The Dog and the Boomerang: Defending complex rules

Just as the global banking regulators strive to sign off on Basel 4, a Bank of England staff blog has come out in defence of regulatory complexity. 

The increasing complexity of financial regulation has spurred commentators to call for simplicity, most pointedly in the classic Andy Haldane speech of 2012. The former central bank economist explained how simple rules can achieve complex tasks: by simply adjusting its speed to keep its angle of gaze fixed, a dog can manage the complex task of catching a frisbee.

Catching a crisis, like catching a frisbee, is difficult," he famously said. 

“Regulation of modern finance is complex, almost certainly too complex,” he said as the world tried to make senses of the global financial meltdown. That configuration spells trouble. As you do not fight fire with fire, you do not fight complexity with complexity. Because complexity generates uncertainty, not risk, it requires a regulatory response grounded in simplicity, not complexity.

Some financial risks are hard to catch with simple rules -they are more like a boomerang’s flight path than that of a frisbee

“To ask today’s regulators to save us from tomorrow’s crisis using yesterday’s toolbox is to ask a border collie to catch a frisbee by first applying Newton’s Law of Gravity.”

But BOE bloggers argue that some financial risks are hard to catch with simple rules -they are more like a boomerang’s flight path than that of a frisbee. 

They argue that complex rules can sometimes do a better job at representing risk and simple rules can be less prudent.

Fit for purpose 

Of course they acknowledge complex rules sometimes encourage the regulated to manage to the rule rather than managing their risk. Moreover there is convincing evidence that prior to the crisis, some of the more complex aspects of the early Basel reforms had been implemented in a way that had loopholes so when their exploitation was discovered people lost confidence in the veracity of banks’ risk weight calculations.

“A scepticism that still continues, being the motivation for the Basel IV output floors for internal models.”

But just because some complex rules were flawed, it does not follow that all are. 

Like the flight path of a boomerang, the post went on to say, portfolio risks can be quite complex and rather unintuitive, so a more complex representation of risk can actually lead to a more prudent outcome. “Ultimately, it’s a case of ‘fit-for-purpose’, but determining what the ‘right’ fit measure of risk is requires a nuanced judgement commensurate with the relative complexity of the scenario, the ‘art’ of risk management,” said KPMG partner Michael Cunningham

Cunningham quipped “I am reminded of the Italian artist Bruno Munari who said "To complicate is simple, to simplify is complicated....everybody is able to complicate. Only a few can simplify."

“Regulators need to simplify where ever practicable. Its grossly underestimated the cost to industry of the myriad of implementation and interpretative challenges that arise from sometimes poorly drafted, vague or even conflicting regulatory pronouncements.”   

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