FDR Framework Key to Global Regulators Restoring Their Credibility and Functioning Markets

Despite repeated claims to the contrary, there is little evidence that governments and their financial regulatory officials have learned the fundamental lesson of the credit crisis.

What is the fundamental lesson of the credit crisis?


According to the Congressional Oversight Panel in its January 2009 Special Report on Regulatory Reform, it is: [emphasis added]

Market participants must have useful, relevant information delivered in an appropriate, timely manner. Recent market occurrences involving off-balance-sheet entities and complex financial instruments reveal the lack of transparency resulting from the wrong information disclosed at the wrong time and in the wrong manner. Mortgage documentation suffers from a similar problem, with reams of paper thrust at borrowers at closing, far too late for any borrower to make a well-informed decision. Just as markets and financial products evolve, so too must efforts to provide understanding through genuine transparency.

What should governments do to provide genuine transparency?

In April 1933, President Franklin Roosevelt describe both what governments should do and what they should not do to provide genuine transparency.

[Although] the federal government should never be seen as endorsing or promoting a private security, there was “an obligation upon us to insist that every issue of new securities to be sold in interstate commerce be accompanied by full publicity and information and that no essentially important element attending the issue shall be concealed from the buying public.”

As markets and financial products evolve, the challenge for governments is to insure genuine transparency by adhering to the framework of what they should and should not do.  This framework is:

• Governments must make sure that useful, relevant information is made available to all market participants in an appropriate, timely manner.

• Governments must not endorse an investment.

A major cause of the credit crisis and the source of the regulators' loss of credibility was the failure of global governments to adhere to what FDR said governments should do and should not do for either structured finance securities or financial institutions.

As readers of this blog know, structured finance products disclose the wrong information at the wrong time and in the wrong manner.  Readers also know that governments failed, and still fail, in their obligation to have financial institutions disclose all useful, relevant information to market participants in an appropriate, timely manner.   

What until now has gone unsaid is that governments also failed because they effectively endorsed their banking system as an investment.

Given that prior to the credit crisis governments never explicitly said "buy" a specific institution's debt or equity, how did they endorse their banks as an investment?

The endorsement by the governments is a result of either of their roles of deposit guarantor and bank examiner.  

• In its role as a deposit guarantor, the government is at risk for losses if a bank fails.  This provides the incentive to carefully monitor each bank's performance and step in before the government would lose money on its guarantee.  

• In its role as a bank examiner, the government is positioned, much like a rating agency, to evaluate the bank, including access to data that is not available to market participants.  The bank examiners even rate the bank on a CAMELS scale [ C = capital adequacy, A = asset quality, M = management, E = earnings, L = liquidity and S = sensitivity to market risk].  The purpose of bank examination is to identify banks that are experiencing trouble and either turnaround the bank or oversee its exit.

Leading up to the credit crisis, market participants assumed that given both their superior access to information and incentive to avoid losses it was an implicit investment endorsement of a bank by the government if the bank was not going through a resolution process.

The credit crisis revealed that just like the rating services failed when it came to rating structured finance securities, governments and their bank examiners failed when it came to rating banks.

A WSJ article presented a possible reason for why banking regulators failed to properly rate the banks.

A top Bank of England official, Andy Haldane, said the new regulator will curtail the FSA's practice of dispatching dozens of examiners to banks to collect loads of granular information... Mr. Haldane noted that ... they rarely yield much useful information for regulators, who can find themselves overwhelmed by the quantity of data.

Given this acknowledgement of the shortcomings of bank examination, it is interesting to note that regulators keep trying to restore credibility in their banking systems by publishing the results of stress tests.  Each time they publish the results, they explicitly endorse an investment in their banks.  Each time they endorse an investment in their banks, they show market participants that they have not learned the lesson of the credit crisis.

George Osborne, the UK Chancellor of the Exchequer, observed in his column in the Financial Times another reason that investors are wary of regulators' endorsements of their banks:

 It is revealing that the [stress] tests conducted last July identified a capital shortfall of just €3.5bn. Yet less than six months later, Irish banks required 10 times that amount.... Europe cannot repeat the same mistake again. It is now clear the new stress tests must be much tougher.... We should look at ways of strengthening the credibility of these tests, including validation by bodies such as the International Monetary Fund.

Mr. Osborne correctly identifies the need for credibility, but he fails to understand the lesson learned in the Great Depression that governments and governmental entities should not endorse an investment.  


Touting the results of a stress tests is endorsing an investment in the banks.  Endorsing an investment in the banks puts the government and its regulators' credibility on the line.  Credibility that is easily loss should the actual performance of the banks not merit the endorsement.  


Mr. Osborne points out that the Irish banks needed ten times more capital than the previous round of stress tests suggested was needed across the European Union.  He could just as easily have discussed the difficulties that Spain is encountering given that it endorsed stress tests that showed that only a few of its banks needed to raise additional capital.  A position that is almost certainly going to come back to haunt them when more banks are going to have to raise capital under the new 'tougher' stress tests.  


Instead of putting their credibility on the line, following the FDR framework, governments should make sure that the asset-level data needed to run a stress test is made available to market participants.  Then, market participants can run the test for themselves and make investments if they are comfortable with the solvency risk of the banks.