Obama Embraces 21st Century Regulatory System

On January 18, 2011, the Wall Street Journal published a column by President Barack Obama highlighting his commitment to having the US adopt and implement a 21st century regulatory system.

The test of the Obama Administration's commitment to this goal is whether it brings the financial regulatory system created by FDR in the 1930s into the 21st century by utilizing information technology and making available to market participants the current asset-level data for all financial institutions.

As President Obama said:

For two centuries, America's free market has not only been the source of dazzling ideas and path-breaking products, it has also been the greatest force for prosperity the world has ever known. That vibrant entrepreneurialism is the key to our continued global leadership and the success of our people.

But throughout our history, one of the reasons the free market has worked is that we have sought the proper balance. We have preserved freedom of commerce while applying those rules and regulations necessary to protect the public against threats to our health and safety and to safeguard people and businesses from abuse.

From child labor laws to the Clean Air Act to our most recent strictures against hidden fees and penalties by credit card companies, we have, from time to time, embraced common sense rules of the road that strengthen our country without unduly interfering with the pursuit of progress and the growth of our economy. 

Sometimes, those rules have gotten out of balance, placing unreasonable burdens on business—burdens that have stifled innovation and have had a chilling effect on growth and jobs. At other times, we have failed to meet our basic responsibility to protect the public interest, leading to disastrous consequences. Such was the case in the run-up to the financial crisis from which we are still recovering. There, a lack of proper oversight and transparency nearly led to the collapse of the financial markets and a full-scale Depression.

Created in the 1930s, the FDR Framework provides the common sense rules that served our financial markets well for over 70 years.  Updating how these common sense rules are enforced is the key for correcting the lack of proper oversight and transparency in finance that saw the financial markets freeze and almost tipped the global economy into a full-scale Depression.

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

[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.”

In simple terms, the FDR 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 was the failure of global governments to adhere to what FDR said governments should do and should not do with regards to genuine transparency for either structured finance securities or financial institutions.

Over the past two years, the goal of my administration has been to strike the right balance. And today, I am signing an executive order that makes clear that this is the operating principle of our government.

This order requires that federal agencies ensure that regulations protect our safety, health and environment while promoting economic growth. And it orders a government-wide review of the rules already on the books to remove outdated regulations that stifle job creation and make our economy less competitive. It's a review that will help bring order to regulations that have become a patchwork of overlapping rules, the result of tinkering by administrations and legislators of both parties and the influence of special interests in Washington over decades.

As technology, markets and financial products evolve, the challenge for governments is to insure genuine transparency for all investments, including investments in financial institutions.  A major source of overlapping rules, outdated regulations and failure to provide adequate oversight in finance was the result of the government's failure to use technology as markets and financial products evolved.  

One of the problems that FDR faced when he took office was the high frequency of bank runs across the US.  The question was how to stop these runs and the harm they caused the local economy in which they occurred.

As discussed in an earlier post, bank runs result from a change in belief about the soundness of a bank.  Since depositors cannot see how the assets that the bank invests in are performing, they have to trust that any losses will not cause the depositor to lose any of their money.  For whatever reason this trust is lost, it is in the depositor's best interest to run to the bank and withdraw all their money.

FDR addressed stopping bank runs in multiple ways.  First, he guaranteed deposits below a certain amount.  For many individual depositors, this meant that the government protected all of their deposits.  This eliminated their need to worry about the soundness of the bank.  Second, he closed a number of banks and effectively said that the remaining banks were sound.  Third, he created a regulatory infrastructure with the power to examine banks and to takeover failing banks.

How does FDR's solution for the banking system reflect the FDR framework and the rule that investors should be provided with useful, relevant information in an appropriate, timely manner.

In the 1930s, it was impractical to make current asset-level data available to depositors and investors.  As a result, under FDR's solution for the banking system, the deposit guarantee put the US into the position of representing all investors.  The regulatory infrastructure provided the authority for regulators to access what they determined was useful, relevant information in an appropriate, timely manner.  This included having bank examiners on site at a financial institution receiving current asset-level information.

There were two potential problems with the government representing investors and depositors.

First, it puts a burden on regulators to keep pace with the evolution of the banking system.  Specifically, as the banking system evolves, regulators have to understand what is useful, relevant information and when the information must be received in order for it to be timely for each financial innovation and product in the banking sector.

Second, it puts a burden on regulators to be able to use the information.  


A WSJ article presented a possible reason for why banking examination and the financial regulatory system failed at the beginning of the credit crisis:

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.

Mr. Haldane identified the flaw in the implementation of the 20th century bank oversight model.  He also understood that solution was to have financial institutions disclose granular asset-level information to the markets.

There are a number of market participants, including competitors, who are able to and have an incentive to analyze all of the individual asset level data that financial institutions could provide and turn it into useful information.

Please re-read that paragraph as it is the key to 21st century oversight of banks.  

Since the markets can and have an incentive to turn the disclosed asset-level data into useful information, the markets are able to bring discipline to the financial system that the regulators with their resources cannot.

For the US to update the financial regulatory system created by FDR in the 1930s to a 21st century regulatory system requires using 21st century information technology.  

Specifically it means applying observable event based asset-level performance reporting not just to the loans and receivables underlying structured finance securities, but across the entire asset side of bank balance sheets.  

What is observable event based asset-level performance reporting?  For each individual loan or receivable on the bank balance sheet, it is simply whenever there is a payment, a delinquency, a default, an insolvency filing by the borrower or similar event, it is reported on a borrower privacy protected basis to the market on the day that it occurs.

Observable event based asset-level performance data is the current information markets need to analyze and assess the risk of each individual bank.  It is the current information markets need to bring discipline to the financial system.

There are no technological hurdles that prevent making this data available.  There are no technological hurdles that prevent the market from using this data.  

Where necessary, we won't shy away from addressing obvious gaps: new safety rules for infant formula; procedures to stop preventable infections in hospitals; efforts to target chronic violators of workplace safety laws. But we are also making it our mission to root out regulations that conflict, that are not worth the cost, or that are just plain dumb.

For instance, the FDA has long considered saccharin, the artificial sweetener, safe for people to consume. Yet for years, the EPA made companies treat saccharin like other dangerous chemicals. Well, if it goes in your coffee, it is not hazardous waste. The EPA wisely eliminated this rule last month. 

But creating a 21st-century regulatory system is about more than which rules to add and which rules to subtract. As the executive order I am signing makes clear, we are seeking more affordable, less intrusive means to achieve the same ends—giving careful consideration to benefits and costs.

Andrew Haldane put a value on asset-level transparency for both financial institutions and the products they produce.

As discussed on NakedCapitalism,

In a March 2010 paper, he compared the banking industry to the auto industry, in that they both produced pollutants: for cars, exhaust fumes; for bank, systemic risk. While economists were claiming that the losses to the US government on various rescues would be $100 billion ([Yves Smith] ahem, must have left out Freddie and Fannie in that tally), it ignores the broader costs (unemployment, business failures, reduced government services, particularly at the state and municipal level). His calculation of the world wide costs:

….these losses are multiples of the static costs, lying anywhere between one and five times annual GDP. Put in money terms, that is an output loss equivalent to between $60 trillion and $200 trillion for the world economy and between £1.8 trillion and £7.4 trillion for the UK. 

Yves Smith then goes on to relate the cost of systemic risk to transparency.

... opacity, leverage, and moral hazard are not accidental byproducts of otherwise salutary innovations; they are the direct intent of the [financial firms'] innovations. No one at the major capital markets firms was celebrated for creating markets to connect borrowers and savers transparently and with low risk. After all, efficient markets produce minimal profits. They were instead rewarded for making sure no one, the regulators, the press, the community at large, could see and understand what they were doing.

Clearly the financial industry will balk at the cost of providing depositors and investors access to all useful, relevant asset-level information in an appropriate, timely manner.  However, this cost is orders of magnitude less than the cost of not having transparency quantified by Andrew Haldane.  As a result, there is no legitimate reason remaining for governments not to require asset-level data for both financial institutions and the products they produce.

This means writing rules with more input from experts, businesses and ordinary citizens.

As an expert in disclosure, I have designed, developed and patented a low-cost information system for  disclosing borrower privacy protected asset-level data on an observable event basis to all market participants.  I look forward to talking with you and your administration.  You can reach me at (781) 453-0638.

It means using disclosure as a tool to inform consumers of their choices, rather than restricting those choices. And it means making sure the government does more of its work online, just like companies are doing.

With current asset-level data available for each financial institution online, bank examination can now be done online.  For example, with each individual financial institution's asset-level data available to all market participants, no longer will bank examiners have to just ask the management of the institution they are concerned about to explain their balance sheet risks.  Now they can turn to credit and equity market analysts and analysts at other financial institutions for answers to their questions.

We're also getting rid of absurd and unnecessary paperwork requirements that waste time and money. We're looking at the system as a whole to make sure we avoid excessive, inconsistent and redundant regulation. And finally, today I am directing federal agencies to do more to account for—and reduce—the burdens regulations may place on small businesses. Small firms drive growth and create most new jobs in this country. We need to make sure nothing stands in their way.

Providing current asset-level data on an observable event basis can also significantly reduce the reporting burden on financial institutions.  A significant percentage of the existing reports and almost all the special requests for additional information by the various regulatory agencies can be eliminated.

One important example of this overall approach is the fuel-economy standards for cars and trucks. When I took office, the country faced years of litigation and confusion because of conflicting rules set by Congress, federal regulators and states.

The EPA and the Department of Transportation worked with auto makers, labor unions, states like California, and environmental advocates this past spring to turn a tangle of rules into one aggressive new standard. It was a victory for car companies that wanted regulatory certainty; for consumers who will pay less at the pump; for our security, as we save 1.8 billion barrels of oil; and for the environment as we reduce pollution. Another example: Tomorrow the FDA will lay out a new effort to improve the process for approving medical devices, to keep patients safer while getting innovative and life-saving products to market faster.

Despite a lot of heated rhetoric, our efforts over the past two years to modernize our regulations have led to smarter—and in some cases tougher—rules to protect our health, safety and environment. Yet according to current estimates of their economic impact, the benefits of these regulations exceed their costs by billions of dollars.

The cost of providing current asset-level data on an observable event basis is not a hurdle.  Particularly when this cost is compared to the trillions of dollars of losses that the global financial system suffered in the credit crisis because market participants did not have this data and could not properly assess risk.

This is the lesson of our history: Our economy is not a zero-sum game. Regulations do have costs; often, as a country, we have to make tough decisions about whether those costs are necessary. But what is clear is that we can strike the right balance. We can make our economy stronger and more competitive, while meeting our fundamental responsibilities to one another.

What has prevented current asset-level data on an observable event basis for each financial institution from being made available until now is the Obama administration and the regulators have not championed moving to a 21st century approach.  

Since striking the right balance in oversight and transparency is now an operating principle of our government, I am confident that the administration and the regulators will champion the 21st century approach.

This approach eliminates reliance on only regulators to detect problems at and curb the risks of a single institution.  This approach eliminates reliance on only regulators to identify systemic problems.  

This approach instead allows the regulators to harness the resources of the market, including ironically, the ability of each financial institution to evaluate its peers.  This approach allows market participants to perform their own analysis on each financial institution and not have to rely on the government and its bank examiners.