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Too-Big-to-Fail and the Complexity Conundrum

In a world where many argue that banks have become too complex to regulate, advocates for a simplified financial system have a debate on their hands.

There is a narrative describing the predicament of financial regulation that goes something like this: Banks are critical to the economy, and the biggest ones are too important to be allowed to fail under any circumstances. Despite concerns raised and policy actions taken over the past five years, assets are more concentrated than ever in the megainstitutions now officially labeled systemically important. They have grown so big and complex as to call into question not only whether they can be properly supervised by resource-challenged regulators but also whether they can be effectively audited and risk-managed from the inside.

Too much complexity? Then simplify. Break up the banks. Reinstate the historical separation between commercial and investment banking, and realign regulation accordingly.

Such outcomes sound logical and could even occur over time — if, for example, higher capital requirements and statutes like the Volcker rule force banks to focus on fewer, less speculative activities. That was the broad intent of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, whose backers regarded institutional complexity as the problem, or at least a big part of it. That kind of thinking prevailed in the wake of the crisis. Federal Deposit Insurance Corp. vice chairman Thomas Hoenig and Federal Reserve Bank of Dallas president and CEO Richard Fisher, among others in policymaking and academic circles, continue to carry that torch.

But today they face increasingly vocal opposition — and not just from big-bank interests that have reflexively resisted many of the reforms and slowed the regulators’ implementation of Dodd-Frank rules. There is also a counterargument that institutional and systemic complexity is a natural consequence of generations of product innovation and market-structure evolution. Complexity might be manageable or containable, but it cannot be rolled back or legislated away.

Indeed, the Financial Stability Board, the Group of 20’s coordinating body for financial regulation, takes complexity as a given. It, along with size and interconnectedness, defines a systemically important financial institution (SIFI). According to the FSB drumbeat, preventing failures and solving the too-big-to-fail problem entail heightened supervision, cross-border regulatory cooperation and structural responses like the U.S. Volcker rule.

Last October in New York, Intelligence Squared, a debate series broadcast on National Public Radio, presented the proposition that big banks should be broken up. Fisher of the Dallas Fed and Massachusetts Institute of Technology professor Simon Johnson argued in favor. Opposing were former J.P. Morgan & Co. banker Douglas Elliott, now a fellow in economic studies at the Washington-based Brookings Institution, and Paul Saltzman, president of the Clearing House Association of New York.

Elliott and Saltzman won: More people in the audience agreed with them after the debate than before. Their logic rested in part on the necessity of complexity. “We need some very large, complex banks to cost-effectively help our businesses and families deal with a large, complex world,” Elliott declared.

The continuing struggle to complete the Dodd-Frank rulemaking is hardly a ringing endorsement of simplification. The Volcker rule, grounded in simply stated principles to insulate core banking functions from risky trading operations, was finalized in December by five U.S. regulatory agencies with 850 pages of accompanying “preamble”; its effective date is still more than a year away.

The FDIC’s Hoenig concedes that the Volcker rule, Section 619 of the act, is “highly complex” and “could be made simpler.” That’s “because SIFIs are highly complex [and] engage in a broad range of complex trading activities” while also being granted too many exceptions and opportunities to game the rules, Hoenig explained in a December 10 statement of support.

In a 2012 paper that crystallizes the anticomplexity argument, Andy Haldane, executive director for financial stability at the Bank of England, documented how cumulative responses to crises have created “a steadily rising regulatory tower”: more costs, people and complications, for the regulators and regulated alike. And as Hoenig lamented in a December 2013 speech, “It is unfortunate that we choose complicated administration over structural change.”

Breaking the cycle requires addressing finance as the complex system that it is and reengineering regulation rather than building the “tower” ever higher. “Focus on improving the macroprudential regulatory framework, periodically assess its effectiveness, and think about where the next crisis is coming from,” Saltzman advises.

The solution is both simple and complex. The two sides are not that far apart. • •

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