On the perils of regulating an infinitely complex financial system. Jon Danielsson. Modelsandrisk.org

On the perils of regulating an infinitely complex financial system

May 17, 2023
The financial system is infinitely complex, so the supervisors can only patrol a small part of it, why it is so hard to regulate finance effectively.

The Silicon Valley Bank, SVB, failed because it invested in government bonds, which lost value as interest rates rose. Predictable and avoidable. So, how come the authorities missed it?

The financial system is the most complex of all human constructs, in fact infinitely complex, and everyone has an incentive to increase that complexity. Furthermore, the system's complexity evolves in reaction to everything happening, so we can term it endogenously infinitely complex.

It is easy to criticise with the benefit of hindsight, and blame the supervisors for the failure of SVB. Perhaps the American regulators being captured by special interests, or the special rules for smaller banks that prevented stress testing SVB for systemic risk. Maybe Donald Trump's deregulation is the cause?

While there is much to that, it is not the whole story. Because the financial system is infinitely complex and resources scarce, the supervisors can only patrol a small portion of it. They have to pick and choose their battles, and it is easy to overlook something crucial. And when lobbying is fierce, as appeared to be the case with SVB, perhaps easier to pick a different battle.

Instead, blame SVB on the modern philosophy of financial regulations. Rather than depending on buffers based on risk measurements or stress testing, emphasise shock absorption.

Buffers or shock absorption in regulating finance
The fallacy of composition in financial regulations

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