Bashing Bankers, Part 3 - Regulators

In 2009, Andrew Haldane, Executive Director of Financial Stability at the Bank of England, published a paper entitled “Rethinking the Financial Network” which, in my opinion, remains the most coherent interpretation of the current financial crisis. At the risk of over-simplification, Haldane’s argument, as I understand it, is that today’s global financial system, as a whole, is so complex that inevitably it behaves from time to time in ways which are catastrophic and unpredictable. To borrow the familiar metaphor from chaos theory, just as a butterfly flapping its wings on one side of the world can cause a hurricane on the other, so a relatively obscure US sub-prime mortgage problem can eventually escalate into the current crippling global financial and economic crisis, with no obvious solution in sight.

In this series of three Opinion articles I’ve asked the question who is to blame for this crisis and whether we are justified in “bashing bankers”. My answer to date is “sometimes yes, sometimes no”. But Haldane’s interpretation is more subtle: in a sense both no-one and everyone is to blame. It is the whole, complex, massively interconnected system which is at fault, embracing investment banks, commercial banks, other financial institutions, rating agencies, regulators, governments, and yes, us the public too.

This might appear to be a rather bleak assessment. Not only is there no “end to boom and bust” but we may be at the mercy of a system which we can’t understand or control. However, this is only true up to a point. If, instead of trying to micromanage the financial system from the bottom up as it were, which is doomed to failure, we instead apply to it the sort of top down heuristics which have proved successful in understanding other complex systems such as the weather, or epidemics, or ecosystems, then there is hope. And although we may not be able to prevent catastrophes, we may be able to learn how to better predict them and mitigate the damage caused. For example although we have not so far been able to prevent hurricanes, and probably never will, we have at least made significant progress in predicting when and where they will occur and preparing ourselves for their impact.

So what does this mean in terms of financial systems and particularly in terms of how we regulate them? Once again Haldane draws some surprising but very important conclusions. In a very recent paper entitled “The Dog and the Frisbee” (read the paper to find out why!) he argues compellingly that regulatory responses to financial crises, including the current Basel III proposals, always have the effect of increasing complexity, which is precisely the wrong approach. To quote: “Modern finance is complex, perhaps too complex. Regulation of modern finance is complex, almost certainly too complex. 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.”

Haldane is, of course a regulator himself. Let’s hope his “keep it simple” message is not ignored.

Nick Collin, Banking Automation Bulletin, October 2012