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Regulatory complexity and the quest for robust regulation

The ESRB ASC report discusses how excessive regulatory complexity can contribute to systemic risk and possible ways to address the issue. While it does not question the need for or extent of financial regulation, the report considers that the observed degree of complexity in financial regulation may limit its effectiveness in dealing with systemic risk. Some actions to address the current degree of regulatory complexity are presented. In order to address systemic risk optimally, the report concludes that current financial regulation should be made more robust to uncertainty.

ESRB Advisory Scientific Committee report No. 8 / June 2019
4 June 2019
Source: European Systemic Risk Board

Prasanna Gai, University of Auckland
Malcolm Kemp, Nematrian
Antonio Sánchez Serrano, European Systemic Risk Board
Isabel Schnabel, University of Bonn

>  Regulatory complexity and the quest for robust regulation

Executive summary:

Regulatory action in response to the global financial crisis, together with broader developments in finance and society, have materially expanded regulation in the financial sector. While there is a general consensus on the need for regulation, there is much less agreement on whether recent increases in the complexity of regulation are necessary and appropriate. As a result, we are seeing a strong pushback from the financial industry, which is arguing that overly complex regulation has led to financial institutions becoming overburdened, hampering their ability to provide financial services efficiently.

However, neither excessive complexity nor excessive simplicity are likely to be features of a regulatory framework that successfully deals with the challenge of maintaining cost-efficiency and adequate risk-sensitivity in an increasing complex world. Ideally, regulation should be robust enough to accommodate the hard-to-predict evolution of the financial system (including the emergence of new business models and financial innovations) while preserving financial stability at a reasonable cost.

Regulation sets limits on the behaviour of actors in the financial arena in order to prevent socially undesirable outcomes. This inherently entails a certain degree of standardisation and a compliance burden with a large fixed-cost component. As a result, it can limit the diversity of business approaches and hence constrain competition and innovation.

Regulatory complexity stems from supply-side and demand-side factors. Supply-side factors include developments in the financial system and crisis-generated policymaking, which may increase regulatory complexity, including through the institutional architecture underpinning it. Demand-side factors include the self-interest of regulated entities. Financial firms may favour complex frameworks where these are better tailored to their idiosyncrasies or even enable them to maintain a strategic informational advantage over regulators. A financial sector that is subject to excessively complex regulation may entail overburdened regulatory authorities. Regulators and regulated entities may be induced to recruit large numbers of highly specialised staff focused on detailed aspects of compliance, with complex rules and a lack of overall perspective.

Excessively complex regulations contribute to increased systemic risk in several ways. First, complex regulatory frameworks create the illusion of a well-controlled system, while at the same time creating incentives for regulated entities to game the system. Second, such a framework risks missing contingencies that are not well understood, e.g. because of a lack of historical experience. An “over-fitted” regulatory system may not be well equipped to address “unknown unknowns”. Third, when risks materialise, the combination of hard-to-understand interactions between different regulations and a wide array of regulatory tools can make policy responses convoluted and difficult to judge. It can also hamper the accountability of regulators and supervisors. Finally, excessive regulatory complexity can encourage the transfer of risks to institutions outside the regulatory perimeter, creating an environment where systemic risk is amplified more than it would have been if risks had remained within the perimeter.

Conversely, overly simple financial regulations are unlikely to properly address the misaligned incentives, informational asymmetries and externalities underlying the need for regulation. They are also likely to be too blunt to deal appropriately with system-wide risks. A simpler framework for capital requirements might, for example, treat exposures with very different risk characteristics similarly, discouraging firms from entering into the safer ones among them.

While public disclosure of information by regulated firms is not by itself sufficient to address regulatory complexity, a transparent cost-benefit analysis, greater evidence-based design of financial regulation, and evaluations of the effectiveness of regulations are desirable actions by regulators to improve financial regulation and to avoid an increase in systemic risk due to excessive regulatory complexity.

This report argues that, in addition, financial regulation should be robust in the sense of being able to preserve its effectiveness when confronted with hard-to-predict developments and innovations. System robustness refers to the capacity of a system to maintain its core functions in the face of unexpected perturbations or disturbances. Regulatory robustness entails being able to cope with a variety of failure-inducing circumstances and behaviours, while not trying to offer the best-tailored response to each specific phenomenon. It therefore accounts for the interaction between Knightian uncertainty (the situation in which future contingencies or their probabilities are difficult or impossible to determine) and systemic risk. Arguably, the quest for robustness could improve the cost-effectiveness of the regulatory outcome while reducing its complexity.

More broadly, the quest for robustness in financial regulation could be facilitated by adopting the following seven principles in the design and reform of financial regulation:

  1. Adaptability: financial regulation (including the calibration of its key tools) must be able to evolve with the financial system and not become an obstacle to innovation. This includes not creating material barriers to entry or discouraging the emergence of new business models. Regulatory sandboxes and sunset clauses could be effective tools to deal with innovation in a controlled environment and ensure that obsolete rules are removed or revised.
  2. Diversity: the diversity of financial institutions and business practices should be preserved, as this represents a powerful safeguard against systemic instability. By introducing some redundancy, diversity also ensures substitutability, i.e. the ability to find ongoing elements of the system that can replace failed elements and ensure the continuity of core functions. Excessive homogenisation of regulated entities and activities is to be avoided.
  3. Proportionality: the burden of regulation (in terms of compliance and enforcement costs, as well as wider costs such as the induced distortions to competition and innovation and the diversion of activity to less regulated sectors) should be commensurate with the importance of the market imperfection at stake.
  4. Resolvability: regulation should allow unviable entities to exit the system, without endangering systemic stability. Efforts must be intensified in the areas of recovery and resolution of all financial institutions (not just banks), and policies tackling internal structure and complexity must be adopted so as to ease the resolution process.
  5. Systemic perspective: financial regulation should aim to ensure the continuous provision of critical financial services to society. A regulatory system that favours the concentration of activities in a limited number of financial institutions can become more vulnerable owing to its dependence on the survival of these few institutions. A systemic perspective requires a comprehensive understanding of correlations and interlinkages, as well as an understanding of macroeconomic feedback mechanisms.
  6. Information availability: regulatory information should allow for prompt identification of contagion channels and pockets of vulnerability. Timely information enables policies to be implemented that react effectively to new developments, either by recalibrating or activating existing regulatory tools or by activating crisis management tools.
  7. Non-regulatory discipline: the presence of regulatory discipline should not entail the removal of non-regulatory discipline. On the contrary, the discipline that derives from market players, effective governance structures and the prevalence of high ethical and personal responsibility standards in the management of financial institutions is complementary to financial regulation and may reduce its need to rely on complex rules.

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