The Rise of a 'Complexitocracy'

“Complexitocracy” is not in the dictionary. But maybe it should be. If it were, the definition would be something like, “governance or control exercised by an elite of quantitative modelers.”

In bank regulation, complexitocracies stem from the notion that the safety and stability of the global financial system is associated with the capacity of banks' capital to absorb extreme losses. Transforming that notion into policy, a bank needs: (1) a method of estimating the maximum probable loss it can be exposed to when operating in the most severely threatening conditions; and (2) available capital that is capable of absorbing such a loss.

The theory is that the safety of the global banking system is assured if (1) is plausible, and (2) is greater than (1).

The Advent of Risk Weighted Assets

For centuries, business has relied on accounting to provide stakeholders with a framework of oversight and governance. In 1974, this reliance was badly shaken by the Bankhaus Herstatt bankruptcy. The sudden collapse of that mid-size German bank exposed a major flaw: Accounting isn't designed to consider whether, and to what extent, a bank's risk position may be endangering its financial condition.

Herstatt was active in the foreign exchange markets. On a single day in 1974, it ramped up settlement risk on a scale that ultimately led to losses of more than 10 times its total capital. This event led the G-10 countries to conclude that accounting alone wasn't providing the assurances they needed concerning the safety of financial markets. In response, the Basel Committee on Banking Supervision was formed with a mission to design and implement additional layers of assurance.

One of the committee's earliest game-changing initiatives was the capital accord of 1988, which introduced a new risk metric, the risk weighted asset (RWA). Under what became known as Basel I, banks were required to organize their risk assets into five buckets, with a fixed percentage applied to each bucket to determine their RWAs. They then had to ensure that a minimum of 8% of RWAs was set aside in the form of protective capital.

What could be simpler?

Complexification in Financial Markets

What the Basel Committee perhaps didn't know at that time was that the RWA's introduction would coincide with an era of unprecedented complexification in financial markets. Market forces and the need for balance-sheet rationalization obliged banks to progressively displace the traditional, and relatively simple, on-balance-sheet depositor/borrower dynamic with the more complex, off-balance-sheet issuer/investor dynamic. This breathed life into the emerging derivative transactions that eventually spawned a proliferation of complex risk intermediation products that, in turn, became the bedrock of complex trading structures. The transformation of the global financial operating landscape, from simple and benign to complex and treacherous, was underway.

The simple 1988 formulation of RWA could no longer cut the mustard in the face of such inexorable complexification. If banking regulation were to remain relevant, the RWA needed to adapt. Banks robustly lobbied for an enhanced RWA by pitching their internal models as its benchmark. The result was Basel II, which was the formal acceptance of quantitative modeling as the regulators' preferred means of calculating RWAs.

The Basel Committee mirrored banks' increased use of statistical mathematics in risk management, evident in the spread of mathematical notation in regulatory mandates. The simple RWA, once easily understood by the many, mutated into complexitocracy, intelligible only to an elite few. Meanwhile, accounting kept its focus on reporting the past without considering the probable financial consequences of accumulating exposures to risk.

A Challenge for Accountants

We can only speculate how things might have been if, back in 1988, the Basel Committee had challenged accountants to develop accounting measures for risk, rather than going it alone with the RWA.

Accountants have a toolkit that could potentially be applied to help broaden the understanding and acceptance of risk information. For example, they nurture an authoritative source of controlled and audited financial data - the general ledger and its sub-ledgers - where all contractual obligations, and the payments and receipts that emanate from them, are registered. They apply accounting techniques and pre-defined aggregation paths to transform atomic transaction data into published financial statements. They maintain networks of revenue and expense allocation tables that interact to produce management reports such as business-line, product and customer profitability.

In summary, accounting transforms complex financial constructs into standardized measures - profit, equity, net interest income, return on investment, unit cost and many more - that stakeholders have come to intuitively understand. Accounting measures provide a common language that enables the broader understanding and comparison of financial information, along with assurance that decisions affecting the business are safe.

Maybe accountants should be put to work on developing new accounting measures for risk, with the much sought-after common, integrated financial and risk reporting framework as its outcome. It might not be as difficult as they think.

Peter Hughes (peter.j.hughes@durham.ac.uk) is chairman of the Risk Accounting Standards Board at SERRAQ. He is also a visiting fellow and advisory board member of the Durham University Business School's Centre for Banking, Institutions and Development (CBID), where he leads research into risk-based accounting. He was formerly a banker with JPMorgan Chase.