Complexity Causes Bad Decisions

In a thought-provoking column in this space, Victoria Finkle recently pointed to research showing that when burdened with complexity, a person is likely to make decisions that are inconsistent with his basic goals and priorities. Some of this research was done with college students. 

Student loans are very complicated. The tendency for complexity to provoke bad decisions tuned to short-term gratification might explain why educational loans have ballooned to over $1 trillion—while higher education costs have increased by far more than the inflation rate.

Maybe Lee Bollinger can elucidate the connection. He is President of Columbia University and also Chairman of the Federal Reserve Bank of New York. Ask Lee whether it's possible for a Fed director to encourage Fed tolerance and facilitation of this lending—and even to deter inquiry into the role of institutions such as Columbia in promoting it. 

Benefits to universities that push student loans could include not only drawing a larger number of customers who pay in full, but also free services or even subsidies from financial services firms.

The Fed itself offers splendid examples of how complexity spawns error.  Simon Johnson recently gave a lucid explanation of the Fed's Byzantine governance structure, featuring three classes of directors with distinct constituencies and roles. 

Bollinger himself, speaking out to defend Jamie Dimon's retention as a director, exemplified the nonsense to which this pointless complexity leads.

Get rid of all of this. 

The regional Fed banks should be recognized as no more than creatures of the Federal Reserve Board. They cannot be more independent than the Fed—nor independent of it—but they can and must be free of conflicts of interest (for instance, Jamie Dimon's), as Esther George eloquently demanded.

The term "crony capitalism" is now applied often to Greece, but we don't have to look so far afield to find it. It's all around us. 

The regional Fed banks hark back to an era when the telephone and airplane were newfangled contraptions. Regional differences in credit conditions were far greater than they are today, and timely decisions required local presence.  Recent resistance to consolidating the Federal Home Loan Bank system (not to mention eliminating needless bank branches) shows how difficult it will be to chop complexity that is no longer justified.   

Jamie himself is also a prime exemplar of Victoria's basic point, which is that complexity causes bad decisions. 

JPMorgan Chase is so complex that, with a jumble of many unrelated problems on his mind, Jamie seems to have made a long series of terrible, indefensible decisions about trading in London.  And these decisions went far beyond his irrelevantly asserted right to trust his direct subordinates.  (Harry Truman knew far better: "The buck stops here.")   

Lending to American consumers, businesses and other entities is, as best practiced, far from a simple business. Going beyond this to dabble in (or, in Jamie's case, to overwhelm) international markets will inevitably degrade the competence with which banks' basic business is conducted—thereby generating risk. 

It will result in short-sighted pursuit of momentary gratification, such as trading profits. Legislation and regulation should effectively prohibit this, protecting the deposit insurance funds and taxpayers.

It doesn't require a Ph.D. in Psychology to recognize and respond to the fact that complexity provokes decisions that violate our fundamental best interests. Recently, I asked an executive of one of our largest banks why his institution had shut down a line of consumer lending that most other banks continue to operate. 

"Those loans are too simple," he told me. "We only make good money on more complicated ones, such as mortgages and credit cards." Grist for the Pew Trusts' mill. 

The same goes for the controversy over standardization and centralization of derivatives trading. In the securities business, it's easiest to make money selling intricate and one-off products. The megabanks will go on fighting and spending to be able to continue selling this way, avoiding market transparency and hence competition in pricing. Don't let them win.

Nonetheless, Elizabeth Warren was dead wrong to suggest that the financial industry be limited to plain vanilla products that encourage apples-to-apples price comparison by customers. Such a regime would inevitably have stifled much of the innovation—PayPal, the prepaid card, electronic payments, PFM, hedge funds—that has provided increasing value to many customers. 

But vulnerable customers such as students and end-users of derivatives require protection from complexity that obstructs competition, hides conflicts of interest, and, worst of all, pushes them inexorably towards bad decisions.

Andrew Kahr is a principal in Credit Builders LLC, a financial product development company, and was the founding chief executive of First Deposit, later known as Providian.