This paper has argued that financial systems are better characterised by uncertainty than by risk because they are subject to so many unpredictable factors. As such, conventional methods for modeling and regulating financial systems may sometimes have drawbacks. Simple approaches can usefully complement more complex ones and in certain circumstances less can indeed be more. This is borne out to a degree by both simulations of capital requirements against potential losses and the empirical evidence on bank failures during the global financial crisis, with potentially important lessons for the design of financial regulation.

 

It may be contended that simple heuristics and regulatory rules may be vulnerable to gaming, circumvention and arbitrage. While this may be true, it should be emphasised that a simple approach does not necessarily equate to a singular focus on one variable such as leverage — for example, the FFT in Section 5 illustrates how simple combinations of indicators may help to assess bank vulnerability without introducing unnecessary complexity. Moreover, given the private rewards at stake, financial market participants are always likely to seek to game financial regulations, however complex they may be. Such arbitrage may be particularly difficult to identify if the rules are highly complex. By contrast, simpler approaches may facilitate the identification of gaming and thus make it easier to tackle.

 

Under complex rules, significant resources are also likely to be directed towards attempts at gaming and the regulatory response to check compliance. This race towards ever greater complexity may lead to wasteful, socially unproductive activity. It also creates bad incentives, with a variety of actors profiting from complexity at the expense of the deployment of economic resources for more productive activity. These developments may at least partially have contributed to the seeming decline in the economic efficiency of the financial system in developed countries, with the societal costs of running it growing over the past thirty years, arguably without any clear improvement in its ability to serve its productive functions in particular in relation to the successful allocation of an economy’s scarce investment capital.

 

Simple approaches are also likely to have wider benefits by being easier to understand and communicate to key stakeholders. Greater clarity may contribute to superior decision making. For example, if senior management and investors have a better understanding of the risks that financial institutions face, internal governance and market discipline may both improve. Simple rules are not a panacea, especially in the face of regulatory arbitrage and an ever-changing financial system. But in a world characterised by Knightian uncertainty, tilting the balance away from ever greater complexity and towards simplicity may lead to better outcomes for society.

 

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