Regulatory Complexity, Uncertainty, and Systemic Risk

Abstract

This paper explores the relationship between regulatory complexity and systemic risk. Building upon the distinction between measurable risk and uncertainty, it outlines the fundamentals of the main regulatory frameworks of the last two decades (with a focus on the Basel Accords). The resulting outcome in terms of excessively regulatory complexity might turn out to be costly, and sub-optimal for crisis prevention. Since modern finance is characterized by uncertainty (rather than risk), less complex rules could be given greater consideration. Rebalancing regulation towards simplicity may produce Pareto-improving solutions, and encourage better decision making by authorities and regulated entities. However, addressing systemic risk in a complex financial system should not entail the replacement of overly complex rules with overly simple or less stringent regulations. The challenge is to define criteria and methods to assess the degree of unnecessary complexity in regulation. To this end, the paper proposes some options affecting the content of the rules, the regulatory policy mix for certain financial sectors, as well as the rulemaking process.

Keywords: economic theory, uncertainty, financial crises, financial regulation

JEL Classification: B20, D81, G01, G28