Thursday, February 17, 2011

Current Asset-Level Disclosure Succeeds Where Capital and Liquidity Standards Fail

Why have efforts to significantly increase bank capital and liquidity standards failed?  Because they are easily undermined by the 'least common denominator problem'.

What is the least common denominator problem?

In the world of large, global financial institutions, the least common denominator is that regulator with the easiest compliance standards.

For example, take capital at banks.  At the beginning of the credit crisis, Tim Geithner frequently commented on the need for the G-20 regulators to maintain a united front and require banks to hold much more capital.  Next month, Tim is going to set the lowest  capital standard among the global regulators.

How is he going to do this?  Currently, the Fed and the Treasury are stress testing the 19 Too Big to Fail banks.  At the end of the stress test, those banks that pass will be allowed to pay dividends because they are deemed to be adequately capitalized.  The bank with the lowest capital ratio that is deemed to be adequately capitalized sets the global standard.

None of the banks would pass if Tim were adopting the Swiss capital standards.  The Swiss capital standards are essentially the capital standards proposed in Basel III multiplied by 2.

Few of the banks would pass if Tim were adopting the Spanish capital standards.  The Spanish capital standards are essentially a ratio of 8% equity to assets.

How are Tim's easiest capital standards transmitted around the world?

Financial institutions are very good at pointing out that they would be at a competitive disadvantage if they were subjected to higher standards.  They simply have to lobby for a "Level Playing Field".

What they get in return for a level playing field is a race to the bottom in standards.

Long time readers of this blog know that your humble blogger has been pushing for disclosure of current asset-level data.  One of the reasons for this is that disclosure of current asset-level data is immune to the level playing field argument and the race to the bottom.

In fact, if one regulator embraced disclosure of current asset-level data it would create a race to the top as it would become the global standard!!!

Why would there be a global race to adopt current asset-level data?

It is only with disclosure of current asset-level data that the market can determine which banks are solvent and which are not.  As used here, solvent means that the market value of the bank's assets exceeds the bank's liabilities.

Obviously, if a bank discloses its current asset-level data and the market determines that it is solvent, it is also adequately capitalized.  It is also at a competitive advantage over its peers who do not disclose current asset-level data, because it is perceived as less risky.

In the absence of disclosure of current asset-level data, market participants will always question whether a bank is solvent or not.

So long as there are questions about whether a bank is solvent, there will also always be the companion problem of liquidity because of the potential for a 'run' on the bank.  Please recall that runs on a bank occur because of the "perception" of insolvency.  In the absence of current asset-level data, there is no actual information to disprove this perception.

Finally, unlike higher capital ratios or forcing banks to hold more liquid assets, current asset-level disclosure does not interfere in the ability of a bank to generate credit for the economy so long as the pricing of the credit properly reflects the risk of the credit.

No comments: