## September 15, 2012

### SCHROEDINGER'S LEDGER:

The law that explains the folly of bank regulation (John Kay, 12 September 2012, Financial Times)

At the recent Jackson Hole conference, Andrew Haldane of the Bank of England again reminded the world's financial policy makers of a central truth about the 2008 crisis. The principal measure of bank resilience prescribed for and by regulators around the world - the capital ratios calculated according to principles laid down by the Basel Committee on Banking Supervision - had no value whatever in predicting the probability that a bank would fail. But a simple measure of the bank's leverage ratio, which anyone with a calculator could compute, did. [...]The likely explanation of his discovery that more complex rules are worse is to be found in Goodhart's law. This proposition was first set out in the 1970s by the economist Charles Goodhart, in the context of the implementation of monetary policy.Prof Goodhart suggested that any measure adopted as a target loses the information content that appeared to make it relevant. People change their behaviour to meet the target. These responses change the relationship between the target - the measure of money supply, or the value at risk - and the objective that policy makers seek to influence: the availability of credit, or the risk exposure of a bank. The target becomes a bad measure of success in reaching the objective as soon as it is adopted as a target. That is why the risk-weighted measure of Basel, which was a regulatory target, proved to be less reliable than the leverage ratio, which was not. [...]The additional complexity of risk weighting stimulated regulatory arbitrage - the creation of instruments that transfer assets from one risk category to another while preserving their essential economic characteristics. The categorisation encouraged banks to reverse-engineer products to meet the demands of rating agency models. The resulting complexity diminished the system's resilience.

Posted by Orrin Judd at September 15, 2012 8:41 AM

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