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Financial regulation: complex illusions and simple truths

It’s a mistake to believe that the more intricate the calculation, the more likely it is to be accurate – whether in financial regulation or in other fields.

In the 1985 film Brazil, a dystopian fantasy about a world brought to a standstill by red tape, anti-bureaucracy freedom fighter Archibald Tuttle vanishes without trace under a mountain of paper. His life is a far cry from the simple heroics of the mysterious figure portrayed by Clint Eastwood in spaghetti westerns, who despatches villains with a single gunshot in frontier towns that seem to lack any rules at all. The Man With No Name has little need for one, since his role does not appear to involve filling out any forms accounting for his actions.

Rules governing financial services have become so labyrinthine that it’s proving difficult for both the regulators and the regulated to understand them.

We wouldn’t really want to live in the sort of town shown in A Fistful of Dollars – the rule of law is necessary to prevent chaos. However, the rules governing financial services have become so labyrinthine that it’s proving difficult for both the regulators and the regulated to understand them. At times it seems as if the world described in Brazil is already with us.

But in reaction to this, there is a growing clamour for simplification. Officials at the Bank of England fear that the increasingly Byzantine nature of banking bureaucracy is clogging up the system. “This race towards ever greater complexity may lead to wasteful, socially unproductive activity”, says a paper written by Bank staff and outside academics in 2014. Burgeoning compliance departments impose a cost that must ultimately be borne by banks’ customers through higher fees.

Fans of simplification think, in any case, that a more streamlined system might produce more effective regulation.

The Bank of England’s paper gives the example of the Basel rules for bank capital. Under the intricate Basel II Internal Ratings-Based approach, banks are supposed to keep enough reserves so that losses will only exceed capital – wiping them out – once every thousand years. However, Bank of England tests on a hypothetical bank found that it ran out of capital ten times more often than this. If the simpler Basel I rules were followed, this didn’t happen even once.

In theory, more complex banking regulation should reduce the chance of banks going bust, because skilled mathematicians should be able work out the probability of defaults for their own particular bank’s portfolio of loans. In practice, however, this is an illusion.

This is largely because financial market analysts underestimate the occurrence of black swan events – moments when financial markets behave unexpectedly and exceptionally badly, or unexpectedly and exceptionally well. It’s better to acknowledge that you’re not totally confident about how the market will perform, rather than to miscalculate the capital you require because you wrongly think that you know what will happen.

The history of the relationship between humans and real black swans is instructive. For centuries a “black swan” meant something either impossible or extremely rare, since such birds did not exist in Europe. But in 1697 the Europeans discovered them in Australia, and the expression changed to mean something commoner, more likely or truer than first supposed.

The extermination of the black swan in neighbouring New Zealand might at first sight present metaphorical hope to regulators. However, the British reintroduced the bird, which is now thriving. Officials at the Financial Markets Authority in Wellington can pop over to a nearby lake to spot literal black swans at the weekend, after fretting over metaphorical ones on weekdays.

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