Andy Haldane, the Executive Director of Financial Stability at the Bank of England, is possibly one of the most knowledgeable top regulators around. Not only knowledgeable actually. Also modest. What I like in him is that he knows what he doesn’t know. He is the representative of common sense among regulators; it’s almost a pleasure to listen to him. To me, the contrast is sharp between Haldane and Lord Adair Turner, who should probably learn a thing or two from him.
In another (long) remarkable speech given at the Kansas City Fed on 31 August (sorry, I’m only catching up with that now) called ‘The dog and the frisbee‘, he demonstrates again his immense knowledge and modesty. He argues that, often, simple and straightforward rules are much more effective than complex and adaptive rules. Of course, what he targets here is the increasingly large Basel regulatory framework and the risk-weighted assets-based regulatory capital ratios. He many times cites research highlighting how unweighted measures performed better in spotting institutions at risk of collapse.
He based his opinion on his economic beliefs. He and I both disagree with the rational expectations hypothesis, which underlines most modern mainstream economic and finance theory. Financial theory is dominated by the ‘modern portfolio theory’, from which is derived some of the most basic financial tools (Capital Asset Pricing Model for example). I’ll get back to this in another post but the assumptions underlying CAPM/cost of capital and modern portfolio theory in general are highly unrealistic. Yet, few practitioners seem to care. Mathematics has taken over as the only way to describe the world and invest. It looks scientific. So it looks good and must be real.
A crucial point he mentions is that economic agents’ knowledge is limited and imperfect, and that the marginal cost of gathering further data may well outweigh the marginal benefit we get from this supplementary data. Even if all possible information could be gathered, cognitive abilities are limited and we may not be able to accurately process it. Finally, even if we could process it, data changes all the time and our conclusion could already be invalidated when released. This reminds me of some of the arguments developed by Mises and Hayek in the economic calculation problem in a socialist society. Indeed, central regulation of the banking sector effectively equates to partial central planning of the economic system.
Haldane also describes how modern risk-management models have to deal with several million parameters in order to assess various banking and trading risks and accordingly apply risk-weights to calculate regulatory capital ratios. The problem, he says, is that the pre-crisis way of thinking (both from a regulatory and an economic points of view) hasn’t changed: mathematical models have failed so what is needed is even more complex mathematics…
I don’t agree with everything Haldane says though. I don’t see the need to tax complexity or the even simple need for a regulatory leverage ratio for example. Moreover, Haldane himself admitted that both during the Great Depression and during the Great Recession, “the market was leading where regulators had feared to tread”, as banks took corrective measures to reassure investors. So if markets take the necessary measure by themselves and regulators can’t spot crises, why even have them in the first place?
Here are a few selected quotes:
- “No regulator had the foresight to predict the financial crisis, although some have since exhibited supernatural powers of hindsight.”
- “For what this paper explores is why the type of complex regulation developed over recent decades might not just be costly and cumbersome but sub-optimal for crisis control. In financial regulation, less may be more.”
- “Take decision-making in a complex environment. With risk and rational expectations, the optimal response to complexity is typically a fully state-contingent rule. Under risk, policy should respond to every raindrop; it is fine-tuned. Under uncertainty, that logic is reversed. Complex environments often instead call for simple decision rules. That is because these rules are more robust to ignorance. Under uncertainty, policy may only respond to every thunderstorm; it is coarse-tuned.”
- “The general message here is that the more complex the environment, the greater the perils of complex control. The optimal response to a complex environment is often not a fully state-contingent rule. Rather, it is to simplify and streamline.”
- “Strategies that simplify, or perhaps even ignore, statistical weights may be preferable. The simplest imaginable such scheme would be equal-weighting or “tallying”. In complex environments, tallying strategies have been found to be superior to risk-weighted alternatives. “
- “Complex rules may cause people to manage to the rules, for fear of falling foul of them. They may induce people to act defensively, focussing on the small print at the expense of the bigger picture.”
- “Of course, simple rules are not costless. They place a heavy reliance on the judgement of the decision-maker, on picking appropriate heuristics. Here, a key ingredient is the decision-maker’s level of experience, since heuristics are learned behaviours honed by experience.”
- “As of July this year, two years after the enactment of Dodd-Frank, a third of the required rules had been finalised. Those completed have added a further 8,843 pages to the rulebook. At this rate, once completed Dodd-Frank could comprise 30,000 pages of rulemaking. That is roughly a thousand times larger than its closest legislative cousin, Glass-Steagall. Dodd-Frank makes Glass-Steagall look like throat-clearing. The situation in Europe, while different in detail, is similar in substance. Since the crisis, more than a dozen European regulatory directives or regulations have been initiated, or reviewed, covering capital requirements, crisis management, deposit guarantees, short-selling, market abuse, investment funds, alternative investments, venture capital, OTC derivatives, markets in financial instruments, insurance, auditing and credit ratings.These are at various stages of completion. So far, they cover over 2000 pages. That total is set to increase dramatically as primary legislation is translated into detailed rule-writing. For example, were that rule-making to occur on a US scale, Europe’s regulatory blanket would cover over 60,000 pages. It would make Dodd-Frank look like a warm-up Act.”
- “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.”
The two following quotes highlight how wrong are those who blame the crisis on ‘deregulation’:
- “Today, regulatory reporting is on an altogether different scale. Since 1978, the Federal Reserve has required quarterly reporting by bank holding companies. In 1986, this covered 547 columns in Excel, by 1999, 1,208 columns. By 2011, it had reached 2,271 columns. Fortunately, over this period the column capacity of Excel had expanded sufficiently to capture the increase.”
- “As numbers of regulators have risen, so too have regulatory reporting requirements. In the UK, regulatory reporting was introduced in 1974. Returns could have around 150 entries. […] Today, UK banks are required to fill in more than 7,500 separate cells of data – a fifty-fold rise. Forthcoming European legislation will cause a further multiplication. Banks across Europe could in future be required to fill in 30-50,000 data cells spread across 60 different regulatory forms.”
Photograph: The Times/Chris Harris
The answer is no. (but not according to this FT article)
Wait… Actually, it already has tools: it’s called monetary policy. Place the interest rate at the right level and stop massively injecting cash in the economy and, perhaps, you won’t witness real estate bubbles?
There are other hugely distorting UK government policies at the moment: the Funding-for-Lending scheme and the more recent Help-to-Buy, which both push demand for property up through artificially low interest rates. I’ll explain that in details in another post.
So the question becomes: why adding other distorting tools (whether ‘macroprudential‘ or ‘microprudential‘) and policies, such as maximum loan-to-value or loan-to-income ratios, on top of already deficient tools and policies? I have another suggestion: why not trying to correct the failings of the first layer of policies? Just saying.
PS: Lord Turner is obviously mentioned in this FT article.
I like Baron Adair Turner of Ecchinswell (Lord Turner for short). Every time he speaks about the financial system, I can hear enough misconceptions and misunderstandings to give me enough material to write several posts. By the way, he used to be Chairman of the UK’s Financial Services Authority, the former UK financial regulator, between end-2008 and early 2013. I have attended a couple of his conferences in the past.
Lord Turner has a particular quality: he is quite good at figuring out the symptoms of a crisis, but always seems to mistake those symptoms for the underlying disease. As a result, he comes up with misguided remedies that are usually very interventionist and with the potential to make things worse. So you’ll probably hear of him relatively often on this blog.
A couple of weeks ago, he published an article called…”The Failure of Free-Market Finance”… As you can guess, I couldn’t miss the opportunity to review it. Well… I was disappointed. Not because he doesn’t make any mistake, but simply because he does not seem to actually justify the title of his article.
Overall, he is right than an excess of debt is partly a reason for the crisis, and that current mainstream economic theory does not factor in leverage (or not enough) and wrongly considers a low and stable inflation as enough/necessary to ensure economic and financial stability. But he never explains how this debt level builds up over time (to be fair, he does explain it in other articles and presentations, but once again, without ever digging enough in order to reach the root cause. Probably more on this later).
I find it quite ironic that someone who promotes a strong state control of the financial sector, like Turner, quotes Friedrich Hayek. My guess is that he needs to reread Hayek. As Hayek never mentioned over-investments as the cause of the economic cycle, but malinvestments (roughly, investments wrongly directed towards less than profitable-enough activities) (although over-investments could arguably be linked to the theory). And Hayek would certainly never have promoted state control, which he saw as the root cause of crises.
Photograph: Alastair Grant/AP