Thursday, April 11, 2013

Bank of England's Andrew Haldane and the campaign to reduce financial regulatory complexity

In case you missed his fabulous speech on Turning the Red Tape Tide, the Bank of England's Andrew Haldane has elevated his campaign to reduce financial regulatory complexity.

Specifically, Mr. Haldane focuses on the pattern of regulation increasing at an exponential rate.
The facts are striking. 
In the UK, the Banking Act (1979) covered 52 sections and 75 pages. By the mid-1980s, the Financial Services Act (1986) and an updated Banking Act (1987) had expanded primary legislation to 110 sections (106 pages) and 212 sections (299 pages) respectively. 
The Financial Services and Markets Act (2000) took this to 433 sections or 321 pages. And the new Financial Services Act (2012) takes this to 695 sections or 534 pages – a tenfold increase in primary legislation in a generation. 
In the US, the picture is no less dramatic. Contrast the legislative responses in the two largest financial crises of the past century – the Great Depression and the Great Recession. The Great Depression spawned the Glass-Steagall Act (1933) – perhaps the single most important piece of financial legislation of the 20th  century. That ran to a mere 37 pages. 
As an aside, I disagree with Mr. Haldane that Glass-Steagall is the single most important piece of financial legislation of the 20th century.  That distinction belongs to the Securities Act (1933) which made the FDR Framework the foundation for our financial system.

It is the Securities Act that introduces the philosophy of disclosure.  This Act makes it the government's responsibility to ensure that market participants have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess this information and make a fully informed decision.
More recently, the Great Recession has spawned the Dodd-Frank Act (2010). It runs to 848 pages or more than 20 Glass-Steagalls. Once completed, Dodd-Frank might run to 30,000 pages of rulemaking.
Clearly, the facts speak for themselves that we have seen a tremendous increase in the number of financial regulations.   We have also seen a tremendous increase in the complexity of the individual regulations.

For example, as Mr. Haldane previously observed, you could calculate the Basel I capital requirements on the back of an envelope.  By the time Basel III capital requirements are done, you will need a powerful computer to handle the millions of assumptions.

What has caused this increase in both amount and complexity of regulation?
In this respect, financial regulation shares many evolutionary characteristics with elements of the legal framework – for example, the tax code. It too has been responsive to events and circumstance including crises, scandals, innovation and liberalisation. And for many of the same reasons, it too has resulted in a rising tide of rulebook complexity....
Viewed through the lens of history, it is not difficult to explain this evolution. As cracks have emerged in the plaster – for example, regulatory and tax loopholes – they have been papered over. Like a bad painter and decorator, new layers have been applied to support the layers below. These were rational responses to real problems. And for a time they will have filled cracks, reduced uncertainties, corrected incentives. 
Yet this evolutionary path leads inexorably towards a framework – whether regulatory or tax – which is a patchwork of make-do-and-mend. History locks in the idiosyncrasies and complexities of the past, generating a steadily rising tide of red tape. As the regulatory and tax codes attest, the resulting frameworks can be Byzantine in their complexity and Heath-Robinson in their design.
In short, regulation is a response to market failure and the complexity of the regulation is a direct result of the market failure that is being fixed.

For the financial system, the market failure the regulations are trying to address is opacity.

For example, regulators are proposing complex rules to limit interbank exposures so as to reduce the risk of financial contagion.

The risk of financial contagion would be reduced if the banks provided ultra transparency and disclosed on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  With this information, banks could assess each of the other banks they do business with and limit the risk of their exposure to these banks based on the riskiness of each bank.

Mr. Haldane then effectively renders complex financial legislation, like the Dodd-Frank Act and its resulting regulations, as much ado about nothing and heading in the wrong direction by simply observing
complex frameworks tend ultimately not to solve the problems for which they were a response. 
They may be ineffective. In filling old cracks, complex rulebooks tend to open up opportunities for new ones to emerge. Indeed, they may increase the likelihood of new loopholes or workarounds emerging. 
Regular readers know that the areas of the financial system that failed in the current financial crisis were those areas where the FDR Framework was not adhered to.

Rather, there was substitution of the combination of complex regulation and regulatory oversight for the combination of transparency and market discipline.  Examples of these opaque areas include banks and structured finance securities.

Since August 9, 2007, it has been obvious that the FDR Framework was not adhered to and that transparency needs to be brought to all the opaque areas of the financial system.

Mr. Haldane offers an explanation for why that hasn't happened yet.
Resistance is strong, particularly among those who gain most from squeezing through the loopholes. 
There is also an in-built professional inertia among regulators [and] lawyers... with large amounts of human capital invested in complexity. 
In removing complexities, society’s gain would be their loss.
He then suggests that there is hope that we will in fact bring transparency to all the opaque areas of the financial system and adhere to the FDR Framework.
Nonetheless, in the light of the financial crisis, we may be nearing an inflection point, where the societal pendulum begins to swing in the opposite direction. There are certainly signs of the red tape tide beginning to turn in the area of financial regulation. A growing chorus of concern has emerged recently about complexities and inconsistencies in banking regulation.... 
For financial regulation, that means asking some big questions [and answering them in light of the banks providing ultra transparency as required under the FDR Framework]. 
Is risk-weighting of bank assets worth the costs? Are bank’s internal risk models more regulatory trouble than they are worth? Does complexity unduly advantage large incumbents over small new entrants? Are armies of supervisors and compliance officers a sign of success or failure?...
When market participants have access to each bank's current global asset, liability and off-balance sheet exposure details, the answer to the questions is easy: No, Yes, No (in fact, market discipline will reward banks that are less complex with a lower funding cost as they are more easily understood), Failure.
This could transform the regulatory framework, for the simpler, for the better.
Requiring banks to provide ultra transparency transforms the regulatory framework for the simpler and better because now the regulators can piggy-back off the analytical and disciplinary capabilities of the markets.

When market participants can independently assess the risk of each bank for themselves, or use third party experts to assess the risk for them, the focus is where it should be: on the risk each bank is taking.

The focus is on risk because under the FDR Framework, market participants know they are responsible for all loses on their exposures and therefore they have an incentive to limit their exposures to what they can afford to lose given the level of risk.

Not only does this end the risk of financial contagion, but market participants can help the regulators identify potential problems by highlight what they see as the risks of each bank.

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