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The Financial System Made Simple

November 15, 2012 at 3:00 AM EST

As perceptively as any economist or regulator, and more thoroughly than most, Andrew Haldane has written the book on the financial crisis and the reforms it has necessitated — except his is not literally a book. It is a compendium of writings and presentations, all in the public domain thanks to the Bank of England, where Haldane is executive director for financial stability and a member of the Financial Policy Committee.

Haldane’s work charts a path from when “macroprudential policy [was] a new ideology and a big idea” — as he said at a Federal Reserve Bank of Chicago conference in May 2009 — to a current bout of revisionism among an increasingly vocal cadre of financial policy experts engaging in what might be called complexity backlash.

Their reaction stems from a deepening understanding of how staggeringly complicated the global financial system and its various institutional and market structures have become, which increases their vulnerability to unforeseen risks. That’s not to mention the thousands of pages of new regulations that further tangle the web, creating what Karen Shaw Petrou, head of  Washington-based consulting firm Federal Financial Analytics, has termed complexity risk.

If the biggest banks can’t be managed or regulated with a great degree of confidence, then the solution may logically lie in simplification — unwinding or rolling back the complexity that has been cited as a root cause of the 2007–’09 meltdown and which continues to vex policymakers.

Proposed simplicity solutions take various forms, including limiting the size of banks, breaking up the systemically important ones or separating commercial and investment banking in the spirit of the U.S. Volcker rule. While the latter, however, began as a simple proposal to reinstate principles of the Glass-Steagall Act of 1933, it required some 30 pages to spell out in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and has generated hundreds more pages of rulemaking detail prior to formal implementation.

Such is modern finance: Complexity is not easily contained. Its theoretical underpinnings were explored by the Bank of England’s Haldane in an April 2009 speech in Amsterdam. He reviewed the state of financial services in the context of complex adaptive systems: “Complex because these networks were a cat’s cradle of interconnections . . . . Adaptive because behavior in these networks was driven by interactions between optimizing, but confused, agents.”

The terminology, though perhaps new to many in Haldane’s audience back then, was grounded in complex systems theory, a multidisciplinary field of inquiry that has been championed by the Santa Fe Institute since the 1980s and has shed light on such areas as epidemiology and network theory, as well as on finance. Haldane contended that the pre-deregulation, compartmentalized financial industry had more “network robustness” — less susceptibility to contagion — than does today’s world of “interbreeded” commercial and investment banks. “That is one reason Glass-Steagall is back on the international policy agenda,” he said. “It may be the wrong or too narrow an answer. But it asks the right question: Can network structure be altered to improve network robustness?”

Flash forward to this year and “The Dog and the Frisbee,” the paper that Haldane co-wrote with Bank of England economist Vasileios Madouros and presented at the Federal Reserve Bank of Kansas City’s economic policy symposium on August 31 in Jackson Hole, Wyoming. The paper compares the feat of a dog catching a Frisbee to financial authorities’ attempts to catch a crisis.

Why did no regulator predict the crisis? “The answer is simple. Or, rather, it is complexity,” states the paper, as it explores how the buildup of decades of regulatory complexity ultimately proved not just “costly and cumbersome, but sub-optimal for crisis control. In financial regulation, less may be more.”

Advocating “a regulatory response grounded in simplicity, not complexity,” Haldane joins Federal Deposit Insurance Corp. director Thomas Hoenig, former Bank of America executive Sallie Krawchek and others in invoking the “S” word. But simplicity can be complicated. Petrou’s prescriptions touch on regulatory capital, liquidity risk, standardized disclosures and more. Genies have to be put back in bottles. “As a general principle, I am skeptical,” says Santa Fe Institute external professor J. Doyne Farmer.

“We will aim to keep our rules as simple as possible,” U.S. Treasury undersecretary for domestic finance Mary Miller affirmed recently, “but recognize that ‘simplicity’ is not always synonymous with ‘smart.’ ” She shot back at Haldane’s paper: “Unfortunately, reality is more complicated.”

Jeffrey Kutler is editor-in-chief of Risk Professional magazine, published by the Global Association of Risk Professionals.

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