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Taking Uncertainty Seriously: Simplicity versus Complexity in Financial Regulation

Author

Listed:
  • Aikman, David
  • Galesic, Mirta
  • Gigerenzer, Gerd
  • Kapadia, Sujit
  • Katsikopolous, Konstantinos
  • Kothiyal, Amit
  • Murphy, Emma
  • Neumann, Tobias

Abstract

Distinguishing between risk and uncertainty, this paper draws on the psychological literature on heuristics to consider whether and when simpler approaches may out-perform more complex methods for modelling and regulating the financial system. We find that: (i) simple methods can sometimes dominate more complex modelling approaches for calculating banks’ capital requirements, especially if limited data are available for estimating models or the underlying risks are characterised by fat-tailed distributions; (ii) simple indicators often outperformed more complex metrics in predicting individual bank failure during the global financial crisis; (iii) when combining information from different indicators to predict bank failure, “fast-and-frugal” decision trees can perform comparably to standard, but more information-intensive, regression techniques, while being simpler and easier to communicate.

Suggested Citation

  • Aikman, David & Galesic, Mirta & Gigerenzer, Gerd & Kapadia, Sujit & Katsikopolous, Konstantinos & Kothiyal, Amit & Murphy, Emma & Neumann, Tobias, 2014. "Taking Uncertainty Seriously: Simplicity versus Complexity in Financial Regulation," MPRA Paper 59908, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:59908
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    File URL: https://mpra.ub.uni-muenchen.de/59908/1/MPRA_paper_59908.pdf
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    Bank regulation; financial regulation; uncertainty; simplicity; heuristics; Basel 2; risk modelling;

    JEL classification:

    • A12 - General Economics and Teaching - - General Economics - - - Relation of Economics to Other Disciplines
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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