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Taking uncertainty seriously: simplicity versus complexity in financial regulation

Taking uncertainty seriously: simplicity versus complexity in financial regulation
Taking uncertainty seriously: simplicity versus complexity in financial regulation
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.
Aikman, David
8174890a-c63f-425b-a30b-1a73dd827e16
Galesic, Mirta
c2fa14e9-d849-426b-a180-16df684ae86c
Gigerenzer, Gerd
16856b2c-59a5-4a16-80da-d2968c4437dd
Kapadia, Sujit
4603ad3d-3d70-43c8-aab3-38d25c1e0557
Katsikopoulos, Konstantinos
b97c23d9-8b24-4225-8da4-be7ac2a14fba
Kothiyal, Amit
dba98f5d-22b2-4721-859a-240fe72ec0b6
Murphy, Emma
98f64991-0f9a-42f3-a8a8-0a8c0e69649f
Neumann, Tobias
41616778-d76f-4369-9bce-a568b365c8ea
Aikman, David
8174890a-c63f-425b-a30b-1a73dd827e16
Galesic, Mirta
c2fa14e9-d849-426b-a180-16df684ae86c
Gigerenzer, Gerd
16856b2c-59a5-4a16-80da-d2968c4437dd
Kapadia, Sujit
4603ad3d-3d70-43c8-aab3-38d25c1e0557
Katsikopoulos, Konstantinos
b97c23d9-8b24-4225-8da4-be7ac2a14fba
Kothiyal, Amit
dba98f5d-22b2-4721-859a-240fe72ec0b6
Murphy, Emma
98f64991-0f9a-42f3-a8a8-0a8c0e69649f
Neumann, Tobias
41616778-d76f-4369-9bce-a568b365c8ea

Aikman, David, Galesic, Mirta, Gigerenzer, Gerd, Kapadia, Sujit, Katsikopoulos, Konstantinos, Kothiyal, Amit, Murphy, Emma and Neumann, Tobias (2014) Taking uncertainty seriously: simplicity versus complexity in financial regulation 26pp.

Record type: Monograph (Working Paper)

Abstract

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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More information

Published date: May 2014
Organisations: Decision Analytics & Risk

Identifiers

Local EPrints ID: 408788
URI: http://eprints.soton.ac.uk/id/eprint/408788
PURE UUID: 51f36b72-5846-4a38-88bc-73894f474308
ORCID for Konstantinos Katsikopoulos: ORCID iD orcid.org/0000-0002-9572-1980

Catalogue record

Date deposited: 28 May 2017 04:01
Last modified: 30 Jul 2020 01:44

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