Sunday, December 5, 2010

RBS seals the fate of bank examination model

With the Financial Services Authority (FSA) supervisory report on RBS, the final nail has been put into the coffin bearing the bank examination model.

If the credit crisis and the RBS supervisory report taught us anything, it is that the current global bank examination model like the rating agency model has failed the test of the market place.

What is the current bank examination model?  As described by Andrew Haldane of the Bank of England in a previous post, it involves global regulators sending out large numbers of examiners to look through the books of individual banks.  Only the examiners see the bank data.  Only they analyze the data.

The role of these examiners is to find threats to the solvency of an individual bank or, more broadly, to the financial system.

In some countries, like the US, the bank examiners look for compliance with a prescriptive approach to regulation in which explicit rules are set out for banks to follow.  Naturally, banks look for legal loopholes to exploit.  In other countries, like the UK, the bank examiners look for compliance with principles-based regulation.

How did the bank examination model fail with regards to RBS?

Damien Reece in the Telegraph provides a very good description.
"The review highlights the impotency of FSA-style regulation....everything that the FSA found it had to investigate RBS for was in fact happening right under its nose. This wasn't backroom stuff. A £49bn bid being forced through at a time when the term credit crunch had already become common parlance to describe the state of financial markets was a pretty obvious cause for alarm, something the media at least had widely picked up on.
So conclusion one in the FSA's 'supervisory investigation of RBS' out on Thursday should have read: 'Failure by the FSA to fulfil its own supervisory role.'
...The FSA now tells us that it is much tougher on supervision, partly thanks to the lessons learned from the RBS disaster. It is now applying its own judgements to the judgements of banks, and other regulated firms. But this is not a recipe for success. It merely creates a system where the ill educated and ill equipped FSA official is second-guessing management teams who, if so inclined, could run rings around a regulator.
...The FSA also now approves all significant appointments at a bank. Somehow I doubt they would have turned down the perfectly plausible Fred Goodwin if he had sought such approval. Thursday's report closes the final chapter on an awful corporate event and merely seals the FSA's inevitable fate."
The global bank examination model also has a history of failing to uncover large bank solvency problems related to credit, particularly real estate loans.  Even after the credit crisis and the bursting of the real estate bubble, the global bank examination model has not proven that it can identify an insolvent large bank.

A few months ago, the European financial regulators ran a stress test to identify banks that might not be adequately capitalized.  Several banks in Ireland passed this test.  Oops.  In the last two weeks it turns out these Irish banks needed a multi-billion euro bailout.

As Ken Rogoff, the former chief economist at the International Monetary Fund, said in a Bloomberg interview,
"the bank stress tests carried out in Europe in July were 'really scary' and 'pathetic.'

'We were told everybody is fine, there is nothing to worry about,'... 'now their credibility is less than ever.'”
The performance by the regulators on the stress test shows that there is no basis for the argument that regulators have learned from and will not repeat the mistakes that resulted in the credit crisis.

This is also true in the US.  US regulators like to routinely say how successful their stress tests were.  Actually, when the results of the stress tests were announced, it was the government's pledge to put in as much capital as it took to keep the banks solvent that calmed the markets.

If the global bank examination model does not work and can no longer be relied on, what will replace it?

As readers of this blog know, I think we need to rely on Supreme Court Justice Louis Brandeis advice and let the bank data see the light of day.  Andrew Haldane at the BoE has indicated that they are moving towards having banks disclose much more data to the market.

The question is will the data disclosure requirements be sufficient so that the market can identify solvency issues with an individual bank, so that market participants can perform their own stress tests, and so that competitors will be comfortable once again transacting with their peers without any government guarantees or subsidies?

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