Wednesday, May 7, 2014

7/5/2014: Simple vs Complex Financial Regulation under Knightian Uncertainty

Bank of England published a very interesting paper on the balance of uncertainty associated with complex vs simplified financial regulation frameworks.

Titled "Taking uncertainty seriously: simplicity versus complexity in financial regulation" the paper was written by a team of researchers and published as Financial Stability Paper No. 28 – May 2014 (link: http://www.bankofengland.co.uk/research/Documents/fspapers/fs_paper28.pdf), the study draws distinction between risk and uncertainty, referencing "the psychological literature on heuristics to consider whether and when simpler approaches may outperform more complex methods for modelling and regulating the financial system".

The authors find that:
(i) "simple methods can sometimes dominate more complex modelling approaches for calculating banks’ capital requirements, especially if limited data are available for estimating models or the underlying risks are characterised by fat-tailed distributions";
(ii) "simple indicators often outperformed more complex metrics in predicting individual bank failure during the global financial crisis"; and
(iii) "when combining information from different indicators to predict bank failure, ‘fast-and-frugal’ decision trees can perform comparably to standard, but more information-intensive, regression techniques, while being simpler and easier to communicate".

The authors key starting point is that "financial systems are better
characterised by uncertainty than by risk because they are subject to so many unpredictable factors".

As the result, "simple approaches can usefully complement more complex ones and in certain circumstances less can indeed be more."

The drawback of the simple frameworks and regulatory rules is that they "may be vulnerable to gaming, circumvention and arbitrage. While this may be true, it should be emphasised that a simple approach does not necessarily equate to a singular focus on one variable such as leverage… [in other words, simple might not be quite simplistic] Moreover, given the private rewards at stake, financial market participants are always likely to seek to game financial regulations, however complex they may be. Such arbitrage may be particularly
difficult to identify if the rules are highly complex. By contrast, simpler approaches may facilitate the identification of gaming and thus make it easier to tackle."

Note, the above clearly puts significant weight on enforcement as opposed to pro-active regulating.

"Under complex rules, significant resources are also likely to be directed towards attempts at gaming and the regulatory response to check compliance. This race towards ever greater complexity may lead to wasteful, socially unproductive activity. It also creates bad incentives, with a variety of actors profiting from complexity at the expense of the deployment of economic resources for more productive activity."

The lesson of the recent past is exactly this: "These developments [growing complexity and increased capacity to game the system] may at least partially have contributed to the seeming decline in the economic efficiency of the financial system in developed countries, with the societal costs of running it growing over the past thirty years, arguably without any clear improvement in its ability to serve its productive functions in particular in relation to the successful allocation of an economy’s scarce investment capital (Friedman (2010))."

And the final drop: clarity of simple systems and implied improvement in transparency. "Simple approaches are also likely to have wider benefits by being easier to understand and communicate to key stakeholders. Greater clarity may contribute to superior decision making. For example, if senior management and investors have a better understanding of the risks that financial institutions face, internal governance and market discipline may both improve."

Top line conclusion: "Simple rules are not a panacea, especially in the face of regulatory arbitrage and an ever-changing financial system. But in a world characterised by Knightian uncertainty, tilting the balance away from ever greater complexity and towards simplicity may lead to better outcomes for society."

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