by Don Alexander, MBA
Associate, RSD Solutions Inc.
Catching a frisbee is difficult. Doing so successfully requires the catcher to weigh a complex array of physical and atmospheric factors, among them wind speed and frisbee rotation. Were a physicist to write down frisbee-catching as an optimal control problem, they would need to understand and apply Newton’s Law of Gravity. Yet despite this complexity, catching a frisbee is remarkably common. Casual empiricism reveals that it is not an activity only undertaken by those with a Doctorate in physics. It is a task that an average dog can master. Indeed some, such as border collies, are better at frisbee-catching than humans (Haldane speech at Jackson Hole 2012).
So what is the secret of the dog’s success? The answer, as in many other areas of complex decision-making, is simple. Or rather, it is to keep it simple. For studies have shown that the frisbee-catching dog follows the simplest of rules of thumb: run at a speed so that the angle of gaze to the frisbee remains roughly constant. Humans follow an identical rule of thumb.
Catching a crisis, like catching a frisbee, is difficult. Doing so requires the regulator to weigh a complex array of financial and psychological factors, among the 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. In complex environments, decision rules based on one, or a few, good reasons can trump sophisticated alternatives. Less may be more.
Yet despite this complexity, efforts to catch the crisis frisbee have continued to escalate. Casual empiricism reveals an ever-growing number of regulators, some with a Doctorate in physics. Ever-larger litters have not, however, obviously improved watchdogs’ frisbee-catching abilities. No regulator had the foresight to predict the financial crisis, although some have since exhibited supernatural powers of hindsight.
So what is the secret of the watchdogs’ failure? The answer is simple. Or rather, it is complexity. Haldane 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.
Modern finance is complex, perhaps too complex. Regulation of modern finance is complex, almost certainly too complex. That configuration spells trouble. Finance has been built on often stringent assumptions about humans’ state of knowledge and cognitive capacity.
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.
Take decision-making in a complex environment. 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 density and complexity of financial regulation has had predictable consequences for the scale and scope of regulatory resources. One metric for that would be the number of human resources devoted to financial regulation, the exponential growth of regulations and the number of regulatory departments.
Of course, the costs of this regulatory edifice would be considered small if they delivered even modest improvements to regulators’ ability to avert future financial crises. The public policy question is – will they? In financial regulation, is more more or is more less?
In forgone output, financial crises can be as costly as wars. The public policy issue, then, is whether the war on crises is best waged with the weapons of the past. 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.
An alternative point of reference when regulating a complex system would be to simplify and streamline the control framework. Based on the evidence here, this might be achieved through a combination of five, mutually-supporting policy measures: de-layering the Basel structure; placing leverage on a stronger regulatory footing; strengthening supervisory discretion and market discipline; regulating complexity explicitly; and structurally re-configuring the financial system.
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.
For more on this follow the link: www.bankofengland.co.uk/publications/Pages/news/2012/075
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