04/07/2014 12:46 pm ET Updated Jun 07, 2014

How 'Too Big to Fail' Became 'Too Big to Manage'

The recent spat between the Federal Reserve and Citigroup underscores the complexity of today's banking balance sheets. The Federal Reserve judged Citigroup to have failed its stress tests on "qualitative" grounds, throwing a monkey wrench in its plans to raise its dividend and conduct share buybacks. The result was an immediate barrage of criticism of the Fed from Citigroup as well as disgruntled investors, who accused the Fed of being opaque and "whimsical."

The episode is a warning shot across the bows of regulators. It emphasizes the onerous challenge they have undertaken in balancing financial stability against growth. More importantly, it hints at why despite their best efforts, they are doomed to fail in their task, particularly as growth returns and memories grow short.

The least mentioned bubble of recent years has been the boom in financial regulation since 2008. In 2011 alone, 14,200 new banking regulations were enacted globally. Lexicons overflow with new regulatory acronyms and buzzwords, such as macro-prudential regulation. And thanks to Frank-Dodd, Basel III and their extended family, a million pages of new prescription to make the world safer is the lasting legacy of the recent financial crisis.

It's an achievement as impressive in its outpouring of ink as it is self-defeating in purpose. Indeed, we have made the financial system even more fragile and difficult to manage going forward.

Rules are written by people. And the human psyche is defined by a continual battle to reclaim islands of certainty from the turbulent oceans of uncertainty that we inhabit. The current crop of financial regulation has tried to make banks safer, through increased capital requirements, enhanced deposit insurance and so on. At the same time, we have also aggregated many financial institutions into larger entities, many of them "too big to fail."

Combined, these increase the aggregate complexity of regulation. To regulate effectively now requires more numbers, more assumptions, more oversight and more people. That is a problem.

First, regulators are creating a rod for their own backs. The sheer volume of information flowing in will not make the world safer by itself. It still needs to be analyzed, assimilated and distilled to identify key risks and trends. The danger is that regulators miss seeing the wood for the trees. The clear failure of regulation in the last crisis, for example, was not that they lacked information but rather that they went into bank after bank and failed to ask the obvious question. If everyone was using the same models, might they not de facto all end up taking the same risks and lead to contagion?

Second, there is the little problem of globalization. Many financial institutions now span multiple jurisdictions. Citigroup, for example, will be overseen by over a hundred different regulators globally. How do regulators propose to coordinate their efforts effectively and pool information? People talk hopefully of cross-border agreements and international initiatives, such as the Financial Stability Board. But in practice, these are doomed to founder on the rocks of human behavior, as domestic priorities overwhelm international solidarity and mistakes slip between the international cracks.

Third, regulation does not live in a vacuum. It is a prisoner to conflicting socio-economic and political pressures. Recovery today is a political imperative, birthing an ongoing clash between political and regulatory objectives. Banks are under pressure to hold more capital whilst also being asked to lend more to key political sensitivities such as small businesses. These are dissenting priorities that cannot co-exist. Complex regulation is a frictional drag on potential growth, and is often discarded in the good times. Regulators are also run by people, who are sensitive and ultimately malleable to the external pressures of their environment.

Fourth, complex rules create perverse behavioral incentives. Rationality is replaced by process. The complicated capital calculations refocus the efforts of financial institutions not on managing their risks prudently but rather on arbitraging regulation -- the same mistake that led to the last crisis. Innovation is channelled down unproductive paths that seek to maximize return on capital, creating new exotic products that emasculate today's regulation and risk tomorrow's crisis (go google UK liquidity swaps).

Fifth, regulators are on the wrong side of the information divide. Their charges know more about the fine detail of their capital models than they do, because they built them. With more complexity, the need grows to trust their word, which makes policing harder. Alongside, regulators have younger and less experienced cadres. Senior regulators are often poached by banks, who can offer more attractive compensation. The result is a constant brain drain of critical experience that could help separate the wheat from the chaff.

This is today's problem. We have chosen to fight complexity with complexity. Unfortunately, our brain is only three pounds in weight. The truth is that regulators cannot hope to understand all the intricacies. The long-term management of an economy sits in an uneasy alliance with their human frailties.

Regulation needs to adapt to today's economy. An economy is a dense network of interacting bodies, from small individual investors to large multinational institutions, all bound by a complex web of money and debt. The players have varying levels of influence that can become destabilizing at times. Particularly, if they are too large, any failure can ripple outwards, spreading financial contagion.

To manage this, we need to aim for simplicity -- understand the essential characteristics, not every last bit of information. In today's world, information grows exponentially over time. Aggregating everything only leads us to the cognitive trap of substituting process for critical reasoning. Crude simple metrics such as leverage ratios are more immune to the vagaries of interpretation and capture what matters, namely, the systemic impact of failure. Alongside, publish not just the capital ratios but the assumptions behind them. Transparency is a wonderful regulator because it allows the wider market, the best aggregator of information, to delineate who is likely to honor their obligations.

And most importantly, restore failure as an option. No institution must be too big to fail. Citigroup and its brethren will one day again run into financial trouble. Probability and history tell us that. But if they are deemed to be too big to fail, we have a major problem when that future event occurs. If the economy is to be spared future contagion, we need to remove the anomaly by shrinking or breaking banks up.

The alternative is let the complexity outrun our simpler minds, right up to the point when it trips and comes crashing down once again.