The BofE’s Andrew Haldane is getting a lot of attention-and rightfully so-for his critique of complex financial regulation, most notably Basel Faulty. Yes, there is a lot to criticize in complex financial regulation-and lord knows, I’ve indulged-but it’s essential to emphasize that simplicity is no panacea. Indeed, complex regulations evolve precisely from the deficiencies of simpler ones.
That is, you have to ask: Why did the rules become complex? Was complexity valued for complexity’s sake? Or did complexity develop/evolve because of the recognized defects of simpler structure?
Most likely. Rules become more complex in an attempt to respond to attempts to exploit simpler rules. There is a regulatory dialectic. The regulators and the regulated interact in a way that leads to spiraling complexity.
Take bank capital requirements. Simple capital requirements specify, say, capital equals a certain percentage of assets. This is fine if assets are identically risky, or the regulated have no ability to tilt their portfolios towards risky assets.
But that’s exactly what happened in the old, simple world with simple capital requirements. Banks looked for riskier assets in order to expropriate their depositors, lenders, and deposit insurers. With capital requirements insensitive to risk, banks had a tremendous incentive to make their assets as risky as possible.
There are two responses to this. One is to limit the nature of the assets banks can hold. The other is to make capital requirements depend on the riskiness of assets.
Both are great in theory, devilish hard in practice. Risk-based capital requirements (or limitations on the assets that banks can hold) demand that regulators have the ability to make discriminating evaluations of the relative riskiness of assets. Even more crucially, they demand that regulators know at least as much as those they are regulating.
Neither condition is likely to hold in practice. And again, there is a regulatory dialectic, as banks sniff out-or create-assets that are “underpriced” from a capital requirements perspective. That is, they identify-or create-assets with risk prices implicit in capital charges that do not reflect true risks, and which satisfy the restrictions on the nature of assets that banks can hold. (Think of AAA ABS of various types. They’re AAA! What could go wrong?) Thus, portfolios end up being riskier than regulators had anticipated.
So they adjust the capital requirements. But as in any regime of price controls-and capital requirements are essentially risk price controls-the regulators don’t have the necessary information to set the prices properly, meaning that some risks are always underpriced. The capital requirements become more complex, setting off a new round of attempts to identify the underpriced and overpriced risks.
What starts simple becomes progressively more complex. Regulations and capital requirements end up being bizarrely baroque not because people like it that way, but because the less baroque rules were exploited.
Put differently: complexity is endogenous, and almost inevitable. Simple sounds nice, but simple is easy to exploit, and complexity blooms in order to counter this exploitation.
Haldane argues that during the last crisis institutions subject to simple rules were less likely to fail than those subject to more complex ones. This is superficially plausible, but again, remember that the rules are endogenous, complexity is endogenous. There was no experiment, natural or otherwise, that randomly assigned some institutions to simple rules and others to more complex ones. The rules and the institutions co-evolved, endogenously. I would bet that there was some other constraint on the complexity of the firms subject to the simple rules that made it unduly costly for them to outwit the simple rules. They stayed simple as a result, so the rules could stay simple too.
Maybe Haldane is right. Maybe there is a simple but robust way of regulating financial institutions. But I have my doubts. Complexity results from the failures of the simple.
Haldane is stating, in an ironically more complex way, the old Indian story of the village beset by mice that brought in cats to rid itself of the rats, then brought in dogs to rid itself of the infestation of cats, then brought in elephants to drive out the resulting packs of dogs-and responded by bringing back the mice to scare away the elephants. Seeing the effects of complexity (elephants) the simpler problems (mice) don’t look so bad.
But don’t be deceived. If Haldane were to get his way, the cycle would begin again. This is the fallen condition of homo economicus.