What can the history and philosophy of science teach us about regulatory reform? In this post, we borrow Thomas Kuhn’s idea of ‘scientific revolutions’ to argue that radical overhauls of regulation often occur after crises but that, once major reforms have been completed, it’s normal to have periods when rules do not change so much. For instance, major reforms made to banking regulations after the Global Financial Crisis of 2007–08 are now coming to an end with future change likely to be more incremental. This post is about why different circumstances call for these different approaches to regulatory change.
Shortcomings of the Basel capital framework became apparent in the 2007-8 crisis. One muchreviewed and debated issue is that capital ratios can be increased by changes to methods and models for calculating RWA (M&M changes hereinafter) rather than by changes to balance sheets. How have UK banks fared in this respect?
For some years, financial regulations have been becoming more complex. This has led some prominent commentators, regulators and regulatory bodies, to set out the case for simplicity, including Adrian Blundell–Wignall, Andy Haldane, Basel Committee and Dan Tarullo. In his contribution, Haldane illustrates how simple rules can achieve complex tasks: by simply adjusting its speed to keep its angle of gaze fixed, a dog can manage the complex task of catching a Frisbee. In this post, however, we argue that some financial risks are hard to catch with simple rules – they are more like a boomerang’s flight path than that of a Frisbee. Complex rules can sometimes do a better job at catching risk; and simple rules can be less prudent.
Two of the country’s largest banks collapse. The subsequent panic brings the banking system to its knees and only a costly government bail-out prevents even greater catastrophe. A radical re-think of regulation is needed. No, it’s not London or New York in 2008. It is Berlin in the 1930s. It’s when risk-weighted capital regulation was born, notably to be used alongside a range of other tools; for example, liquidity requirements and such modern ideas as bonus deferrals and capital conservation. But the idea that no single regulatory measure is likely to be sufficient on its own was forgotten. In 2008 it had to be painfully re-learned making this episode a striking example of the importance of studying past financial crises.