Prudential Regulation And The Knowledge Problem

In this article I examine the regulatory structure created by Title I of the Dodd-Frank Act and ask whether the prudential regulatory authority given to the Financial Stability Oversight Council is an effective tool for accomplishing the mission of identifying and containing risk in the financial system. Prudential regulation, the principal tool at the disposal of the FSOC, was developed in the 19th century to counteract moral hazard in the banking system. Over time, prudential supervision has become policymakers' regulation of choice, to the point where it is now employed in the oversight and regulation of non-bank financial firms. However, due to the limits of human knowledge -- what I refer to as “the knowledge problem” -- I argue that it is unlikely that prudential-style regulation, dependent as it is on the planning of a central regulator, can achieve the reduction in systemic risk envisioned by Title I of Dodd-Frank. I draw on advances from complex systems theory to show how complexity and the knowledge problem present significant obstacles for any framework of systemic risk regulation built around a system of prudential supervision. Finally, I outline some alternatives to prudential regulation for regulating non-bank financial firms and reducing systemic risk in a way that minimizes regulators' reliance on their necessarily incomplete knowledge.