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

April 12, 2021

The almost infinite complexity of the financial system is the main reason why it is so hard to keep it under control. And that complexity is due to everybody that works in the financial system having incentives to increase its complexity, including the regulators.

The financial system is the most complex of all human constructs. Not only is it infinitely complex for all practical purposes, but 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.

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

Start with the private sector. Complexity is at the root of the secret sauce that allows the smartest market participants 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.

That is easy, but what about the regulators?

Take the people working for a macro prudential regulator, someone tasked with financial stability. 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.

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

What is needed is better risk culture in regulatory agencies, the topic of my next piece.