Understanding the Determinants of Regulatory Complexity

Project overview

Regulatory reform of the financial system has been one of the most pressing policy debates in the European Union in recent years and has highlighted the need for a new set of rules adapted to a more integrated, globalized, and complicated financial landscape. In this context, both market participants and policymakers have raised the issue of rapidly increasing complexity.

Motivated by this, this project explores the determinants and implications of asset complexity and market opacity in environments with asymmetric information and the role of regulation in enhancing efficiency. In the first part, we explore the incentives of product designers to produce complex products (products that are difficult to understand) and how complexity interacts with their incentives to design good-quality products. In the second part, we explore the implications of opaque markets (where risk exposures of counterparties are not observable) for the design of securities and resulting market liquidity. Within these frameworks, we study the effect of policies that aim to increase information disclosure and transparency in markets.

Summary, output, and dissemination

Research summary

The financial crisis of 2008/2009 and the subsequent sovereign debt crises in the Eurozone have highlighted new risks in the financial system, and the need for a new set of rules and regulations adapted to a more integrated, globalized, and complicated financial and banking landscape. Part of these reform efforts resulted in the creation of the Single Supervisory Mechanism and the Single Resolution Mechanism. These supranational mechanisms centralized Eurozone banking supervision and regulation added another layer of regulation above national legislations in Eurozone countries and created a new set of rules for banks. The creation of these mechanisms, as well as the ongoing efforts to add more layers of banking regulations (for example a common European deposit insurance), have been accompanied by economic and political debates that question the appropriateness and effectiveness of these rules at addressing the many challenges evidenced during the recent crisis. A major criticism of these rules has been that they are too complex to be successfully implementable and politically feasible – they are long, difficult, and costly to understand. This raises the following key questions. What are the costs and benefits of complex regulations? When is regulatory complexity more likely to emerge?

This project has investigated both theoretically and empirically what the drivers of regulatory complexity are and what are its implications for a regulation’s efficacy, implementability, and political feasibility. In particular, it explores regulators’ incentives to complexify or simplify rules, and the implications for socio-economic wellbeing. The novel aspect of this research was to think of complexity as a regulator’s tool or choice. That is, given a rule that is to be implemented, such as capital requirements on banks or carbon emission restrictions on companies, a regulator can choose to make it simple (e.g. one rule applied for all) or to complicate it (e.g. by making capital constraint rules contingent on banks’ asset types, or by making emission restrictions contingent on the industry, the type of firm, etc.). In the example of banking regulation, some evidence indicates that, during the recent crisis, markets focused more on the leverage ratio (simple rule) than on the solvency ratio (complex rule), one possible reason being that there is less discretion (that is, complexity) over the former. For example, both Bear Sterns and Lehman had solvency ratios clearly above the regulatory threshold before they declared bankruptcy. This suggests that the level of complexity of rules may determine the ability of policy makers to effectively measure and manage systemic risk. In this sense, this project also relates to the classical issue of rules vs. discretion in policies.

The project has had two pillars: one theoretical and one empirical. 

First, we have constructed a theoretical framework to underpin the drivers of regulatory complexity. Our contribution is to introduce a novel notion of complexity, which affects how difficult it is for people to acquire information about product (e.g. regulation) quality. In our model, an agent can accept or reject a product proposed by a designer, who can affect the quality and the complexity of the product. Examples include banks that design financial products that they offer to retail investors, or policymakers who propose policies for approval by voters. We find that complexity is not necessarily a feature of low-quality products. While an increase in alignment between the agent and the designer leads to more complex but better-quality products, higher product demand or lower competition among designers leads to more complex and lower quality products. Our findings produce novel empirical implications on the relationship between quality and complexity, which we relate to evidence within the context of regulatory policies.

Second, we are investigating the drivers of regulatory complexity using data from US legislatures. This is an ongoing project with Zoel Martin Vilato, a PhD student at UPF, and Dana Foarta. We are interested in studying how political polarization in US legislatures affects the regulation of the policies that are proposed and passed. To evaluate the effect of party polarization on regulatory complexity, we apply textual analysis techniques to measure the complexity of the content of bills proposed in state chambers between 2009 and 2018. We have several measures of complexity, from the number of pages, the number of words, the number of complicated words, and a Shannon entropy measure applied to the words used in each document. We then regress our different measures of the complexity of bills on measures of party polarization developed by Poole and Rosenthal (2001). We establish that higher chamber polarization is significantly associated with more complex rules. We are now working on having exogenous proxies for polarization to make our statements causal.

Publications

“The Good, the Bad, and the Complex: Product Design with Asymmetric Information“, joint with Vladimir Asriyan (CREI, UPF, BSE) and Dana Foarta (Stanford GSB), is now forthcoming in the Americal Economic Journal: Microeconomics.

Dissemination and related activities

Before being published, the paper “The Good, the Bad, and the Complex: Product Design with Asymmetric Information” was presented at many international conferences and academic and policy institutions:

• Stockholm School of Economics, November 2018
• AEA Meetings, January 2019
• HEC Paris, March 2019
• ECB, April 2019
• Columbia Business School, April 2019
• Catalan Economic Society Meeting, May 2019
• Toronto Rotman Business School, September 2019
• Oslo Business School, October 2019
• University of Barcelona, November 2019
• UVA Amsterdam, March 2020
• Lausanne, May 2020
• INSEAD Finance Online, June 2020