Complexity of Regulation Limits its Effectiveness

(Appeared in Business Day on 28 October 2015) The American economist Robert L. Heilbronner, in his marvellous book “The Worldly Philosophers”, notes on the rise of socialism in the late 19th century that “capitalism has become so complex that it needed direction, but capitalists insisted on a ruinous freedom”. By regulating every aspect of economic life, including the prices of basic food, fuel, clothing, and many other products, socialism tried to provide such direction–and failed miserably. Seeing the disastrous failure of socialism everywhere and anywhere it has been tried, one cannot help but wonder just how much direction capitalism needs in order to remain manageable and ultimately yield an inclusive, fair, and equitable society.

This is the formidable challenge regulators and policy makers face nowadays. Luckily, academia can provide some input. In a stream of recent papers, economists study various aspects of complexity in financial markets.

First, and foremost, a better understanding of the term complexity is needed. What is complexity and what does it mean that capitalism has become complex? The American economist and complexity scientist W. Brian Arthur defines complexity as “the study of the consequences of interactions”. The key insight from the word study is that complexity is related to our understanding of the consequences of interactions, for example the interactions among workers competing for a scarce job, or the interactions among firms in selling a product. These interactions can be manifold and their consequences are not always straightforward. If we want to understand them, we need a certain set of cognitive skills and, in many cases, computing power.

Thus, when Heilbronner writes that capitalism has become complex, he describes a situation in which nobody has the cognitive skills or computing power required to perfectly understand the economy, including all the intricacies of markets and the production process. As Princeton economist Markus Brunnermeier, and Martin Oehmke from Columbia University point out, complexity is another word for bounded rationality, where bounded rationality describes individuals who act on insufficient information or with a cognitive bias.

Unfortunately, there are many situations in which customers have insufficient information or are biased. Buying a financial product, for example, is one such situation. When the proverbial man on the street buys a financial product, he is typically concerned with three things: how much bang he will get for his buck, how long it will take him to get this bang, and what the risk is of not getting it at all. But what if the risks were obscured in a mountain of legal Mumbo Jumbo? What if a financial product was so complex that not even a university degree in finance and law would be sufficient to fully understand it?

It turns out that banks, particularly banks in the United States, love such products. Boris Vallee from Harvard Business School and Claire Celerier from the University of Zurich study the complexity of financial retail products in an innovative new working paper. Using text analysis of the actual product description, they show that indeed the complexity of financial products has increased over the past couple of years. But not only that. They also show that this increase in complexity is more prevalent at banks with a less sophisticated investor base. Overall, their finding is consistent with banks using complexity as a way to alleviate competitive pressure. Clearly, such a behaviour is detrimental to investors. But investors are boundedly rational, they do not have the resources to fully read or understand a highly complex financial product.

From an economic perspective the banks’ behaviour constitutes an externality: consumers bear the costs of reduced competition but will not receive the best possible product.

A similar externality lay at the heart of the financial crisis of 2007/2008. Former Goldman Sachs trader Fabrice Tourre was found guilty by a Manhattan Federal District Court of defrauding investors in a scheme involving some of these highly complex financial products. He became infamous due to an email in which he wrote he would sell mortgage backed securities, a particularly complex type of financial product, to “widows and orphans”.

Externalities need to be regulated. So, as a natural reaction to the crisis, regulators have reacted in the only way they know how: by enacting more regulation. Most of these new regulations help to make the financial system more stable and resilient. But the new regulation in itself is rather complex.

In a widely acclaimed article titled “The Dog and the Frisbee”, the Bank of England’s Chief Economist Andy Haldane explores “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”. Haldane points out that the sheer amount of of new regulation is mind-boggling. The first global bank regulation standard in 1988, called the Basel I accord, after the city where it was agreed upon, had about 30 pages of regulation. The successor agreement Basel II, agreed upon in 2004, already had 347 pages of regulation. The new and revised Basel III accord, which was enacted as a reaction to the financial crisis, comes in at 616 pages already.

And this complexity of the international agreements is dwarfed by the complexity of their national implementations. Conservative estimates put the national implementations of Basel III, including the Dodd-Frank Act in the United States, at tens of thousands of pages of new regulation.

From a complexity perspective, this is madness.

Banks, and in particular large international banks, can hire the army of lawyers necessary to survive in a business environment where the player with the most expertise at interpreting–and circumventing–existing regulation has a competitive edge. But think about smaller banks in emerging countries. They will clearly be at a disadvantage. It is no wonder that colleagues who were part of the Basel III negotiations later report that the new agreement was reached to no small part due to pressure from the United States. Their banks will fare particularly well in such a complex regulatory environment.

And it is not only financial regulation. What could be called “regulatory exuberance” can be found in every aspect of the economy, from environmental law to consumer protection and antitrust law. This is not to say that regulation does not serve a purpose or that every piece of regulation adds unnecessary complexity. But often more regulation means more complexity. The problem with regulatory exuberance is that it does not make regulation more effective. If anything, the opposite is the case.

In his book “The Great Degeneration: How Institutions Decay and Economies Die”, the conservative Harvard historian Niall Ferguson argues that excessively complex regulation is one of the main impediments to economic growth and one of the contributing factors of the decay of Western institutions. The lesson South Africa can learn is that we should place less emphasis on the amount of regulation and more emphasis on its effectiveness. It should be a goal of every government to reduce the amount of regulation inherited from previous governments by 10%.

Sometimes less is more. But almost always simpler is better.

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