Andrew G Haldane: Turning the red tape tide Remarks by Mr Andrew G Haldane, Executive Director, Financial Stability, Bank of England, at the International Financial Law Review Dinner, London, 10 April 2013. *  *  *  Regulatory and legal frameworks share common roots. Both are complex, evolutionary systems, shaped by history. They are the result of a set of well-intentioned historical actions by technicians charged with filling cracks, creating certainty, shaping incentives for the common good. Both legal and regulatory frameworks have many of the characteristics of a classic public good. But the cumulative consequences of even well-intentioned actions may not always deliver outcomes which necessarily serve society well. That is because such actions are typically a response to events and circumstance. The resulting frameworks have a history of pathdependence (David (1985)). This history-dependence may “lock-in” sub-optimal technologies, such as QWERTY keyboards and VHS video-recorders. The financial regulatory framework may be another example of a locked-in technology. The events which have shaped the evolution of financial regulation include crises, scandals, innovation and liberalisation. Each has elicited a response, typically the addition of a new regulatory layer. The cumulative consequence has been a regulatory tide which has tended to flow in only one direction – towards a lengthier, more complex rulebook. In this respect, financial regulation shares many evolutionary characteristics with elements of the legal framework – for example, the tax code. It too has been responsive to events and circumstance including crises, scandals, innovation and liberalisation.

The spread of certain fund management techniques, in particular index management, which has proven very popular on equity markets, may have contributed to amplifying movements in financial asset prices. This technique endeavours to match as accurately as possible developments in stock market benchmark indices. It therefore mechanistically leads managers to accentuate current price trends by buying stocks that are on the rise and selling those that are falling. It can be argued that  2  BIS Review 54/2001  index funds distort the price of the targeted indexes and that, as a result, the indices might end up creating rather than measuring performance. The impact of risk management techniques on market dynamics is particularly enlightening with regard to the question of asset price overshooting. Value-at-risk calculations have become a crucial element of the standards approach used by market participants to evaluate the risk inherent in their market activities and set up exposure limits. Of course, central banks and financial institutions should continue to encourage the use of these instruments. But, in times of financial turmoil, the growing use of homogeneous risk management techniques by financial intermediaries has had the paradoxical effect of amplifying the initial shock and the spill-over effect. Regardless of the intrinsic qualities of these risk management tools, their growing use may have produced some adverse consequences. When market players rely on converging risk evaluations, they tend to take the same decisions at the same time, thus amplifying the initial shock to prices and trading volumes.