Monday, September 3, 2012

Complex systems and simple regulation (ls)

As always, the recent Jackson Hole conference has been a source of excellent contributions. I find the speech of Andy Haldane most notably.

Some teasers:

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.

Delivering that would require an about-turn from the regulatory community from the path followed for the better part of the past 50 years. If a once-in-a-lifetime crisis is not able to deliver that change, it is not clear what will. 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.

A tremendously striking result is displayed with the following regression:

Obviously, risk-based capital ratios - even though they are calculated with state-of-the-art risk management models -  have virtually no explanatory power for the probability of bank failure. A simple rule of thumb is clearly superior, namely a combination of the unweighted leverage ratio and GDP growth.