The dynamics of complex systems, such as large banks or interconnected financial webs, are not well understood. That means uncertainty needs to be taken seriously if financial regulatory frameworks are to be robust. Timeliness would be a third criterion. Complex systems often exhibit a knife-edge property, with discontinuities and tipping points a naturally-recurring feature.5 Those same features have punctuated the present financial crisis. In physics as in finance, once over the cliff-edge there is little chance of full recovery. That underscores the importance of timely, pre-emptive regulatory intervention if financial disaster is to be averted. (a)  Simplicity  How do existing regulatory rules compare against these criteria – simplicity, timeliness, robustness? Take simplicity. By any standard, existing regulatory rules are far from simple. For large banks, they can be highly complex. They have become more so over time given the evolution of the Basel framework. Back in the days of Basel I, calculating a regulatory capital ratio was not especially taxing or time-consuming. It involved little more than half a dozen calculations. These calculations could be conducted on the back of a small envelope by a competent clerk. Possessing envelopes and clerks, banks, regulators and market participants were able to perform those calculations. They were transparent and verifiable. In that way, regulatory rules (Pillar I) provided a solid platform for supervisory discretion by regulators (Pillar II) and market discipline by investors (Pillar III). The Basel pillars were mutually reinforcing. Basel II changed that calculus.
(b) Timely conversion is defined as a bank’s ratio falling below the trigger level no less than one month and no more than one year before a “crisis”. The number in this column is the proportion of “crisis” banks for which timely conversion does not occur (i,e, there is a Type II error) at this trigger level. (c) For each metric, the threshold for a signal of impending distress is as given in Charts 5 to 8. 18  BIS central bankers’ speeches