How should regulators deal with uncertainty? Insights from the Precautionary Principle

One September morning, the Lord Mayor of London was called to inspect a fire that had recently started in the City. Believing that it posed little threat, he refused to permit the demolition of nearby houses, probably due to the expense of compensating the owners. The fire spread and ultimately destroyed most of the city. The Great Fire of London had begun. Only when the fire became too extensive to be readily halted did the full extent of the danger become evident. Financial regulators today face a similar challenge preventing financial crises- action causes significant costs to some but the consequences of inaction are much more uncertain. To combat this, we argue they should apply the precautionary principle.

Regulatory reforms and the dangers of complacency

Despite a refined and expanded regulatory tool kit, there continue to be significant challenges in combating threats to financial stability. Researchers at the IMF have argued – in Financial crises: causes, consequences and policy responses – that regulators have generally been better at managing than preventing crises. Biases in the perception of risk arising from cognitive weaknesses, overconfidence in analytical tools and methods and impediments to information-sharing across large institutions are all factors that may weaken regulators’ ability to anticipate financial crises, just as they contributed to the IMF’s failure to predict the 2008 financial crisis.

There was a relatively wide awareness that risks were increasing due to greater financial imbalances, the rapid growth of structured credit and the search for yield. Despite that, there was a tendency to argue that the financial system was resilient enough to withstand these pressures, and that problems would correct themselves without great detriment to the market or consumers. In consequence, policymakers did little to counter such developments. The April 2007 Bank of England Financial Stability Report described many of the risks that subsequently led to the crisis a year later, but opened with the comment that “the UK financial system remains highly resilient”.

Since the financial crisis, a great deal of work has gone into strengthening the regulatory framework and increasing the resilience of the financial system. In the UK, micro-prudential supervision now aims to be forward-looking, judgement-based, and more pro-active. And there is additional macro-prudential oversight of the financial system as a whole in the Bank of England’s Financial Policy Committee. Specific reforms include higher and more risk-sensitive capital and liquidity requirements, tighter controls around the use of leverage and off-balance sheet vehicles, restrictions on mortgage lending and the separation of investment and retail banking.

Valuable though they are, there is a risk of placing too much reliance on the effectiveness of the latest regulatory tools. Regulators may be working at the limits of their ability to understand the nature and scope of risks in supervising complex financial institutions. The complexity of financial transactions and arrangements may, moreover, push regulators to rely excessively on third parties and banks’ and insurers’ own risk assessments when assessing the overall risk profiles of financial institutions.

For example, financial institutions previously argued that their increasingly complex financial arrangements made them more resilient when the opposite turned out to be true. Innovations such as credit derivatives were represented as an effective way of spreading risk and bringing greater transparency to the market; in practice, they served as a source of contagion.

Regulation and the precautionary principle

We maintain that financial regulators should develop a capacity to take a genuinely precautionary approach in respect of the methods, models and accounting they rely on.

The precautionary principle is an approach that seeks to improve decision-making under conditions of uncertainty. It has been used by the World Health Organisation to guide decision-making for public health, and embodied in international treaties on environmental protection. The principle has a central place in UN efforts to prevent dangerous climate change, being applicable especially to those aspects of climate risk that are inherently uncertain and unpredictable, and is the main reason why the EU legislated against a generalised roll-out of genetically-modified crops.

The principle maintains that if an action or policy has a suspected risk of causing harm to the public then, in the absence of a clear consensus among researchers, the burden of proof that it is not harmful falls on those taking an action rather than on those who seek to prevent it.

Financial regulators have adopted a number of measures that are consistent with the precautionary principle. A good example of such an approach is the development of resolution planning. This seeks to manage the failure of a financial institution and thus reduce its impact, even where such failure appears highly improbable. Significant progress has been made in defining the framework for resolution, although more needs to be done to implement it in practice.

Rupert Read, in collaboration with Nassim Taleb, has developed an approach along these lines that seeks to reduce the fixation on evidence and to place a greater emphasis on a precautionary approach, particularly in cases where there is a risk of ruin from rare and unpredictable events. Read and Taleb argue that it is intrinsically challenging to take an ‘evidence-based’ approach to rare and ruinous outcomes, because there is so little information to assess such black swan events. This is precisely why a regulator needs to be sceptical about the robustness of much of the available evidence for risk assessment.

Is such an approach possible? There are certainly challenges in taking preventive action, even when it might be warranted, stemming for instance from uncertainty about the probability and impact of risks as well as the consequences of such action. But in a recent Bank Underground post, Foulis and Bahaj argue powerfully that there is a need for policymakers to use macro-prudential tools in an active manner even in the face of this uncertainty.

The precautionary principle recommends pro-active, preventive measures when specific activities pose a credible risk of significant harm to society, and it is impossible to measure and manage these risks adequately. It suggests that regulators should think more about the limitations of their knowledge – assessing carefully the reliability of what they know, and paying more attention to what they don’t know.

A Conclusion

Although we do not have space to discuss them in detail, there are a number of questions for financial regulation that might stem from application of the precautionary principle.

Are financial regulators able to incorporate into their supervisory assessments information about limitations of models, methods and third-party assessments? While such tools such as stress testing have added considerably to the understanding of risks facing financial institutions, are regulators placing too much reliance on them as a way of quantifying the risk of catastrophic events? The high level of investment and sophistication of the approaches used may obscure the limitations of these models when it comes to making supervisory decisions. This suggests that financial regulators should continue to be sceptical about the soundness of even apparently well-capitalised institutions, especially where they judge them to be taking excessive levels of risk.

How can financial regulators act sufficiently rapidly to forestall issues before they become too great to be contained? Should the burden of proof be shifted when thinking about regulatory issues? Rather than regulators or supervisors having to demonstrate the need for restrictions, there may be cases where financial institutions should be prohibited from taking certain actions where they are unable to convince regulators of their safety. Such an approach would allow regulators to act sufficiently in advance to forestall risks before they crystallise.

Do supervisory authorities have sufficient support to challenge conventional wisdom and break out of group-think? In the current challenging economic climate, there are frequent suggestions that regulators are being too cautious and that they should pay more attention to the benefits that financial innovation can bring. On the contrary, the authors believe that it is imperative for regulators to remain aware of what can prevent them from identifying and responding to risks in the financial system in a timely and robust manner. Broad acceptance of the precautionary principle can strengthen their resolve to act in such instances. Anything less risks being reckless.

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