An excellent argument for reducing Basel capital rules from a Bank of England paper

In an excellent new paper, Andrew G Haldane and Vasileios Madouros, two senior Bank of England officials, make the case that less is more in financial regulation, and that the Basel capital rules have become too complex to be effective. In its conclusion, the paper argues that the Basel rules should be reduced substantially in complexity. A call to change the foundations of Basel from outside the regulatory community would be seen as irrelevant, but this argument comes from inside one of the world’s most important financial regulators. The paper was presented last Friday at the Federal Reserve Bank of Kansas City’s Jackson Hole conference.

The authors’ theoretical arguments for less is more are simple:

1) Too much information can’t be effectively processed

2) Less information may lead to better decision making

3) Taking weighted probabilities in complex environments may be suboptimal

4) Financial markets and especially crisis don’t fit into models well

5) Rules make people react defensively in order to not get into trouble, but also lead to poor decision making when faced with complex events

As the paper notes, “These are “Five Commandments” of decision-making under uncertainty. That description is apt. Like disease detection, frisbee catching, sports prediction and stock-picking, living a moral life is a complex task. The Ten Commandments are heuristics to help guide people through that moral maze, the ultimate simple rules. They have proven remarkably robust through the millennia. Less has been more.”

Applying this theory to the Basel capital rules, the authors conclude that the following policy requirements are necessary:

1) De-layering the Basel structure – “This would be a turning back of the clock, restoring the regulatory framework as a backstop to commercial risk management.”

2) Placing leverage on a stronger regulatory footing – right now, capital is more important than leverage in the Basel framework. This should be reversed.

3) Strengthening supervisory discretion and market discipline – focus on the big risks with more data available “On Call.” Further, “one of the secrets to making this new supervisory approach a success will be the accumulated experience of supervisory staff.” This might be a tough assignment in some parts of the world.

4) Regulating complexity explicitly – Basel subsidized complexity. Instead, banks are too big to be risk-managed, so the better approach is to tax complexity.

5) Structurally re-configuring the financial system – “Quantity-based regulatory solutions have gained currency during the course of the crisis. In the US, the
Volcker rule is a quantity-based regulatory commandment: ‘Thou shalt not engage in proprietary trading’. In the UK, the Independent (“Vickers”) Commission on Banking has also proposed structural, quantity-based reforms: ‘Thou shalt not co-mingle retail deposit-taking and investment banking’.”

While the paper has the UK’s bias of principal-based regulation and that may turn off some readers, we think that this is the best piece of financial regulatory thinking that we have read all year. The case is well laid out in theory and substantiated by real world examples, and we simply agree with the conclusions. SFM readers may not need to read the entire paper but we encourage giving the ideas summarized here a good consideration. Ideally, this would be the structure of financial regulations going forward.

The full paper, The Dog and the Frisbee, can be found here.

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