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Rules versus Discretion

2013 Financial Markets Conference

April 2013

An interview with Andrew Haldane, executive director for financial stability, Bank of England

Paula Tkac: Hi, I'm Paula Tkac here at the Financial Markets Conference with Andy Haldane to talk a little bit about rules and discretion in financial regulation. Thank you for coming.

Andrew Haldane: Thank you, Paula. Nice to be here.

Tkac: So, based on your comments today and your now infamous dog and Frisbee speech, I get the sense that your optimal regulatory scheme would be some simple rules with a fair amount of regulatory discretion. Is there any hope of reining it back in? What would it take to get us to a simpler system? Is it going to take political courage? (We heard a little bit about the political interplay with regulation earlier today.) Is it going to take another crisis? Is it possible to get us to your optimal world?

Haldane: I hope so. I've been quite encouraged actually for the course of the last six months or so that the penny maybe be beginning to drop within the regulating community, perhaps in the fiscal community, too. Why do I say that? What we had as recently as a month ago...a communique from the G-20 heads of state which began to talk about these issues. It began to talk about the fact that a complex rule book might be giving rise to inconsistency across banks, across countries that needed to be remedied. And some of the evidence that we're gathering suggests that those inconsistencies are one, very considerable and two, becoming if anything greater over time. It's too early to be declaring victory, that's for sure, it'll be a long haul. The rule books that we've built up have built up over decades, if not centuries, and we won't be able to dismantle them with the click of a finger. But I think, I hope the pendulum's just beginning to swing the other way.

Tkac: So it sounds to me as though at least some people are seeing that there are costs to those inconsistencies—having this wide degree of variability and perhaps conflicting outcomes under what is well-intentioned regulation. How are these inconsistencies and the amount of information that's coming out of various regulatory activities, or just the complexity around them, how is it affecting market participants, in terms of the role of market discipline influencing firms? And what's the role of market discipline in our system now and in the system that you might envision that would be much simpler?

Haldane: Well, I do think market discipline has got a bit of a bad rap actually through the crisis, partly because with the benefit of 20-20 hindsight, some market prices were doing a pretty poor job actually of conveying risks in the system, including the risks that were being carried by some of the world's biggest banks. But this would not be the time to abandon market discipline as one of the three pillars that might try and support our financial system in the future.

I think we need to try and reinforce market discipline, make it somewhat easier for investors to peer into the black box that banks sometimes can be and make sense of the risks that are there. I think there's a big job, too, for the banks themselves to shed some light on the black box that is their balance sheets. We had some very interesting initiatives by the Enhanced Disclosure Task Force, which is a body of market participants last year. Proposals for increasing the transparency around balance sheets in ways that ought to increase investor confidence and ultimately help markets better price risk, so that third pillar, the market discipline pillar, can be resurrected. So I think both banks and investors and regulators have a real job to play in getting market discipline functioning.

Tkac: So my last question has to do with the dynamics of regulations. We read in the paper this morning about how important it is for any sort of internal risk management to sort of consistently update itself and innovate to improve models as the world changes around them. So, in this world of thinking about simple rules versus complex rules and the role of discretion, how do you view sort of that dynamic process?

Haldane: Well, I mean two points: the first one is that the notion of dynamically updating the rule book we have fills me with horror. Dynamically updating what we have, to take account of mistakes, miscalibrations, regulator arbitrage, is an impossible task. This is one of the strongest rationales for streamlining things somewhat. If we are to spot the mistakes, to miscalibrate, to spot the avoidance in arbitrage, that is that much easier if the rule book is somewhat simplified and streamlined. But, let's be clear. Even if we have that streamlined rule book, we would still need to make, inevitably need to make, running repairs to the regulatory framework. This is a great mistake we made with earlier international agreements. We didn't dynamically update, we didn't make running repairs when our obvious defects...

Tkac: So they become stale...

Haldane: They become stale, and the gap gets...and the problems become greater, they're allowed to fester and grow and accumulate. Regulators in the future need to be much more fleet of foot, much more dynamic, much more willing to say, "You know what, we got that calibration wrong, let's recalibrate." Or, "You know what, we got that rule wrong. Let's drop that and do this instead." Those running repairs are going to be a core part of regulators' tasks in the next 10 years, just given the scale of changes that we've made.

Tkac: So we've cycled back to the beginning, right? So the first repair is to sort of recalibrate what we've got and move more to simple rules.

Haldane: I think so. Well, let's cross our fingers. So far, so good.

Tkac: Good. Well, thank you very much, Andy. It's been a pleasure.

Haldane: Thank you.