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:, 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."


Brian O' Hanlon said...

Boiled down to the most simple level, something that most people do not realize, is that 'risk' is actually a hybrid concept, being comprised of the product of two elements.

Risk equals - 'probability' multiplied by 'impact'.

Like a lot of things, I guess, the science behind this makes a lot more sense, when we plug it into an example. It is so difficult to resist perhaps, making a reference to the 'impact' of the financial crisis upon society in Ireland. I mean, in the area of risk management theory, it would be hard to find any clearer example of an 'impact'.

That is one side of the equation.

We are very clear about one side of the equation, so we then need to look at 'probability'. This is the area, which does appear to cause difficulties in practice. Because it appears that a lot of people had underestimated the 'probability' of the risk maturing in Ireland during the crisis in the manner that it did, and having the level of impact that it did.

This is very much the point that Marian Finucane might make on Irish radio (often in the context of discussions, where the name 'Morgan Kelly' seems to arise). That is, as Marian would say, if one opened their 'beak' in Ireland, and mentioned that we might be living in a bubble and headed in the 'wrong direction', one would have been subject to much abuse.

I could honestly conclude, that I myself, would have been very annoyed by someone who raised doubts about assessment of risks, and probability of negative impacts, before the 'crisis' hit in Ireland in the late 2000's. Even after the crisis had finally hit, and people discussed with me, the fact that it was 'bad',... I would have been reluctant to accept the fact that the risk had matured as badly as it had done, even then.

Risk as I mentioned is one of these strange things.

It could not be simpler in terms of the equation. It is the pure hybrid of two 'concepts' that most people do understand very well - probability and impact. But when we put them together for some strange reason, we continually manage to underestimate the 'product' of these simple ingredients,... and even after the risk has matured, many of us, still manage somehow to live in complete denial.

This was never illustrated in more stark relief perhaps, than in that famous RTE PrimeTime episode, in which Morgan Kelly gave his most 'bleak' assessment of the reality in Ireland in 2008,... and he was in the company of some extremely talented, extremely intelligent people, who refused to see it, when presented so plainly to them. If we honestly believe now in 2014, than many of the rest of us, could have redeemed ourselves any better on that occasion, we'd be very much mistaken I think. B.

Brian O' Hanlon said...

The thing that teachers about risk management that I have always had, have tried to teach us that when you reduce either the 'impact' or 'probability' side of the equation, down close to zero,... you essentially cancel out the risk.

Again, plugging the equation into a 'real world' example, as in Ireland. What we do find, before any crisis hit society, was that a lot of people were working diligently to reduce the 'probability' side of the equation. The impact of the crisis in Ireland, although very severe in reality, it relied on a low probability sequence of events to occur,... specifically at a time in Ireland, when the little economy there, was experiencing a 'growth cycle' for the first time in generations (for the first time ever perhaps in the entire history of the new state).

I can recall that during the 2000's decade many descendants of Irish men and women who had emigrated to the United States or Great Britain, or elsewhere during the 20th century, would return to Ireland, in order to trace their ancestors and meet distant relations. It was not only a proud time for native Irish citizens, to think that they had 'arrived'. It was a proud time also for the descendants and distant cousins of the Irish, all over the globe.

What we really had was a low probability sequence of events, that turned into an absolute misfortune on an impressive scale.

But I think, that if we look back again to the theory of 'risk management', what you will remember is that idea of reducing the factor on either side of the equation down to close to zero, and one cancels out the 'risk'.

I am not convinced, that there was an awful lot more that the authorities in Ireland should have done, or perhaps could have done to work on the 'probability' side of the equation. But looking at the 'impact' side of the risk equation,... there is a lot of scope of investigation, into what we could have done, on the 'impact' side of it,... that may not have eliminated the risk altogether, but would have greatly, greatly reduced the impact when it did happen, as a result of that awfully low probability catastrophe.