Taking uncertainty seriously - simplicity versus complexity in financial regulation

Our Financial Stability Papers are designed to develop new insights into risk management, to promote risk reduction policies, to improve financial crisis management planning or to report on aspects of our systemic financial stability work.
Published on 02 May 2014

Financial Stability Paper No. 28
By David Aikman, Mirta Galesic, Gerd Gigerenzer, Sujit Kapadia, Konstantinos Katsikopoulos, Amit Kothiyal, Emma Murphy and Tobias Neumann

Distinguishing between risk and uncertainty, this paper draws on the psychological literature on heuristics to consider whether and when simpler approaches may outperform more complex methods for modelling and regulating the financial system. We find that: (i) simple methods can sometimes dominate more complex modelling approaches for calculating banks’ capital requirements, especially if limited data are available for estimating models or the underlying risks are characterised by fat-tailed distributions; (ii) simple indicators often outperformed more complex metrics in predicting individual bank failure during the global financial crisis; and (iii) when combining information from different indicators to predict bank failure, ‘fast-and-frugal’ decision trees can perform comparably to standard, but more information-intensive, regression techniques, while being simpler and easier to communicate.

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