When the world’s financial clearinghouse says the world’s banking system has gotten too complicated, then something is wrong.

But that is exactly what the Bank of International Settlements said today in its 250-page annual report/credit crisis autopsy report:

The truth is that as financial institutions grow more complex, the demands on risk management grow much more quickly. A large, integrated financial institution today has hundreds of subsidiaries, all operating quasi-independently; it is impossible for any individual to understand what all the parts of such an organisation are doing, much less how they will interact in response to a major event. Enterprise-wide risk management would seem to be an impossibility in such cases. Moreover, some banks are not only too big to fail but, in having important relationships with a large number of other institutions, are also too interconnected to fail. Officials must insist that institutions be comprehensible both to those who run them and to those who regulate and supervise them. And, in the future, a financial firm that is too big or too interconnected to fail must be too big to exist.

BIS’s solution may not be appealing to this nation’s largest banks (and the regulatory agencies that support them):

In summary, as officials look forward they need to balance stability with efficiency. Reducing moral hazard, keeping institutions simple and small, and reducing their international reach will all come at the expense of economies of scale and scope. In the end, a safer and more stable financial system may very well be a less efficient one. Hence it is critical that policymakers work to build a system that is as efficient as possible for the maximum tolerable level of risk they choose.

Then, BIS takes a mighty swing at US regulators and their policy of preventing the nation’s largest banks from failing. Bernanke’s not going to like this one:

In summary, financial regulators, fiscal authorities and central bankers face enormous risks. To avoid deepening and prolonging the crisis, they need to act quickly and guard against policies that hinder adjustment or create additional distortions in financial flows. Governments will be tempted to subsidise
industries that need to contract – but losers need to be allowed to lose. They will be tempted to encourage banks to lend to those who should borrow less – but it is not possible to deleverage by borrowing. And they will be tempted to turn a blind eye to insolvent institutions, allowing them to continue operating – but as hard experience teaches, zombie banks must be closed or returned to health as quickly as possible. In all of these cases, governments must realize that, by insisting on speedy resolutions despite political controversy, they are acting in the best interests of the public.

I couldn’t agree more.

In my next blog, I’ll analyze BIS’s formula for containing financial risk. You can find the full BIS annual report here.