Often when an organizational problem occurs, the typical response is to create regulations to prevent that problem from happening again. For example, in a machine shop where safety gloves often went missing, the company centralized access to new gloves; required request forms for new gloves, with supervisor approval; and had auditors check for compliance. As expected, the number of lost gloves was significantly reduced. However, the new rules cost more than the gloves themselves, negatively affected morale, and reduced productivity.
In many cases "controls" imposed to fix a problem become so complex that they create new problems. This eventually leads to an increasingly bureaucratic cycle of further breakdowns, more complex fixes, and more breakdowns.
The Dodd-Frank Financial Reform Act, passed in the wake of the financial crisis, has the potential to be a classic example. Its various sections deal with bank bailouts, regulating derivatives and swaps markets, mortgage reform, consumer protection, and a number of other issues. In other words, it's a well-intentioned attempt to fix what went wrong in the years leading up to 2008.The problem with Dodd-Frank is that it's 1,000 pages of legislative guidelines, all of which need to be interpreted. So now as various regulatory agencies move into action, the complexity of implementation is generating outcries of concern in the financial industry, and defensive reactions on the part of the regulators.
JPMorgan Chase's CEO Jamie Dimon has been one of the most vocal critics of the process, citing not only the cost of compliance, but also the difficulty of actually making the regulations work effectively. With this chart, he implies that regulatory complexity was one cause of the financial crisis. Regulators didn't talk with each other or coordinate their responsibilities. And Dodd-Frank only adds to this complexity.
Another vocal critic is Karen Petrou, managing partner of a firm that analyzes bank regulations. She says that Dodd-Frank's implementation is creating "complexity risk" for the financial system. As she explains in a NY Times column by Joe Nocera, "If we don't understand the cross-cutting effects and inherent contradictions in all of the stringent standards now being written into final form, we risk doing real damage to the sound, stable and -- yes -- profitable financial industry regulators say they support and the economies sorely need."For example, the legislation requires bank boards to be responsible for 184 additional activities, which may be unnecessary -- or even impossible.
Responding to these and many other criticisms, Treasury Secretary Geithner argues that Wall Street is suffering from amnesia about the recent financial crisis. In his view, if the banks and other financial institutions don't follow the regulations, we'll have another meltdown.
We do need controls to close the gaps that allowed the financial system to fall apart. But if the regulations are unreasonably complex, they will not only create unnecessary costs, but are likely to be unenforceable and eventually ineffective.
What's clearly needed is something in the middle -- simple and practical controls that banks can understand and that regulators can enforce. Getting there requires dialogue, compromise, and coordination. Wall Street institutions, government regulators, and other parties need to get together in multiple forums and co-create workable practices that fulfill the spirit and intent of the Dodd-Frank guidelines. And leaders on both sides should convene key parties to map out and streamline the regulatory processes. The alternative is the continuation of dueling op-ed pieces and a financial system that runs a higher risk of another breakdown.
How can we create regulations that work without being overly complex?
Cross-posted from Harvard Business Online.