Everybody working in the financial system has an incentive to increase its complexity, including the regulators

The financial system is perhaps the most complex of all human constructs. Not only is it infinitely complex for all practical purposes, it is also endogenously infinitely complex — it continually increases its own complexity.

And herein lies a problem. That very complexity is the reason why it is so hard to keep it under control. What frustrates the good mission of the financial authorities.

So why then are the financial authorities so blasé about complexity? As far as I can tell, no central bank or macro prudential regulator is doing anything about complexity. If I am wrong, please drop me a line.

I did get some counterarguments. The various authorities are pushing all the simplification agenda, best not to call it deregulation, even though that is what it is. However, I am not discussing the complexity of regulation, but the complexity of the financial system. These are, of course, not unrelated, but they are not the same.

Perhaps the reason is that everybody that works in the system has an incentive to increase the complexity.

Start with the private sector. Complexity is at the root of the secret sauce that allows the smartest to make money. They like and profit from complexity. And, even though half of them are below average ability, they all seem to think they are the smartest.

Besides that, the primary benefit of regulation to regulated firms is as a barrier to entry, why they so often support increased regulation.

That is easy, but what about the regulators? Do they have any incentives to decrease complexity? I don't think so.

Their job, livelihood and career prospects depend on an unruly financial system that has to be kept under control. The more complex and dangerous the financial system is, the more important their job is. If one just looks at the individual regulator's basic private incentives, they are all for increased complexity. A primary incentive for financial regulators is to be seen making rules, since, if they are not, they are accused of being “asleep at the wheel”.

So if we want to counteract that rather perverse incentive structure, their direct employer, and by extension, the government, need to give them the opposite incentives — reduce complexity. And they do not, as far as I know.

What is needed is better risk culture in regulatory agencies.