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The complexity of the simplicity solution

by Robert Teitelman | Published May 29, 2012 at 11:33 AM

In Tuesday's New York Times, Joe Nocera follows up on some recent commentary from former Bank of America Merrill Lynch executive Sallie Krawcheck about the dangers of financial complexity. Nocera confesses that two years in, he's still "not sure what to think about the darn thing" -- that darn thing being the ever-loving Dodd-Frank. Well, that's not too surprising, since an omnibus reform bill like Dodd-Frank can only be judged in the long run, when it actually does something, or more confusingly, deters bad things from happening. Besides, Dodd-Frank may have passed Congress, but it's still not anywhere near to being fully written (see the Volcker Rule), which alone is a reason to worry. Nocera is exactly right on one score: Dodd-Frank is a nightmarish monument to rule-making complexity, which still lacks the kind of underlying architectural principle that would provide some regulatory backbone -- and political consensus. I would quibble with him a bit about the "appealing simplicity" of Glass-Steagall. That simplicity only shines through in retrospect -- and much of it is nostalgia. For its day, Glass-Steagall was extremely complex -- banks had to be ripped apart and reassembled, and there was no guarantee it would work. And by the time it was repealed -- for good or ill -- it was encrusted like a barnacled freighter with complexities, exceptions, loopholes and inconsistencies. But it did, in retrospect, make an argument about the dangers of mixing commercial and investment banking. The only argument Dodd-Frank makes is that we need more rules.

Nocera agrees with Krawcheck, who after getting pushed out of a cost-cutting BofA has return to the public eye with commentary in the Harvard Business Review (in June, she has a blog at HBR here) and the Financial Times, about the dangers of complexity in finance. It's actually a theme that extends well beyond banking. Not only are the largest financial firms profoundly complex, not to say vast, but globalized markets, with their hopped-up bestiary of often custom-made synthetic instruments, remain well beyond what any CEO or regulator can possibly track. The density of interconnections is not only mind-boggling, but the level of dynamism -- it changes all the time -- and innovation insures that regulators, even if they could build a truly global oversight and tracking mechanism, which they can't, will always be behind, often dramatically so. Hell, regulators long ago traded the monitoring of actual loans for extrapolations using mathematical models; they had no choice. In a 2011 speech, the Bank of England's Andrew Haldane illustrated the growth in bank risk categories from Basel I in the '90s to Basel II a decade or so later: Basel I measured seven different risk buckets, Basel II wrestled with over 200,000. Ouch.

Krawcheck offers some basic ideas for "paring back the complexity risk" in banking. She argues for looking at the bank's overall risk profile; for compensating bank executives based on the bank's risk profile (in terms of debt and equity); paying out dividends as a percentage of earnings; reforming the credit agencies (sigh); and urging boards to worry about booming, not struggling, businesses. (The last advice makes sense, but if we need to remind boards of that, we're really screwed.) All this is very nice, but very broad -- and given, yes, the complexity of banking, it's a little hard to see the kind of effect it would have. In fact, except for her first notion, I'm not sure it would do much to either rein in complexity or too-big-to-fail. The devil here is in the details. How would you calculate the "overall risk profile"? Is this a mark-to-market process, in which daily, weekly or monthly numbers are generated, like the much abused and suspect value-at-risk? How, given the enormous complexity, would these metrics be generated -- and by whom? If J.P. Morgan Chase & Co.'s big ugly trade managed to escape the bank's internal risk management operation -- not to say regulators -- how would that have found its reflection in the bank's overall risk number? It's a rule: It's the stuff we don't know -- or don't want to know -- that tends to kill us. And just remember: We've had a devil of a time just trying to provide guidelines on bank capital. What makes anyone think calculating an overall risk profile would be easier?

Nocera is more upbeat. He thinks Krawcheck's idea for compensation, based on the makeup of that risk profile, would force banks to reduce complexity. Again, I'm not totally convinced. High-paid senior executives are increasingly like shareholders: Given the fact that they've been making serious money (and picking up shares) for years, they have a capacity for risk. It's not like they're worried about paying the mortgage if they lose their job or their pay gets slashed; the upside beckons. Many of them come from trading backgrounds, where a higher levels of debt won't deter them -- particularly in markets that are more euphoric than today. At the very least, you'd need to combine this kind of pay regime with higher capital ratios that would force banks to build more equity and employ less debt and leverage. The danger is that any steps taken to reduce complexity, and thus risk, will also threaten earnings and compensation, which will only create the incentive to go crawling out the risk curve, perhaps in ways that are not obvious to regulators. For those who care to look -- and not enough do -- the downfall of Glass-Steagall came because the banks were losing their shirts to the less regulated entities. Regulations forced them to practice banking in a relatively simple way. Complexity may be risky, but it's also, at times, extremely profitable.

Nocera doesn't go here, but there is one further, and disturbing, outgrowth of overly complex finance: the political. Generally Americans have no idea what really goes on in the banking system, in finance, or indeed, in the economy. It's not all their fault (although given how many souls don't have a clue what the Federal Reserve is or does, is a failure of the educational system). When regulators and politicians aren't sure, when a Robert Rubin or a Jamie Dimon gets surprised, what's an ordinary citizen going to know? A powerful, complex financial system is a threat to a democratic system, not just because it could blow up again, but because it exists beyond the frontiers of rational political discourse. Yes, it creates a powerful lobbying force that may spawn distortions. But far more than that, complexity insures that any discussion in campaigns (see the debate over private equity) or in the punditry tends to default to the cartoonish, the inaccurate and, on whatever side, the foolish. It's one reason, we have increasingly opted to deal with a complex financial system with vast agglomerations of rules like Dodd-Frank that no one -- not me, not Nocera, nor the president -- has any real confidence will operate in a crisis.

There are many reasons for our current daggers-drawn political polarization. One of them is that too many Americans confront a world they cannot begin to understand. A big part of that breakdown traces itself to a global financial system that creates grave anxieties. A big part of that, in turn, is a banking system that, as Nocera rightly says, is simply complex and thus viewed as beyond anyone's control. In the long run, that's a real danger. - Robert Teitelman

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