Yet the regulatory response to the crisis has largely been based on the level of thinking that created it. The Tower of Basel, like its near-namesake the Tower of Babel, continues to rise. An alternative point of reference when regulating a complex system would be to simplify and streamline the control framework. Based on the evidence here, this might be achieved through a combination of five, mutually-supporting policy measures: de-layering the Basel structure; placing leverage on a stronger regulatory footing; strengthening supervisory discretion and market discipline; regulating complexity explicitly; and structurally re-configuring the financial system. (a)  Reconstructing the Tower of Basel  The quest for risk-sensitivity in the Basel framework, while sensible in principle, has generated problems in practice. It has spawned startling degrees of complexity and an  14  BIS central bankers’ speeches  over-reliance on probably unreliable models. The Tower of Basel is at risk of over-fitting – and over-balancing. It may be time to rethink its architecture. A useful starting point might be to take a more sceptical view of the role and robustness of internal risk models in the regulatory framework. These are the main source of opacity and complexity. With thousands of parameters calibrated from short samples, these models are unlikely to be robust for many decades, perhaps centuries, to come. It is close to impossible to tell whether results from them are prudent. One simple response to that concern may be to impose strict limits, or floors, on model outputs. These would provide a binding regulatory backstop.

Of course, the costs of this regulatory edifice would be considered small if they delivered even modest improvements to regulators’ ability to avert future financial crises. The public policy question is – will they? In financial regulation, is more more or is more less? To begin to answer that, consider a set of empirical experiments on the performance of regulatory rules, simple and complex. (4)  Risk-weighting capital – simple or complex? The primary source of complexity in the Basel framework is granular, model-based risk-weighting. Heightened risk-sensitivity of the regulatory framework was intended to improve the detection of bank weakness. But if the financial environment is uncertain, complex risk-weighting may be sub-optimal. As when predicting Alpine avalanches or Wimbledon winners, simpler weighting measures may be more robust. This is a testable proposition. To do so, we take a sample of about 100 large, complex global banks, defined as those with total assets over $ billion at end-2006. 15 These large banks are likely to hold a diverse array of assets and to use complex, internal models to calibrate regulatory capital against these assets. So at least in principle, risks to these banks should be better captured by granular, risk-sensitive capital measures. Von Neumann-Morgenstern principles, with probabilistic-weighting, ought to apply. Consider the relative performance of two measures of capital in predicting bank failure during the course of the crisis: the Basel Tier 1 regulatory capital ratios with assets risk-weighted and simple leverage ratios with assets equally-weighted – a 1/N rule.