake, the gnomes have written into the new Basel III rules a dangerous bias in favor of sovereign debt. The growing complexity of the rules leaves more room for banks to pursue regulatory arbitrage, identifying assets that can be classified as safe, at least for compliance purposes.

Messrs. Haldane and Madouros also describe the larger problem: a belief among regulators that models can capture all necessary information and then accurately predict future risk. This belief is new, and not helpful. As the authors note, "Many of the dominant figures in 20th century economics—from Keynes to Hayek, from Simon to Friedman—placed imperfections in information and knowledge centre-stage. Uncertainty was for them the normal state of decision-making affairs."

A deadly flaw in financial regulation is the assumption that a few years or even a few decades of market data can allow models to accurately predict worst-case scenarios. The authors suggest that hundreds or even a thousand years of data might be needed before we could trust the Basel machinery.

Despite its failures, that machinery becomes larger and larger. As Messrs. Haldane and Madouros note, "Einstein wrote that: 'The problems that exist in the world today cannot be solved by the level of thinking that created them.' Yet the regulatory response to the crisis has largely been based on the level of thinking that created it. The Tower of Basel, like its near-namesake the Tower of Babel, continues to rise."

Exploding the myth that regulatory agencies are underfunded, they note that in both the U.K. and U.S. the number of regulators has for decades risen faster than the number of people employed in finance.

Complexity grows still faster. The authors report that in the 12 months after the passage of Dodd-Frank, rule-making that represents a mere 10% of the expected total will impose more than 2.2 million hours of annual compliance work on private business. Recent history suggests that if anything this will make another crisis more likely.

Here's a better idea: Raise genuine capital standards at banks and slash regulatory budgets in Washington. Abandon the Basel rules on "risk-weighting" and other fantasies of regulatory omniscience. In financial regulation, as in so many other areas of life, simpler is better.

Original paper: http://www.bankofengland.co.uk/publications/Pages/speeches/2012/596.aspx