Taking Uncertainty Seriously: Simplicity versus Complexity in Financial Regulation

26 Pages Posted: 3 May 2014

See all articles by David Aikman

David Aikman

Bank of England - Monetary Assessment and Strategy Division

Mirta Galesic

Santa Fe Institute; Max Planck Society for the Advancement of the Sciences - Max Planck Institute for Human Development

Gerd Gigerenzer

Max Planck Society for the Advancement of the Sciences - Max Planck Institute for Human Development

Sujit Kapadia

European Central Bank (ECB); Bank of England

Konstantinos V. Katsikopoulos

Max Planck Society for the Advancement of the Sciences - Max Planck Institute for Human Development

Amit Kothiyal

Erasmus University Rotterdam (EUR); Tinbergen Institute

Emma Murphy

Bank of England - Financial Stability Assessment Division

Tobias Neumann

Date Written: May 2, 2014

Abstract

Distinguishing between risk and uncertainty, this paper draws on the psychological literature on heuristics to consider whether and when simpler approaches may outperform more complex methods for modelling and regulating the financial system. We find that: (i) simple methods can sometimes dominate more complex modelling approaches for calculating banks’ capital requirements, especially if limited data are available for estimating models or the underlying risks are characterised by fat-tailed distributions; (ii) simple indicators often outperformed more complex metrics in predicting individual bank failure during the global financial crisis; and (iii) when combining information from different indicators to predict bank failure, ‘fast-and-frugal’ decision trees can perform comparably to standard, but more information-intensive, regression techniques, while being simpler and easier to communicate.

Suggested Citation

Aikman, David and Galesic, Mirta and Gigerenzer, Gerd and Kapadia, Sujit and Katsikopoulos, Konstantinos V. and Kothiyal, Amit and Murphy, Emma and Neumann, Tobias, Taking Uncertainty Seriously: Simplicity versus Complexity in Financial Regulation (May 2, 2014). Bank of England Financial Stability Paper No. 28. Available at SSRN: https://ssrn.com/abstract=2432137 or http://dx.doi.org/10.2139/ssrn.2432137

David Aikman

Bank of England - Monetary Assessment and Strategy Division ( email )

Threadneedle Street
London EC2R 8AH
United Kingdom

Mirta Galesic

Santa Fe Institute ( email )

1399 Hyde Park Road
Santa Fe, NM 87501
United States

HOME PAGE: http://www.santafe.edu

Max Planck Society for the Advancement of the Sciences - Max Planck Institute for Human Development ( email )

Lentzeallee 94
D-14195 Berlin
Germany

Gerd Gigerenzer

Max Planck Society for the Advancement of the Sciences - Max Planck Institute for Human Development ( email )

Lentzeallee 94
D-14195 Berlin
Germany

Sujit Kapadia (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom
020-7601-5507 (Phone)

Konstantinos V. Katsikopoulos

Max Planck Society for the Advancement of the Sciences - Max Planck Institute for Human Development ( email )

Lentzeallee 94
D-14195 Berlin
Germany
+49-(0)30-82406-354 (Phone)

HOME PAGE: http://ntfm.mpib-berlin.mpg.de/mpib/FMPro?-db=MPIB_Mitarbeiter.FP5&-lay=L1&-format=MPIB_Mit.htm&-op=

Amit Kothiyal

Erasmus University Rotterdam (EUR) ( email )

Burgemeester Oudlaan 50
3000 DR Rotterdam, Zuid-Holland 3062PA
Netherlands

Tinbergen Institute

Burg. Oudlaan 50
Rotterdam, 3062 PA
Netherlands

Emma Murphy

Bank of England - Financial Stability Assessment Division ( email )

London
United Kingdom

No contact information is available for Tobias Neumann

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