“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.” John Kay, ‘The law that explains the folly of bank regulation’, Financial Times, September 12, 2012
John Kay suggests that Andrew Haldane’s discovery that more complex rules are worse than less complex rules was first explained in the 1970s by the economist Charles Goodhart and is known as Goodhart’s law. Goodhart suggested that any measure adopted as a target quickly loses the information content that appeared to make it relevant. Individuals and organizations change their behavior in order to meet the new target. Such responses change the relationship between the target – the measure of the money supply or the value at risk – and the objective that the policy makers seek to influence: the availability of credit or the risk exposure of a bank. The target now becomes a bad measure of success in reaching the policy objective.
That is why the risk-weighted measure of success of Basel, which was a regulatory target, proved to be less reliable than the leverage rate, which was not. The additional complexity of risk, required by Basel, stimulated regulatory arbitrage – the creation of instruments that transfer assets from one risk category to another while preserving their essential economic qualities. The assets were subtly reverse-engineered to satisfy the Basel-based requirements of the credit rating agencies.
If Goodhart’s law truly holds, then serious attempts to promote financial stability must avoid adding complexity to bank regulations. Instead, attention should shift to issues of bank structure – notably bringing back Glass- Steagall to dissect commercial from casino banking and forcing banks of any category to downsize in order to render themselves sufficiently small to fail, – and to the imposition of a leveraging rule sufficiently simple as to limit bank manipulation.