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More viewpoints from Robert Bruce

Financial regulators would do well to pause from their mighty labours in adding to the mountain of legislation, rules and guidance and consider the behaviour of the average dog, says Robert Bruce

This article was first published in the July/August UK edition of Accounting and Business magazine.

It is summer. Listen to that short sentence. It is one of the most relaxing in the English language. Now imagine you are no longer in your office. You are on a beach somewhere. And as you look through the shimmering heat haze you can see a dog running. It is trying to catch a frisbee thrown skimming over the sand. It leaps exuberantly and carries out a breathtaking high-speed manoeuvre. The frisbee is seized in mid-air. You can settle back now. You have just learned the most important lesson in regulation. The future of the accounting profession, standard-setters, bankers, financial services, and almost anyone you care to mention depends on it.

You need to go back to last summer: August, to be precise. In Jackson Hole, Wyoming, Andy Haldane, the splendidly off-the-wall executive director for financial stability at the Bank of England is about to get to his feet and make a speech to the Federal Reserve Bank of Kansas City’s annual economic policy symposium. It is a big deal, but it is summer and it is Haldane. The audience is alert.

‘Catching a frisbee is difficult,’ he starts. ‘Doing so successfully requires the catcher to weigh a complex array of physical and atmospheric factors, among them wind speed and frisbee rotation. Were a physicist to write down frisbee-catching as an optimal control problem, they would need to understand and apply Newton’s Law of Gravity. Yet despite this complexity, catching a frisbee is remarkably common. Casual empiricism reveals that it is not an activity only undertaken by those with a doctorate in physics. It is a task that an average dog can master.’

Then comes the heart of his argument. ‘Indeed some,’ he says, ‘such as border collies, are better at frisbee-catching than humans.’ The penny is starting to drop among his banking audience.

Haldane continues. ‘So what is the secret of the dog’s success?’ he asks. And then he tells them. ‘The answer, as in many other areas of complex decision-making, is simple. Or rather, it is to keep it simple. For studies have shown that the frisbee-catching dog follows the simplest of rules of thumb: run at a speed so that the angle of gaze to the frisbee remains roughly constant. Humans follow an identical rule of thumb.’

Where are we going with this?

We are talking of the great economic crisis. ‘Catching a crisis, like catching a frisbee, is difficult,’ he tells his audience. ‘Doing so requires the regulator to weigh a complex array of financial and psychological factors, among them innovation and risk appetite. Were an economist to write down crisis-catching as an optimal control problem, they would probably have to ask a physicist for help. Yet despite this complexity, efforts to catch the crisis frisbee have continued to escalate. Casual empiricism reveals an ever-growing number of regulators, some with a doctorate in physics. Ever-larger litters have not, however, obviously improved watchdogs’ frisbee-catching abilities.’

And anyone who has looked, even in a casual way, at the sheer quantity of legislation, activity and paperwork produced since the crisis broke understands the point. The legislators and politicians will point to public anger. This anger, they will argue, has to be assuaged. People have to understand that something is being done. But the point that Haldane was making is that, while the public may sleep better from observing the astonishing amount of legislation and bickering so spawned, the problem itself remains unaddressed. ‘So what is the secret of the watchdogs’ failure?’ asked Haldane. ‘The answer is simple. Or rather, it is complexity.’

And this urge to pile further complexity on complexity is driven on inexorably by everyone in the financial world. Earlier in the year, the International Accounting Standards Board (IASB) ran a forum on financial reporting disclosure. Russell Picot runs external financial reporting at one of the world’s biggest banks, HSBC. Putting it simply to the forum, he pointed out that ‘the pressure from the regulators is always to add more disclosure rather than to remove disclosure’.

Paul Lee of Hermes Equity Ownership Services said: ‘The miasma of data, too often provided by management in an entity’s financial reports, does not reflect clarity of thought.’ And the degree of detail being minutely argued over in the IASB’s latest offerings on leasing and insurance, for example, does not suggest that the tide of complexity is doing anything other than roaring up the beach, overwhelming everything in its path.

Haldane’s still voice of calm needs to be heard: ‘In financial regulation,’ he said, ‘less may be more.’

Fighting complexity

His conclusion to the speech took the form of a warning: ‘Modern finance is complex, perhaps too complex,’ he said. ‘Regulation of modern finance is complex, almost certainly too complex. That configuration spells trouble. As you do not fight fire with fire, you do not fight complexity with complexity. Because complexity generates uncertainty, not risk, it requires a regulatory response grounded in simplicity, not complexity. Delivering that would require an about-turn from the regulatory community from the path followed for the better part of the past 50 years. If a once-in-a-lifetime crisis is not able to deliver that change, it is not clear what will. To ask today’s regulators to save us from tomorrow’s crisis using yesterday’s toolbox is to ask a border collie to catch a frisbee by first applying Newton’s Law of Gravity.’

So this summer, as you lie on the beach wondering about the future, keep the image of that chasing dog at the forefront of your mind. It is the regulator supreme. It knows of only one objective. And the most effective way of achieving it is the simplest. Its jaws snap shut. Job done.

THE US REGULATORY MOUNTAIN: NO SUMMIT YET IN SIGHT

There is a pattern here. In the wake of the Enron crisis a decade or more ago, the US passed the Sarbanes-Oxley legislation. This was supposed to ensure that such a calamity never happened again.

I remember being at a seminar in London where a trio of US accountants and lawyers flooded the screen with a sequence of spreadsheets of the information which the average company would require to satisfy the regulation. Memory may be playing tricks, but I recall the seminar lasting for many hours. Then came the great banking collapse. More legislation was created. This was the massive edifice of Dodd-Frank, implemented ‘to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end ‘‘too big to fail’’, to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes’.

When the Dodd-Frank Act was passed in 2010, it was 2,600 pages long. It was then decided that some 243 further rules would be required; 100 or so committees spawned consultation papers that in turn demanded several hundred pages of documentation. And still it continues. The chronological listing on the website of the Securities and Exchange Commission, shows still further proposed rules and ‘interpretative guidance’ scrolling through as we speak.

Robert Bruce is an accountancy commentator and journalist

 

Last updated: 18 Jun 2013