A senior Bank of England executive has called for a rethink of the Basel Capital Accord, suggesting instead that regulatory bodies rip up the rule-books and adopt a simpler judgement-based supervisory approach.
In a paper given at an economic policy symposium in Jackson Hole, Wyoming, Andrew Haldane, executive director for financial stability and a member of the Bank's financial policy committee, says that regulatory models have become overly-complex, and unsuitable for modern crisis-control.
He argues that complex rules often have punitively high costs of information collection and processing; rely on "over-fitted" models that yield unreliable predictions; and can induce defensive behaviour by causing people to manage to the rules.
Haldane states that regulatory responses to financial crises, past and present, have been to increase complexity with: "a combination of more risk management, more regulation and more regulators". Meanwhile, detailed rule-writing in the form of legislation has increased dramatically, as has the scale and scope of resources dedicated to regulation.
Haldane states that simple rules such as the leverage ratio and market-based measures of capital outperform more complex risk-weighted models and multiple-indicator measures - such as those applied by the Basel Accord - in their crisis-predictive performance.
He suggests that the Basel framework could take "a more sceptical view of the role and robustness of internal risk models in the regulatory framework...simplified, standardised approaches to measuring credit and market risk, on a broad asset class basis, could be used."
Second, he says the leverage ratio could be placed on an equal footing with capital ratios, an approach taken by the Bank of England's financial policy committee, and market-based indicators of capital adequacy added to regulators' and investors' indicator set.
Third, Haldane calls for a fresh approach to financial supervision, one which is less rules-focussed and more judgment-based. He notes that this approach "will underpin the Bank of England's new supervisory model when it assumes prudential regulatory responsibilities next year".
To be effective, he says that will require more experienced regulators working to a smaller, less detailed rulebook. He adds that greater simplicity and consistency in disclosure practices could also strengthen market discipline.
Haldane concludes that: "Modern finance is complex, perhaps too complex...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."
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