Harmonisation lifts systemic risk

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  • In a banking industry, as in an investment portfolio, risk is reduced by uncorrelated diversification.

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  • The effect of regulation is always to impose homogeneity of models on what should otherwise be diversified.

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  • As Rod Price stated "Any model adopted by a regulator and applied across a market will fail."

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Sir, Rod Price’s letter (February 20) is subtle and profound. Bravo for its discussion of the recursive and self-falsifying properties of the use of financial models. This insight is especially acute: “Any model adopted by a regulator and applied across a market will always fail.”

We should expand this insight to the broader sense of “model”: not only mathematical models, but also business models, organisational models, conceptual models, capital adequacy models. In a banking industry, as in an investment portfolio, risk is reduced by uncorrelated diversification. But the effect of regulation is always to impose homogeneity of models, in both the broad and narrow senses, on what otherwise would be diversified. Regulation in this regard always increases systemic risk. If regulation across countries is made homogeneous by international “harmonisation” (an instructive example was the use of credit rating agencies’ ratings), the global systemic risk is correspondingly increased still further.

Alex J. Pollock, Resident Fellow, American Enterprise Institute, Washington DC, US

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Alex J.
Pollock

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