Speech of the Year
Catch the Frisbee: Keep It Simple |
A regulator, of all people, shows how complex regulations
contributed to the financial crisis.
WSJ Editorial, September 12, 2012
While Americans were listening to the bloviators in Tampa and Charlotte, the
speech of the year was delivered at the Federal Reserve's annual policy
conference in Jackson Hole, Wyoming on August 31. And not by Fed Chairman Ben
Bernanke. The orator of note was a regulator from the Bank of England, and his
subject was "The dog and the frisbee."
In a presentation that deserves more attention, BoE Director of Financial
Stability Andrew Haldane and colleague Vasileios Madouros point the way toward
the real financial reform that Washington has never enacted. The authors marshal
compelling evidence that as regulation has become more complex, it has also
become less effective. They point out that much of the reason large banks are so
difficult for regulators to comprehend is because regulators themselves have
created complicated metrics that can't provide accurate measurements of a bank's
health.
The paper's title refers to the fact that border collies can often catch
frisbees better than people, because the dogs by necessity have to keep it
simple. But the impulse of regulators, if asked to catch a frisbee, would be to
encourage the construction of long equations related to wind speed and frisbee
rotation that they likely wouldn't even understand.
Readers will recall how ineffective the Basel II international banking
standards were at ensuring the health of investment banks like Bear Stearns. The
inspector general of the Securities and Exchange Commission, which adopted the
Basel standards in 2004, would report in 2008 that Bear remained compliant with
these rules even as it was about to be rescued.
Messrs. Haldane and Madouros looked broadly at the pre-crisis financial
industry, and specifically at a sample of 100 large global banks at the end of
2006. What they found was that a firm's leverage ratio—the amount of equity
capital it held relative to its assets—was a fairly good predictor of which
banks ended up sailing into the rocks in 2008. Banks with more capital tended to
be sturdier.
But the definition of what constitutes capital was also critical, and here
simpler is also better. Basel's "Tier 1" regulatory capital ratio was thought to
be more precise because it assigned "risk weights" to each category of assets
and required banks to perform millions of complex calculations. Yet it was
hardly of any use in predicting disasters at too-big-to-fail banks.
We've argued that Basel II relied far too much on the judgments of
government-anointed credit-rating agencies, plus a catastrophic bias in favor of
mortgages as "safe." Instead of learning from that mistake, the gnomes have
written into the new Basel III rules a dangerous bias in favor of sovereign
debt. The growing complexity of the rules leaves more room for banks to pursue
regulatory arbitrage, identifying assets that can be classified as safe, at
least for compliance purposes.
Messrs. Haldane and Madouros also describe the larger problem: a belief among
regulators that models can capture all necessary information and then accurately
predict future risk. This belief is new, and not helpful. As the authors note,
"Many of the dominant figures in 20th century economics—from Keynes to Hayek,
from Simon to Friedman—placed imperfections in information and knowledge
centre-stage. Uncertainty was for them the normal state of decision-making
affairs."
A deadly flaw in financial regulation is the assumption that a few years or
even a few decades of market data can allow models to accurately predict
worst-case scenarios. The authors suggest that hundreds or even a thousand years
of data might be needed before we could trust the Basel machinery.
Despite its failures, that machinery becomes larger and larger. As Messrs.
Haldane and Madouros note, "Einstein wrote that: 'The problems that exist in the
world today cannot be solved by the level of thinking that created them.' Yet
the regulatory response to the crisis has largely been based on the level of
thinking that created it. The Tower of Basel, like its near-namesake the Tower
of Babel, continues to rise."
Exploding the myth that regulatory agencies are underfunded, they note that
in both the U.K. and U.S. the number of regulators has for decades risen faster
than the number of people employed in finance.
Complexity grows still faster. The authors report that in the 12 months after
the passage of Dodd-Frank, rule-making that represents a mere 10% of the
expected total will impose more than 2.2 million hours of annual compliance work
on private business. Recent history suggests that if anything this will make
another crisis more likely.
Here's a better idea: Raise genuine capital standards at banks and slash
regulatory budgets in Washington. Abandon the Basel rules on "risk-weighting"
and other fantasies of regulatory omniscience. In financial regulation, as in so
many other areas of life, simpler is better.
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