RegulationJun 5 2014

The rhyme of history

twitter-iconfacebook-iconlinkedin-iconmail-iconprint-icon
Search supported by

Macro-prudential regulation and financial stability are the new buzzwords among policymakers. And thanks to Frank-Dodd, Basel III, Solvency II and their extended family, a million pages of new prescription to make the world safer is the lasting legacy of the recent financial crisis.

It is an achievement as impressive in outpouring of ink as it is self-defeating in purpose. Yet again, we have failed to learn the lessons of history. Indeed, we have made the financial system even more fragile for the years ahead.

Change

Financial crises are not new phenomena. They have been around for centuries and have occurred with an alarming frequency – once a decade on average for the past 400 years in Western Europe alone. Coincidentally, changes in banking regulations have maintained an impressive correlation in their shorter lifespan, occurring about once a decade for the past two centuries – a Sisyphean tragi-comedy where the solution to the last crisis seems inevitably to blinker us to the next.

This perennial pattern is born of a fundamental facet of being human – our primal fear of uncertainty. Rules are written by people. And the human psyche is defined by a continual battle to reclaim islands of certainty from the turbulent oceans of uncertainty that we inhabit.

When it comes to regulation, two innate psychological biases dominate. First, there is hindsight, namely, the perfect clarity of knowing the facts after they occurred. This allows us to project a false sense of control by engendering the false belief that the crisis could somehow have been anticipated. Second, there is our extreme brevity of financial memory, which instinctively pushes awkward questions just beyond our temporal horizon.

The result is that we do not learn from the last crisis, preferring instead to find external scapegoats. The introspection needed is sorely lacking. The tools of speculation – stocks, derivatives, mortgages and so on – are scrutinised, demonised and finally rehabilitated through regulation. But the all-too-human wielders and the incentives that drove them are never mentioned.

The current crop of financial regulation has tried to make banks safer, through the ringfencing of domestic retail banking, increased capital requirements, enhanced deposit insurance and so on. At the same time, we have also aggregated many financial institutions into larger entities, many of them ‘too big to fail’.

Combined, these increase the aggregate complexity of regulation. To regulate effectively now requires more metrics, more information, more oversight and more people.

A single regulator is no longer enough. Many financial institutions now span multiple jurisdictions. HSBC and Citigroup, for example, will be overseen by over 150 different regulators globally. This presents major problems of international co-ordination. People talk hopefully of cross-border agreements and international initiatives, such as the Financial Stability Board. But in practice, these are doomed to founder on the rocks of human behaviour.

Regulation does not live in a vacuum. Like every sphere of human life, it is impacted by the conflicting socio-economic and political pressures around us. Recovery today is a political imperative, birthing an ongoing clash between political and macro-economic objectives. Thus, for example, banks are under pressure to deleverage while also to lend more to key political sensitivities such as housing and SMEs. The consequence is dissenting national priorities and an enhanced ability for mistakes to slip between the international cracks.

Additionally, the conflicting rules create perverse incentives. Rationality is replaced by process. The complex capital requirements refocus the efforts of financial institutions not on managing their risks prudently but rather on arbitraging regulation – the same mistake that led to the last crisis.

Innovation is channelled down paths that seek to maximise return on capital, creating new exotic products that sidestep today’s regulation and become the harbingers of tomorrow’s crisis. The army of new people hired alongside – risk, compliance, structurers, consultants and so on – represent increased costs with limited tangible benefits. These pass along the economic chain to businesses, consumers and investors, presenting further impediments to growth.

Simplicity

Regulators also risk creating a rod for their own backs. The volume of information flowing in now is enormous but will not make the world safer by sheer weight. It still needs to be analysed, assimilated and distilled to identify key risks and trends. The danger is that regulators miss seeing the wood for the trees. The clear failure of regulation in the last crisis, for example, was not that they lacked information but rather that they went into bank after bank and failed to ask the obvious question. If everyone was using the same models, might they not de facto all end up taking the same risks and lead to contagion?

We live in a complex world that is continually evolving. This is a natural consequence of our changing human interactions, which respond dynamically to the incentives in our environment and the influences of our peers – both good and bad. In aggregate, the resulting flows of money, trust and sentiment become hard to predict.

The key lesson of history is that we cannot fight complexity with complexity. Regulators cannot hope to understand all the intricacies. The long-term management of an economy sits in an uneasy alliance with their human frailties.

That is not to say we cannot regulate. We need only to understand the essential characteristics, not every last bit of information.

An economy is a dense network of interacting bodies, from small individual investors to large multinational institutions, all bound by a complex web of money and debt. The players have varying levels of influence that can become destabilising at times. Particularly, if they are too large, any failure can ripple outwards, spreading financial contagion.

It becomes vital, therefore, to ensure that no institution is too big to fail. Citigroup and HSBC will one day run into financial trouble. Probability and evolution tell us that. Therefore, we can either keep trying to postpone the inevitable or we can remove the anomaly by shrinking or breaking them up.

Failure must be an option at all levels. Economies re-establish new connections when old ones vanish. We already accept the failure of individuals and firms, with bankruptcy codes to minimise societal disruption. Why not the same for financial institutions?

Regulation should also aim for simplicity and transparency. In today’s world, information grows exponentially over time and choosing to aggregate only pulls us back into the cognitive trap of substituting process for critical reasoning. Rather, crude simple metrics such as leverage ratios are more immune to the vagaries of interpretation and capture what matters, namely, the systemic impact of failure. Alongside, transparency means more disclosure to the market, the best aggregator of information, allowing a clearer delineation of who is likely to honour their obligations.

These ideas may not be the perfect ribbon-tied solution we hope for perennially. But they capture a fundamental truth that regulation needs to understand: we live in a complex world, but our brain is only three pounds. Else, we condemn ourselves to repeating the cycle of night and day – crisis and regulation – once again.

Bob Swarup is author of Money Mania: Booms, Panics and Busts from Ancient Rome to the Great Meltdown

Key points

Financial crises have been around for centuries and have occurred with an alarming frequency

When it comes to regulation, two innate psychological biases dominate: hindsight and our extreme brevity of financial memory

Regulation should aim for simplicity and transparency