There is a literature on how best to regulate systems in the face of such Knightian uncertainty. It suggests some guideposts for regulation of financial systems. First, keep it simple. Complex control of a complex system is a recipe for confusion at best, catastrophe at worst. Complex control adds, not subtracts, from the Knightian uncertainty problem. The US constitution is four pages long. The recently-tabled Dodd Bill on US financial sector reform is 1,336 pages long. Which do you imagine will have the more lasting impact on behaviour?

Second, faced with uncertainty, the best approach is often to choose a strategy which avoids the extreme tails of the distribution. Technically, economists call this a “minimax” strategy – minimising the likelihood of the worst outcome. Paranoia can sometimes be an optimal strategy….

Third, simple, loss-minimising strategies are often best achieved through what economists call “mechanism design” and what non-economists call “structural reform”. In essence, this means acting on the underlying organisational form of the system, rather than through the participants operating within it. In the words of economist John Kay, it is about regulating structure not behaviour…

I personally sympathize with simpler controls for the banking industry.

With an international dataset of credit default spreads as a credit risk measure, we propose a novel empirical framework to identify the structure of credit risk network across major financial institutions around the recent 2007-2008 global credit crisis. The findings directly shed light on credit risk transmission in a financial network and help find systemically important financial institutions from the perspective of interconnectedness. Specifically, Lehman Brothers, Morgan Stanley, Safeco, Chubb, and possibly AIG in the US and BNP Paribs, Dresdner bank, and UBS in the Europe are primary senders of credit risk information. Goldman Sachs, Bear Sterns, Bank of America, and Metlife in the US and Barclays, RBS, Commerzbank, and HVB in the Europe play the role of the exchange center on the credit market by intensively receiving from some financial institutions and then transferring credit risk information to others. Finally, Citigroup, Wachovia, JPMorgan and Hartford in the US, and ABN AMRO, ING, Rabobank, and Deutsche Bank in the Europe appear to be prime receivers of credit risk information.

An attempt in the right direction. (data driven) However, it is the national regulators who will implement the add-on for systemically significant banks, and I still has doubt if they will be willing to base that add-on on international interconnectedness.