Ireland's fifth bailout - Trust, but Verify

The Irish government and its EU/IMF partners have gone to great lengths in analyzing the loan portfolios and stress testing the Irish banks.  They have hired numerous high priced consultants (including BlackRock, Boston Consulting and accountants) to add credibility to their findings.  Finally, they have announced that their banks need another 24 billion euros of capital.

What will investors think of these findings?

The FDR Framework would suggest that investors will initially trust this figure, but they will want to verify it for themselves.

If the Irish government wants to retain the trust of the market participants, it will immediately adopt the FDR Framework and announce that it will make current asset and liability-level data available on the banks.

This is the data that the market needs to independently verify the results.  This is the data that the market needs to retain trust in the Irish banking system.

If the Irish government does not adopt the FDR Framework, it is the equivalent of raising a giant red flag and saying "do not trust the results."

Without this data, market participants are left to wonder if BlackRock plugged in the result that the Irish government could fund through the existing EU/IMF bailout facility and backed into the loss estimates.

For the fifth time, the Irish government is asserting that its estimate of losses is conservative.  Are they?  It is only with access to each bank's current asset and liability-level data that investors can answer that question for themselves.

The FDR Framework passes the test of our times

Alan Greenspan wrote a column for the Financial Times in which he observed that the Dodd-Frank Act was based on the assumption that

... much of what occurred in the market place leading up to the Lehman Brothers bankruptcy was excess (hardly controversial) and that its causes would be readily addressed by this wide-ranging statute (questionable).

The act requires regulators to create a couple of hundred detailed regulations.  The potential problem with this he observes is that

... the regulators are being entrusted with forecasting, and presumably preventing, all undesirable repercussions that might happen to a market when its regulatory conditions are
importantly altered. No one has such skills. 

This is why this blog has urged regulators to adopt the FDR Framework.  Adopting the FDR Framework first simplifies the task and provides regulators with guidance as they create the new detailed regulations under the Dodd-Frank Act.

Mr. Greenspan then goes on to confuse opacity with the Adam Smith's "invisible hand".

... The problem is that regulators, and for that matter everyone else, can never get more than a glimpse at the internal workings of the simplest of modern financial systems. Today’s competitive markets, whether we seek to recognise it or not, are driven by an international version of Adam Smith’s “invisible hand” that is unredeemably opaque. With notably rare exceptions (2008, for example), the global “invisible hand” has created relatively stable exchange rates, interest rates, prices, and wage rates. 

In the most regulated financial markets, the overwhelming set of interactions is never visible. This is the reason that interpretation of contemporaneous financial market behaviour is subject to so wide a variety of “explanations”, especially in contrast to the physical sciences where cause and effect is much more soundly grounded. 

Under the FDR Framework, visibility into the overwhelming set of interactions is not necessary.

What market participants require is visibility and access to all the useful, relevant information in an appropriate, timely manner when they consider an investment.  It is the responsibility of the market participant to do their homework on this information as they know that it is buyer beware when they make an investment.

Mr. Greenspan then goes on to argue that financial complexity was a contributor to today's standard of living and productivity.

Is the answer to complex modern-day finance that we return to the simpler banking practices of a half century ago? That may not be possible if we wish to maintain today’s levels of productivity and standards of living. During the postwar years, the degree of financial complexity has appeared to grow with the rising division of labour, globalisation, and the level of technology. 

...The vexing question confronting regulators is whether this rising share of finance has been a necessary condition of growth in the past half century, or coincidence. 

In moving forward with regulatory repair, we may have to address the as yet unproved tie between the degree of financial complexity and higher standards of living.

The answer is that we must return to the principles on which our capital markets were based over a half century ago.  These principles, which are reflected in the FDR Framework, combine a philosophy of disclosure and the practice of caveat emptor (buyer beware).

Where complexity exists in financial products, it is the regulators' responsibility to make sure that this complexity does not create opacity with regards to all the useful, relevant information.

Where opacity exists in looking at a financial institution's current asset and liability-level exposures, it is the regulators' responsibility to make sure that this opacity is eliminated and that all useful, relevant information is made available to all market participants.

The FDR Framework and Disclosure of Discount Window Borrowing: Part II

A Bloomberg article explains how the Fed has traditionally acted as a gatekeeper of useful, relevant information on the financial institutions it regulates and is being dragged kicking and screaming to disclose this data.

For most of its 98-year history, the Federal Reserve has operated with all the transparency and enthusiasm for change of the Vatican. Now the ultra-secretive Fed is starting to change its ways, if somewhat grudgingly. Some of the new openness, such as Chairman Ben S. Bernanke’s plan for quarterly press briefings, is the central bank’s idea. Much of it comes under duress. 

Today, the Fed is set to disclose which banks borrowed from its discount window during the darkest moments of the 2008-09 financial crisis... Still, the Fed won’t disclose the collateral it accepted, which would reveal the risks it took.

Please note that disclosure of discount window borrowings does not negatively impact the central bank's role as lender of last resort.  As was pointed out in an earlier post on the FDR Framework and disclosure of discount window borrowing:

if the market was provided all the current asset and liability-level data under the FDR Framework, it would know which banks were borrowing at the discount window because they were insolvent waiting to be resolved and which banks were borrowing at the discount window that were solvent and had a temporary funding issue.

One of the features of the FDR Framework is that it shows exactly what collateral a central bank lends against.  As Walter Bagehot recommended a century ago, central banks are suppose to only lend against good collateral.  With disclosure under the FDR Framework, the market can see if this is true or not.

The article then makes the case for disclosure.

... Given the prominent role the world’s biggest banks played in causing financial losses worldwide, largely because of what investors didn’t know or didn’t understand, some say the loans should be made public at once, ... Only then, the reasoning goes, would investors and counterparties of a Fed borrower be able to manage their own risks. “The free-market system only works if it’s fully informed,” says Lynn E. Turner, who battled the Fed over disclosure issues while serving as the Securities and Exchange Commission’s chief accountant from 1998 to 2001. “There’s a lot of similarity between the Fed and an SUV with blacked-out windows.”

The article continues by laying out the Fed's justification for not disclosing information.

The Fed says such calls threaten its core function: preserving market confidence by acting as a lender of last resort. Publicizing the names of discount-window borrowers could spark bank runs or discourage sick banks from seeking help until they are fatally compromised. “The full monty may not be a good thing,” says Frederic Mishkin, a former Fed governor. 

For the Fed, keeping information from investors is nothing new... 

The discount window is the Fed’s oldest lending channel and traditionally its most secretive. Banks have been free to use it without publicly revealing the fact since the Fed’s 1913 birth... 

Some former Fed insiders say the public should routinely be clued in when private institutions tap the public purse, in the same way the SEC requires companies to inform investors of major financial events. “This should be material information. Investors should have the right to know,” says Roberto Perli, a former Fed board economist who is managing director of International Strategy & Investment in Washington.

Banks traditionally have been reluctant to use the window, fearing that savvy investors could tell by following clues in Fed loan data and market activity...

This justification is fundamentally wrong.

• Market confidence is undermined when the market does not know what is happening.  As the article points out, how are counterparties suppose to manage their own risk?

• As pointed out above, disclosure does not interfere with the Fed's lender of last resort role.  What would interfere is if the borrower runs out of good collateral to pledge.

• As pointed out in numerous posts on this site (see here for a list), disclosing current asset and liability-level data like discount window borrowing actually prevents bank runs.  With all the useful, relevant information disclosed, market participants can distinguish between solvent and insolvent discount window borrowers.  The Fed's current policy contributes to financial market instability and sparks bank runs.  In the absence of information, when rumor leaks out that a bank is borrowing at the discount window, depositors and investors have an incentive to engage on a run on the bank to get their money back because they do not know if the borrowing was a sign of insolvency or not. 

• The reluctance to borrow from the Fed's discount window will disappear with disclosure of current asset and liability-level data.  Since the markets are able to distinguish between solvent and insolvent borrowers, there is no longer a need for a bank to be reluctant to be seen borrowing at the discount window.

Update

The market analysts have quickly reviewed the Fed loan data and low and behold it turns out that the Fed violated Bagehot's recommendation.  It appears that the Fed lent against securities that the rating services rated "D", as in defaulted.  

As a result of its gamble, the Fed claims it did not lose any money on the loans tied to these securities.  However, have the banks that provided these securities realized all the losses produced by these securities?

The FDR Framework and Credit Ratings

The search for an alternative to the credit rating services has begun.

In the US, the Dodd-Frank Act requires that regulators figure out how to remove references to the rating agencies from all regulations.

In the UK, the Bank of England recently published a paper discussing how difficult this task will be to accomplish.  According to an article in the Telegraph,

The agencies, which rank the risks attached to lending to an institution or country, have been attacked for failing to fully realise the dangers emerging ahead of the meltdown, particularly around complex financial products. 

... Nonetheless, the agencies are still built into the financial system through the use of their ratings in regulation, investment processes and financial contracts, Bank staff and academics reported. 

"The hardwiring of ratings is now so pervasive that market participants could not ignore them even if they did not consider them reliable," their report warned. 

However, its authors said abolishing the agencies "is not an option. Other gatekeepers would emerge to fill the void with their own ratings-like research and advice." 

To reduce the reliance on ratings, the paper said one option might be a dual approach, with regulators and fund managers considering an internal risk assessment from the borrower in question as well as its agency rating. 

The report also looked at whether rating agencies could return to the model in which investors pay for their information, rather than current set-up which sees borrowers pay to be rated. 

The agencies, who could see their revenues hit by investors "free-riding" and not bothering to pay for the data, argue that moving to an "investor pays" model would create a privileged group with access to crucial information. However, the problems may not be insurmountable, the Bank report said. 

A third option – that a government pays for the credit rating system by creating a single public agency, was dismissed as "fraught with difficulty". This set-up could imply that the state would assume responsibility for any negative consequences of its rating decisions, creating moral hazard, the report said. 

The report fails to consider the FDR Framework solution.  Under the FDR Framework, all the useful, relevant information is made available to market participants in an appropriate, timely manner.  There are not suppose to be any gatekeepers, like rating agencies or regulators, to this information.

What does this mean for the rating agencies?  It is the end of their informational monopoly.

What does this mean for investors?  Under the FDR Framework, investors are responsible for doing their homework as they know that it is buyer beware when making an investment decision.

Under the FDR Framework, investors have the option of dual tracking:  doing their homework plus looking at an independent analysis/rating.

The question is what is the value of a rating if the investor has the same information and can do the analysis for himself?  The answer is the value that the investor assigns to it.

It is a feature, not a bug, of providing all the useful, relevant information that many analytical firms will emerge to offer their own ratings-like research and advice in the hopes of being paid by the investors for this research and advice.  Nobody complains about this model for equities.

At the same time, firms will continue to pay Moody's, S&P and Fitch to produce their ratings for investors who do not want to pay.

Finally, by restricting itself to assuring access to all the useful, relevant information in an appropriate, timely manner, governments avoid any potential moral hazards associated with ratings.

The FDR Framework and Disclosure of Discount Window Borrowing

If financial institutions in the US were required to disclose current asset and liability-level data under the FDR Framework, the Federal Reserve would not have to worry about disclosing discount window borrowings.

If the market had current asset and liability-level data, it would know which banks were solvent and which were insolvent.

Since the market would know the solvency status of each financial institution, it would be easily able to tell which banks were borrowing from the discount window on a temporary basis and which were borrowing while waiting for regulators to resolve them.

Irish bank's fifth bailout suggests its time to implement FDR Framework (updated)

Ireland is approaching the conclusion of its bank stress tests and preparing for its fifth round of bank bailouts.  In preparation for the bailout, the Irish government hired BlackRock to value the loans at several of the banks.  As a result of this evaluation and the stress tests, the mainstream media is reporting that additional capital injections of 25 billion euros will be identified.

This is the fifth time that the Irish government, either by itself or using high priced third parties, has examined the balance sheets of the banks, claimed to identify and value the troubled assets, and injected capital into the banking system.

Beyond hoping, why should anyone believe that this time they got it right?  More importantly, why should the Irish government keep pursuing this strategy when one of the fundamentals of the financial markets is to Trust, but Verify?

Before the results are officially released, there are several market participants who are already on record as saying that twice this amount of capital is needed (see this post and this Independent article).  In addition, because of financial constraints under the IMF-EU Bailout, it looks like the need for 25 billion euros of capital reflects the constraint of available capital under the bailout and not the true condition of the financial institutions.

Arguing that there were experts involved does not improve the believability that this time the Irish government got it right.  To date, the Irish government has hired and paid for high priced experts and what there is to show for it is an ongoing run on both the Irish banking system and its sovereign debt.  

This ongoing run is occurring despite an unaffordable guarantee of the unsecured and senior bank debt holders, two rounds of bad loan purchases by NAMA, one round of stress tests and now compromised loan valuations combined with stress tests.

This blog has long maintained that the simple, low cost solution for restoring confidence in the Irish financial sector and stopping the bank run is for the Irish government to adopt and implement the FDR Framework.  With the current asset and liability level data disclosed under the FDR Framework, market participants will be able to analyze the data and prove to themselves the adequacy of the 25 billion euro capital injection.

If the Irish government believes that 25 billion euros is really the last capital injection necessary, they will also announce adoption of the FDR Framework.  Adopting the FDR Framework would be the equivalent of saying we are confident in our analysis and here is the underlying loan level data to prove it.

Update


According to a Bloomberg article, the Irish government is going to adopt the Spanish government's strategy for recapitalizing the banks:  tell the banks to raise the money from private investors and leave open whether the government is going to recapitalize or unwind the bank.

As this blog has pointed out, the only way that investors are going to invest in these banks is if they can see and analyze the current loan-level data so they can determine for themselves the riskiness of the investment.

There are two ways to provide this data:  the opaque way favored by Wall Street where only a few select investors get to see the data or the transparent way favored by the FDR Framework where all market participants get to see the data.

This blog has repeatedly pointed out that the opaque way favored by Wall Street is designed to favor Wall Street.  By contrast, the transparent way favored by the FDR Framework is designed to favor all market participants including, in this case, the banks that would like to issue capital.

Update II


According to a Wall Street Journal article,

"So far, every time we thought that we had reached the bottom a new piece of bad news has come along and demoralized people," Richard Bruton, Ireland's economy minister, said in an interview Wednesday with German newspaper Handelsblatt. "We need an honest assessment at last, and one that is based on international best practice."

Perhaps, as this posting suggests, the problem with international best practice is that it relies on "Trust Us" and fails to recognize that market participants also want to be able to "Verify" for themselves.

... If the stress tests manage to squelch doubts about the viability of the country's banking sector, that could translate into lower borrowing costs for both the banks and the Irish government. That, in turn, would help ease the burden of Ireland's huge debt load, a major drag on the country's battered economy. 

In an effort to promote the stress tests' credibility, Irish officials have been touting the fact that the tests have been conducted in part by outside advisers from BlackRock Inc. They also have been lobbying the European Union, International Monetary Fund and European Central Bank to issue statements Thursday validating the tests' outcome, according to people familiar with the matter. 

A sure way to discredit the stress tests is to hold up these visibly conflicted third parties as saying that the outcome of the stress tests are valid.

Ireland's crisis arose from of an epic property-lending binge that propelled Ireland's economy for years. When real-estate prices started tumbling, it wrecked the banking sector.
Repeated banking bailouts have pushed Ireland to the brink of insolvency. 

Last December, unable to borrow money on the public markets, the debt-laden country accepted a €67.5 billion international rescue package.the banks. But the existence of those funds failed to dispel investor fears about the sector's health. 

Actually, raising these funds confirmed that the Irish government did not have its arms around the situation despite four previous efforts at restoring confidence.

Investors are worried that the banks are sitting on potentially major losses on residential mortgages. Those portfolios will be a focal point of the stress tests, according to officials at the central bank. 

So far, losses on home loans have been modest compared with the industry's more than €70 billion in write-downs on commercial real estate. 

But more borrowers have been falling behind on their home loans. As of Dec. 31, about 5.7% of residential mortgages were at least 90 days past due, up from 3.6% a year earlier, according to Ireland's central bank.

Ultimately, the Irish government will adopt the FDR Framework solution and provide the banks' current asset level data to the markets.  Without doing this, it will continue to struggle with restoring confidence in the banking sector and its sovereign debt.

The FDR Framework Eliminates Reliance on Only Regulators as Risk Managers

Richard Bookstaber is a veteran financial institution risk manager and senior governmental advisor.  To the best of your humble blogger's knowledge, the two of us have never spoken.  What is remarkable is how in his interview with Fortune and posts on his blog is how he presents the problem that the FDR Framework is uniquely designed to solve.

In his Fortune interview, he observed

Start by looking at the huge structure that exists in finance and ask: What is that about? 

First, the main function of finance and Wall Street generally is to provide capital. Now, the people who provide capital will do it more willingly if they have the liquidity to get out of their obligations by selling to other people. So you add the markets for trading to provide that liquidity. 

Go one step further. When people buy and sell securities they are taking on risk. So to address that, Wall Street offers instruments to help with hedging and risk management. You end up with derivatives and the like. 

All of that is reasonable. But the next step is where things start to get into trouble. Those in finance start to realize that it's hard to make money in a competitive market. They look for ways to get an edge. And to do that, they try to create informational asymmetries and institutional barriers.

Yves Smith at NakedCapitalism frames the creation of informational asymmetries and institutional barriers as

But opacity, leverage, and moral hazard are not accidental byproducts of otherwise salutary innovations; they are the direct intent of the 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.

The FDR Framework is built on the foundation of disclosure and caveat emptor (buyer beware).  It is the responsibility of government to ensure that all market participants have access to all the useful, relevant information in an appropriate, timely manner.

If the government performs its responsibilities, informational asymmetries are minimized.

Mr. Bookstaber then discusses risk management in his interview

The first step in risk management is getting the data. You can't manage what you can't measure. Step two is to create a process for analyzing that data and, as issues occur, learn from those issues to refine that process.

This quote parallels the basis for our financial markets under the FDR Framework.  The first step is to get the data. You shouldn't invest in what you can't analyze.  Step two is to analyze the data.  This is the responsibility of the investor under buyer beware.  This analysis is done both before investing and while an investor in a security.

Mr. Bookstaber then discusses why it is so difficult to develop rules for Wall Street and what can be done to improve the effectiveness of regulation.

If you find a valve in a nuclear power plant that isn't working right and replace it, the valve is not going to try to fool you into thinking it's on when it's really off. In the market, traders will try to fool you. In other words, there's a realm of feedback and gaming that can occur in the financial markets that doesn't occur in an engineering system. That makes developing rules much more difficult for Wall Street than for safety in engineering. 

When you observe the market, the very fact that you are observing it as a regulator almost guarantees that the people in the market will react as a military adversary and develop the best defense against it. They will try to find ways around it. And, as I said in my testimony before Congress, derivatives are the weapon of choice for gaming the system. 

The key point is that, whether rule- or principle-based, rather than looking at the regulation itself, it's more important to look at the system and understand in what way the system is structured that makes it difficult to regulate. 

And that gets back to themes in my book about complexity and tight coupling. 

If you make the system more transparent and simple then regulators have a chance to observe what's occurring and the time required to respond accordingly. That makes the regulation more effective.

The FDR Framework is focused on maximizing the transparency of the system.  It has the added benefit that this transparency lets the market exert discipline before the regulators are required to step in.

Finally, Mr. Bookstaber observes how hard it is to get someone to be responsible for reducing risk and verifying that it is done.

That is an issue of governance. When I was in charge of risk management at Salomon Brothers, the big issue wasn't so much finding the outsized risk as it was making sure that somebody took responsibility for reducing it and then verifying that it was done. 

The last two steps are the most difficult. Nobody wants to take the step of doing something about an outsized risk because that's costly. Taking off a trade that you think will work has both transaction and opportunity costs. So it's tough for a regulator to step in and say cut that out so the risk doesn't slam the economy. The CEO may say, "I can't believe you increased our financing cost or made us reduce our exposure. Because of you, we had to walk away from revenue!" The regulators are caught in a counter-factual argument. If they do their job and as a result the potential crisis doesn't happen, then it looks like all they did was to unnecessarily tamp down profit opportunities. 

One of the key features of the FDR Framework is that it makes someone in addition to the regulators responsible for reducing risk and verifying that it is done.

As has been discussed previously on this blog, under the FDR Framework, financial institutions would be required to disclose their current asset and liability level data.  With access to this data, market participants, including investors and competitors, could analyze the risk of the firm.

With the result of their analysis, market participants could adjust both their exposure and the cost of this exposure based on the risk of the financial institution.  Financial firms with higher risk could expect to find that their cost of funds increases and their access to funds decreases.  Financial firms with lower risk could expect to find that their cost of funds decreases and their access to funds increases.

Who is responsible for managing risk at a financial institution?  Management.  They have to select the risk profile that optimizes their cost of and access to funds.

Who is responsible for verifying risk is addressed?  The market participants.  They have a strong incentive to do this as it is their investment that will be lost.

Spain Shows Why Endorsing Investments is Bad Policy

As regular readers of this blog know, the FDR Framework predicted that the Spanish financial regulators are setting the country up for significant financial instability if the regulators' estimate of the amount of capital needed for the savings banks is too low.

Since that prediction, Moody's has been very vocal in stating that it thinks the estimate is low and cutting the ratings of the sovereign and the banks as a result.

As reported in an article in the Wall Street Journal, investors have tried to verify the Spanish government's estimate of the capital needs of each savings bank prior to investing.  While the investors are not getting access to all the useful, relevant information in an appropriate, timely manner, they are getting substantially more information than was previously available to market participants.

Unfortunately, the results of their analysis of this information suggest that the problem is worse than the savings banks or government is letting on.  As a result, they are not investing.

As it becomes more apparent that the savings banks will not be able to raise the needed capital, this will drive up the cost of funds at both the bank and sovereign level.

Spain's plan to rescue its regional banks is running into headwinds as private investors, who are being asked to pour in cash, and ratings firms raise questions about whether the lenders have admitted to all of their real-estate losses. 

... Eight of Spain's cajas must present their capital-raising plans to regulators by April 10. That has caused a flurry of activity in recent weeks as savings banks sounded out hedge funds and private-equity funds and others pursued initial public offerings. 

But the exercise has stirred questions from investors about the level of reserves that the banks hold against real-estate risk in their portfolios. The banks also have faced questions over whether their executives have distanced themselves sufficiently from local politics; in some cases, they have even been quizzed about managements' own understanding of what is on their books. 

... The pressure on Spain to show that it can clean up its banking sector has heated up in recent days. Moody's Investors Service on Thursday downgraded Spanish banks, citing, in part, greater financial pressures on the Spanish government and its smaller lenders. 

"We remain cautious on the capacity of savings banks to get private funds, to the extent that private investors may have concerns on whether savings banks have undertaken an upfront recognition of losses," said Alberto Postigo, a senior analyst at Moody's. 

... The savings banks have until September, with some exceptions, to raise their core Tier 1 capital ratios—a key measure of financial strength—or turn to the Spanish state for funds. Spanish authorities said earlier this month that the entire banking sector needs €15.1 billion ($21.3 billion) to meet these new rules, although they said a significant amount could come from the private sector. 

Spain's Fund for Orderly Bank Restructuring has made available €15 billion to assist the sector. Sovereign wealth funds from Qatar and United Arab Emirates have also pledged funds to invest in the savings-bank sector, although the recipients haven't been disclosed.
If little capital can be raised from outside investors, "it will be a disappointment for the whole Spanish market," said a Madrid-based fund manager. 

One of Spain's largest savings banks, Banco Base, already has scrapped plans to go public in the face of a lukewarm response from investors and a tight timetable to raise capital, say people close to the bank. It instead will try to sell a partial stake in the market or seek government funds. 

If private investors won't commit to Spanish savings banks, this could sharply raise the cost of funding for all banks, including larger, publicly listed entities, say analysts. 

To be sure, savings bank Mare Nostrum, with €71 billion in assets, is generally liked for its professional board and comparatively low real-estate exposures, said people who have attended its presentations. 

But many investors are still wary. 

"Spain is an attractive market for longer term," said Fred Rizzo, an analyst with T. Rowe Price International Inc. in London. But first, he said, the cajas "need to clean up and recapitalize, then we can make apples-to-apples comparisons with other European banks." 

A litmus test for confidence in the Spanish banking sector will be the success of the offering of the largest entity, Bankia, a lender with €344.5 billion in assets. It is comprised of Caja Madrid, Bancaja of Valencia, and five others, and must raise €5.78 billion to comply with the requirements. 

In some cases, though, Bankia's pitch to investors has fallen flat. 

A banker who attended a recent presentation said that according to calculations based on the bank's literature, the "capital hole" appeared far larger than what the bank planned to raise in the market. Moreover, this person said, the disclosure about asset quality was limited, and management couldn't answer questions about the some structured products on its books. 

A Bankia representative declined to comment on the banker's comments but said the bank has been making progress in consolidating operations and cleaning up its balance sheet, and had recently reached an agreement to cut costs through early retirement for employees. The bank is moving ahead with its IPO, which it hopes to complete before summer.

UK Regulators Under Siege Over Higher Bank Capital Requirements

As predicted in a prior post, the Financial Times ran an article on how the banking industry is attacking the UK financial regulators for their interest in imposing capital requirements that are higher than those specified in Basel III.

As predicted, the attacks on the financial regulators illustrate how the attempt to set higher capital requirements ultimately becomes a race for the bottom.  For example, it is subjected to the 'level-playing field' argument where the capital requirements of a different country preempt the higher capital requirements sought by the national financial regulator.

UK bank regulators are coming under attack on two fronts, with both investors and international peers chiding the Bank of England and Financial Services Authority over their aggressive stance on bank capital. 

Concerns have mounted as a proposal by a Bank of England adviser, calling for the doubling of new internationally agreed capital ratios, appears to have gained ground. 

... Basel III rules, due to be phased in as the global standard for bank capital by 2019, have set the core tier one capital ratio – the key measure of financial strength – at 7 per cent of risk-weighted assets. 

Regulators are still thrashing out how much more than that SIFIs must hold. The recent Bank of England paper called for an overall 15-20 per cent ratio. 

The sense of a growing divide between regulators in the UK and Switzerland on the one hand, and the US and much of continental Europe on the other, is alarming investors, sparking fears that UK banks will be disadvantaged or forced abroad. 

“My view is the UK is going mad,” said one London hedge fund investor with large bank
shareholdings. “Regulators are basically saying: ‘We can’t police the banks, so let’s build a massive wall to protect ourselves instead’.” 

Davide Serra, founding partner of asset management firm Algebris, said: “Higher capital will just lead to higher mortgage and credit card costs for everyone.” 

... Big UK banks, such as HSBC, Standard Chartered and Barclays, that came through the crisis relatively unscathed are angry that they face the prospect of high capital demands set in the light of rivals’ failure. 

HSBC executives have privately urged some of the bank’s leading investors to voice their unease to regulators, according to people familiar with the situation. 

The vitriolic rhetoric comes as concern grows that the UK is falling out of line with most international peers on the issue of SIFI capital levels. 

US regulatory officials are growing frustrated with the pace and direction of negotiations on the still outstanding capital issues as well as on the requirements for holding liquid reserves.
“Right now, this is a confusing, unresolved muck,” said one senior figure in the US administration, adding that he was determined US banks would not be required to go much beyond the Basel III 7 per cent ratio. 

... Officials say the Bank and FSA are aware that the UK needs to maintain a level playing field, particularly with rivals in continental Europe.

Gambling by Financial Regulators puts Financial System at Risk

By not adhering to the FDR Framework and maintaining their monopoly on all the useful, relevant information from financial institutions and structured finance securities, financial regulators put the financial system at risk.

How do they put the financial system at risk?

They keep the financial system dependent on the financial regulators to properly analyze all the useful, relevant information on financial institutions and structure finance securities.

Have the financial regulators been successful in the past at properly analyzing all the useful, relevant information?

No!  The most recent example is the credit crisis that started in 2007.

Why isn't the financial regulators' claim that they learned from their mistakes credible?

The number one lesson they should have learned is that they are capable of making mistakes analyzing this information.  If they had learned this lesson, they would be in the process of making sure that all the useful, relevant information is disclosed to the market.  It is only with this disclosure that market participants can analyze the data and correct the regulators mistakes.

Do market participants really need all of this granular asset and liability-level data?

Yes!

Under the FDR Framework, governments and their regulators are suppose to ensure that market participants can access all the useful, relevant information in an appropriate, timely manner.  It is the market participants responsibility for analyzing this data.

However, it is not a requirement that every market participant analyze this data.  What is important is that there are some market participants who can and will analyze this data.

For example, each of the Too Big to Fail financial institutions has both the ability and incentive to analyze this data.  As Jamie Dimon says, they want to know who their "dumbest competitor" is.  That way, they can properly manage both the amount and price of their exposure to this competitor.

Why wouldn't stress tests with disclosure of the assumptions and the results be adequate?

First, it keeps the market dependent on the regulators for doing the analysis correctly.  A critical aspect of doing the analysis correctly is the assumptions made.  If the assumptions are faulty, then so are the results.  This blog has cited numerous examples where market analysts in the US and Europe, particularly Ireland and Spain, have disagreed with the stress test assumptions and subsequently have been shown to be right.

Second, it prevents the market analysts from running their own stress tests using all the useful, relevant information.  There is no knowing what mistakes the regulators are making that these analysts might uncover.

What happens if the financial regulators gamble, maintain their monopoly on all the useful relevant information and they are wrong with their analysis?

The taxpayer bails the financial regulators out, but only if the sovereign is perceived by the market to be capable of doing so.

Currently, we are seeing a demonstration in Ireland and Spain of what happens when the market does not believe the sovereign is capable of bailing out the regulators for their mistake.

Isn't there a half-way house that does not require disclosing all the granular asset and liability-level data, but would still deliver the same results?

No!  For example, when monitoring a loan portfolio it is important to be able to answer the question: when a loan stops performing is the reason unique to the borrower or is it reflective of a systematic problem?  The only way to answer this question is with granular level data.

Ultimately, the search for a half-way house is an effort to maintain the monopoly and keep gambling.  The financial regulators are gambling that by themselves, they can do a better job analyzing this data than could a combination of the market and the financial regulators.

Common sense suggest that this gamble by regulators is a bad bet.  History shows that this gamble by regulators is a bad bet as the cost, as shown by the Bank of England, to bailout the regulators and the economy from the recent credit crisis is well into the trillions.  Clearly, this gamble of trillions of dollars by regulators is not one that taxpayers or the government officials they elect would approve of.

Contingent Convertible Securities Meet the FDR Framework

In seeking to bridge the gap between the level of capital a financial institution is required to hold under Basel III and the far higher capital levels recommended by David Miles and Anat Admati, the Bank of England's Andrew Haldane has suggested using Contingent Convertible Securities (Co-Cos).

Co-Cos are suppose to automatically convert into equity as a financial institution runs into trouble.

As reported in a Guardian article,

In contrast to his Bank of England colleague David Miles, who has said banks should more than double their capital ratios to 20%, Haldane argued that piling in more capital to banks might not be answer. Instead, he questioned whether the new regime for bank capital – known as Basel III after the Swiss city where the regulators are based – "will be sufficient to cope with next time's crisis". 

Basel III is replacing Basel I – the first international standard for bank capital agreed in 1988 – and Basel II, which was implemented before the 2007 financial crisis unfolded. 

"There may be straightforward ways to rebalance the Basel scales, re-injecting market discipline," Haldane said. "Having banks issue a graduated set of contingent convertible securities [to the bankers as part of their bonus], which are responsive to early signs of market stress, is one possible way of doing so."

A primary reason for having bankers purchase Co-Cos is that with current financial reporting they are the only substantial buyers of Co-Cos.  Of all the potential investors, only bankers have access to the current assets and liability-level detail of their financial institution and can therefore assess the risk.  No other investor can assess the risk and therefore value these securities.

The FDR Framework suggests a way to make Co-Cos attractive to investors and address the following problems Mr. Haldane identifies with Basel III capital requirements.

A critic might argue that regulatory capital ratios have become too complex to verify, too error-prone to be reliably robust and too leaden-footed to enable prompt corrective action,

Under the FDR Framework, the steps needed to make Co-Cos attractive to investors and an important part of a financial institution's capital structure are:

• Require financial institutions to disclose their current assets and liability-level data.  Access to this data will allow investors to assess the risk of the financial institution and value the Co-Cos.

• Require financial institutions to issue two types of Co-Cos:  one funded by banker bonuses and the second, of equal or greater size, purchased by investors not affiliated with the financial institution.

It is the price on the investor Co-Cos that addresses Mr. Haldane's issues.  The price on the investor Co-Cos will be very sensitive and will reflect what the market thinks is the risk and solvency of the financial institution.  If the price declines substantially, it is a clear signal that prompt corrective action is needed.

Investor Co-Cos are the best friend of the regulators responsible for financial institution supervision.  Their price is the market's way of telling the regulator that there are issues with a specific institution.

Extend and Pretend Policies Perpetuate Financial Instability

The FDR Framework is a model that cannot be ignored because of its predictive abilities.

As discussed previously (see here and here), the FDR Framework predicts that financial regulators through their monopoly on all useful, relevant information on financial institutions and structured finance products both contribute to and perpetuate financial instability.

An example of how financial regulators perpetuate financial instability is the policy of extend and pretend.  The goal of these policies is to plan on a future event bailing the financial institution out of its current problem.

The classic for regulators practicing extend and pretend was the late 1980s Savings and Loan crisis.  As a result of the high interest rates in the early 1980s, the S&Ls were insolvent.  Rather than acknowledge this, regulators came up with a one-time equity adjustment.  This allowed the S&Ls to gamble on redemption in commercial real estate and long term bonds.  Ultimately, their gambles did not pay off and the regulators had to close most of the S&Ls.

The FDR Framework predicts that extend and pretend policies will most likely fail because financial regulators miss that analysts understand their role in our financial markets under the FDR Framework is to trust, but verify.  They trust the government when it says that everything is ok.  Then they start digging around to find the facts that verify the accuracy of this statement.

The only question with extend and pretend policies is how long will it take before the market analysts ferret out enough information to show the statement is wrong.

If the gamble on redemption works before the market analysts can ferret out enough information, then the extend and pretend policy works.

If the gamble on redemption has not worked when the market analysts ferret out enough information, then the market is subject to financial instability.  Unfortunately, this financial instability is not limited by the actual facts, but is driven by worse case assumptions as the actual facts to anchor the market are not available due to the regulators' information monopoly.

So what happened with the extend and pretend policies involving Spain and its savings banks?

According to an article in Bloomberg,

Thirty of Spain’s smaller banks had their senior debt and deposit ratings downgraded, as Moody’s Investors Service reviews whether governments are willing to support all their lenders in a crisis. 

...“It seems increasingly plausible that hard choices will need to be made at some point over the rating horizon, balancing the sovereign’s incentive to support the banks with the need to protect its own balance sheet,” Moody’s said in the statement. “It is, in Moody’s view, increasingly likely that the sovereign will not be prepared to write all banks a blank check.” 

Governments are seeking to guarantee taxpayers don’t have to step in to support lenders in distress by ensuring creditors bear losses, prompting Moody’s to reconsider the state support it factors into its ratings. 

...“This is the first step in a wider review of the systemic support available to smaller institutions, institutions we think it unlikely would be considered to be systemic,” Moody’s Chief Credit Officer for Europe, the Middle East and Africa Alastair Wilson said in a telephone interview today. “We’re going to carry out a series of country-by-country reviews of banking systems.” 

He declined to say which countries would be examined next. 

Banks of a size to make them central to the smooth running of the financial system are still likely to receive support, Wilson said. 

...“That certain lenders have problems is well-known and can’t be denied,” said Pablo Garcia, head of equities at Oddo Sociedad de Valores in Madrid. “But in our opinion, at least 70 percent of the Spanish financial system is highly solvent.” 

Spain’s credit rating was cut to Aa2 on March 10 by Moody’s, which said the cost of shoring up the banking industry will eclipse government estimates. The ratings company said then that Spanish lenders may need as much as 50 billion euros ($70.3 billion) to meet new capital requirements, a figure that compares with the Bank of Spain’s estimate that 12 lenders will need 15.2 billion euros.

As the analysts at Moody's ferret out more information, they are concluding that the Spanish government's estimate of how much capital the savings banks need is wrong.  Without the current asset level data to constrain their analysis, the analysts are now applying assumptions that call into doubt the solvency of the sovereign.

As predicted by the FDR Framework, adopting the extend and pretend policies with regards to its savings banks did not enhance Spain's financial stability.  The extend and pretend policies appear to have set the stage for a sovereign credit crisis.

Stress Tests Contribute to Financial Instability

The FDR Framework is a model that cannot be ignored because of its predictive abilities.

As discussed previously (see here and here), the FDR Framework predicts that financial regulators through their monopoly on all useful, relevant information on financial institutions and structured finance products both contribute to and perpetuate financial instability.

An example of how financial regulators contribute to financial instability is the stress tests.  The stated goal of these tests is to restore and enhance confidence in the market.

The FDR Framework predicts that this will not happen because the financial market participants do not have access to the current asset and liability level data that the participants need to run stress tests on their own and confirm the findings of the regulators.

So what happened with the latest round of stress tests in the US?

According to a column in the Wall Street Journal,

Beyond confirming that BofA is trailing the big-bank pack, the meaning of the Fed's decision wasn't exactly clear, however. That's largely because of the paucity of information the Fed released about the 19 financial institutions that took part in the latest stress tests. Instead, investors are being left to wonder what part of BofA's capital plan may have caused unease. 

And although Bank of America in its statement pointed to progress made in building capital, the Fed's rejection "highlights again how its capital levels are weaker than others," noted Evercore Partners analyst Andrew Marquardt. He estimated BofA had a Tier 1 ratio of 5.5% to 6%, based on future Basel III capital rules, compared with an average for big banks of closer to 7%. 

The Fed didn't even release details about which banks' capital plans had been approved or rejected, leaving that up to individual institutions. That has even led to questions around other firms.  

... The Fed's stress tests should give markets greater confidence. In this instance, they have generated additional uncertainty.

According to a Breakingview column,

... It all makes it look as though the Fed is on top of keeping banks’ balance sheets healthy. But the U.S. central bank should still reveal more about its rationale. 

The basics are straightforward. 

... The bank is not there yet. And the Fed deserves credit for reminding the bank’s executives and directors of that. But it’s not clear whether the Fed is worried about BofA’s core earnings falling short or about potential losses being higher than the bank projected, to pick a couple of possible concerns. 

Of course the Fed may simply be making a show of saying “no” to somebody. 

...That’s not nothing, but for a company with Tier 1 common equity of $125 billion, it’s surely not enough to have a big impact on its soundness. Greater transparency from the Fed would help clear up the reasoning.

As predicted by the FDR Framework, the stress tests failed to enhance confidence in the market.  In fact, they created greater uncertainty.

Examples Confirming Regulators Contribute to Financial Instability

In two earlier posts (see here and here), the theory of how regulators through their monopoly on all useful, relevant information on financial institutions and structured finance products both contribute to and perpetuate financial instability was laid out.

This post is going to focus on two examples to show how this theory holds up in practice.

Both examples are courtesy of Chris Whalen in this week's Institutional Risk Analyst.  For those of you who do not know Chris, he knows banks inside and out and offers a highly regarded service that rates each bank's riskiness.  Once per week, through the Institutional Risk Analyst, he shares his insights.

The first example is the recently completed stress tests in the US on which Chris observes:

While the US central bank did not provide results for specific institutions, the assumptions in the Comprehensive Capital Analysis and Review (CCAR) are more instructive than the Big Media seems to notice. Indeed, a close reading of the CCAR document provides a compelling argument for why the Fed should not be supervising financial institutions. 

For example, the Fed has a down 6% for housing prices in its "stressed scenario," but that is about where we are now. Incredibly, the central bank also has a down 5% for HPI [Housing Price Inflation] in 2012, again in a "stressed" scenario. This implies that the Fed's "normal" estimate for HPI is positive for 2011-2012? Hello? 

Chris comments highlight one of the ways in which financial regulators with their information monopoly contribute to financial instability.

The market is dependent on the regulators to analyze the data correctly.  Chris is a very able analyst who happens to be in the business of assessing the riskiness of banks, but he does not have access to the same data to run his own stress tests on the banks.

What he does have is the ability to analyze the assumptions used by the regulators in testing the data.  Based on the facts cited and the tone of his comments, it is unlikely that Chris believes either the regulators analyzed the data correctly or the outcome of the test.

If the goal of the stress tests is to restore market confidence and increase financial stability, it appears to have had the opposite impact on Chris.   He finds the stress tests as providing a compelling argument for the Fed being stripped of its bank supervision authority.

Is the reaction by Chris to the US stress tests unusual?  According to the NY Times Dealbook article on the bank stress tests, the answer is no.

Still, some bank analysts doubted whether the stress tests were all that stressful. “Although they still have the economy in a recession in 2011, they have home prices down an additional 10 percent,” noted Frederick E. Cannon, the chief equity strategist at Keefe, Bruyette & Woods [an investment bank that for many years focused only on the banking industry]. “A lot of people are already expecting that in the current environment.” 

In any case, Friday’s results did not mark the end of stress tests; in fact, they are only the beginning. The Fed plans to make the kind of review that was just completed an annual event.

Have European financial regulators with their information monopoly done better than the Fed?

No.  The first round of stress tests showed banks in Ireland, like Allied-Irish, to be adequately capitalized.  Within months, these banks had to be nationalized.

What about the current round of stress tests in Europe and, in particular Ireland?  According to an article in the Independent, analysts do not feel these stress tests will be better than the first round of stress tests.

Details of the 'shocks' in the European tests, many of which will also be included in the more imminent Irish stress tests, were revealed yesterday to clamouring criticism from analysts who deemed the tests too lax. 

Meanwhile, Anglo Irish Bank chairman Alan Dukes yesterday said the worst-case property scenarios Irish banks were being tested against looked "too rosy", a view echoed by property giant Savills. 

Bloxhams' chief economist Alan McQuaid said all the details that had emerged about the stress tests led him to believe Ireland's banks could need an injection of more than the €35bn allowed for in the bailout. 

... The EBA has vowed to make this year's version more robust, but analysts at Citi yesterday said they remained "sceptical of the ability of these new bank stress tests to reinstate market confidence". 

The sentiments were echoed by analysts at Credit Sights who said "anyone looking for a worst-case scenario rather than a moderate stress test will be disappointed". 

The Irish version of the stress tests are also coming under criticism for being too lax, with experts hitting out at the worst-case assumptions that commercial property prices will fall by a maximum of 70pc from the peak and house prices by a maximum of 60pc. Mr McQuaid said the picture emerging of the stress tests meant the banks "will swallow up the entire €35bn earmarked for it".

The analysts' responses suggest that at best they see the stress tests as much ado about nothing and at worse a confirmation that the regulators do not understand how to analyze their monopoly information correctly.

Unfortunately for the regulators, the market has experience with and substantial losses to show for when the regulators fail to accurately analyse the data (see sub-prime mortgages and CDOs).  As a result, the plan to make stress tests an annual event would appear to be an attempt to remind the market that it is dependent on the regulators to analyze data correctly and to encourage financial instability.

The second example is the potential losses by the GSEs related to private mortgage insurance on which Chris observes:

Many of the mortgages that the MI's [private mortgage insurers] pretend to insure are actually 'rejected" upon default. The act of "rejection" is not the same as rescission and, in effect, amounts to the MI pretending that the loan was never insured in the first place. Litigation typically ensues. 

... the biggest exposure to the MIs lies with loans sold to the GSEs.  

... in the case of the MIs, the question of mere restatements is entirely inadequate to describe the public disclosure shortfall.  Few claims made against MIs are paid because they have no capital, especially compared with their total exposure. Instead of raising real capital or trying to shed risk exposures, senior officials from the MIs instead spend money on litigation and lobbyists. 

... MIs have much less "capital" than insured losses.  Premiums paid over the past two years were used to pay past claims, NOT rebuilding reseves.  If the smiling image of Charles Ponzi  comes to mind, then you've got the idea. 

... Most MI contracts are written against GSE guaranteed loans and pay only after all losses are known. Until a year ago, when the FASB changed the rules on accounting for securitizations, the GSEs would leave defaulted loans in pools and pay investors principal and interest as though the loan was still money good. The FAS 166/167 rule change forced the GSEs to buy bad loans back from investors for cash, but the same rule change allowed the GSEs to value delinquent loans at a higher value than the expected loss estimates would suggest. 

In the last year, problem loans started popping up on the balance sheets of the GSEs, but Fannie and Freddie have so far refused to press the MIs for payment. Remember that MI pays only at the end of the default process, when the total loss is realized.  And the GSE only just completed the review of losses for the 2004-2008 period.  As the GSE warehouse of delinquent and defaulted loans grows by billions of dollars each month, there is still no demand for payment from the MIs by the FHFA. As we noted in an earlier comment, we figure that there is as much as $200 billion in defaulted loans sitting on the books of Fannie and Freddie at cost -- that is, close to par value. Neither GSE details the total amount of defaulted loans on its books. 

... Both investors and Congress need a lot more details about the purchases of defaulted loans by Fannie and Freddie. We need to know exactly how many dud loans have migrated back to the GSEs, what their loan loss reserve is, how much of that loan loss reserve is "covered" by the MIs and how much "capital" the MIs have against these exposures.   The GSE are letting dead loans sit on their books in part to avoid recognizing the losses, an event that would drive many of the MIs into bankruptcy. If you look at how slow the process of final loss recognition by Fannie and Freddie is proceeding, then you'll understand why the publicly disclosed loss rates reported by Fannie and Freddie have been falling.
Instead of demanding insurance payments, the GSEs are doing everything in their power to keep the MIs looking like going concerns so that they can count the MI "receivable" as a good asset. 

... If there was a proper mark-to-market on the MIs (like all proper insurance/reinsurance businesses do), then the MIs would be massively insolvent. The GSEs would have to take another huge amount of capital from Treasury. Geithner and the GSEs are trying to avoid it, and to date are getting away with it. Sad to say, nobody at the FHFA seems to have a clue about this issue.  But we understand that a certain independent minded committee chairman on Capitol Hill is preparing for hearings on this monumental act of fraud against the taxpayer, not to mention the holders of GSE debt. 

This example highlights another way in which regulators with their information monopoly contribute to financial instability.

The information monopoly encourages regulators to implement extend and pretend policies.  After all, they have data that the market does not have and they are in a position to influence its disclosure to other market participants.  These policies always fail, but not before a period of time has elapsed in which economic decisions are distorted.

The reason that extend and pretend policies always fail is that financial regulators miss that analysts like Chris Whalen understand their role in our financial markets under the FDR Framework is to trust, but verify.  They trust the government when it says that everything is ok.  Then they start digging around to find the facts that verify the accuracy of this statement.

The only question with extend and pretend policies is how long will it take before the market analysts ferret out enough information to show the statement is wrong.  When that happens, the market is subject to financial instability.

Unfortunately, this financial instability is not limited by the actual facts, but is driven by worse case assumptions as the actual facts to anchor the market are not available due to the regulators' information monopoly.

More on Financial Regulators as Source and Perpetuator of Financial Instability

Is it fair to say that financial regulators are both a source and perpetuator of financial instability?

Yes.

Financial regulators have a unique position.  They are the only financial market participant who can see the current asset and liability level data at any financial institution.

Please reread the preceding sentence as it is the key to understanding why financial regulators are both a source of and perpetuator of financial instability.

No other financial market participant can see current asset and liability level data at a financial institution or in a structured finance security.  All other financial market participants receive periodic consolidated financial statements.  The only exception is management which can see the current asset and liability level data for the financial institution they run and the structured finance securities they service.

Why is the regulators' monopoly on current asset and liability level data important?

Our financial markets are based on the idea of combining the notion of disclosure with caveat emptor [buyer beware].  As the FDR Framework puts its,

• Governments are responsible for disclosure.  They must ensure that market participants have access to all the useful, relevant information in an appropriate, timely manner;

• Market participants are responsible for doing their homework [trust, but verify] using the disclosed information.

With its monopoly on information, regulators interfere with the functioning of the financial markets when it comes to financial institutions.  The monopoly prevents market participants from being able to do their homework.


How does this monopoly make regulators a perpetuator of financial instability?


As discussed in the post, Bank Capital and Bank Runs, banks are unstable because depositors and investors have no way of knowing if a bank is solvent or not.  If doubt about a bank's solvency is raised, the best course of action for the depositor and investor is to withdraw their funds as quickly as possible - this is referred to as a run on the bank.

To limit bank runs, the US government adopted deposit insurance.  This eliminated the solvency issue for retail customers [the depositors], but not for wholesale customers [investors, other financial institutions].  


The Financial Crisis Inquiry Commission documented how wholesale customers withdrew their funds because they could not determine if a bank was solvent or not.  The reason wholesale customers could not determine if a bank was solvent is the financial regulators' monopoly on current asset and liability level data prevented them from having the data needed to do this analysis.


The monopoly effectively perpetuates financial instability.


How does this monopoly make regulators a source of financial instability?


It prevents market participants from doing their homework and properly pricing the risk of financial institutions and structured finance products.  As a result, market participants must rely on the financial regulators to do the analytical work for them and be right in their analysis. If the financial regulators are wrong, the market is over-invested in risky assets.

There is a long history of financial regulators not being right in their analysis and spotting problems before they threaten to become systemic issues.  We had the U.S. Savings & Loan Crisis, the Less Developed Country Debt debacle, Long Term Capital Management meltdown, and of course the sub-prime wipeout.  

Please note, these episodes of financial instability occurred when the monetary authority and supervisory authority were combined (the Fed) or when they were separate (the BoE and FSA). 

What is the solution to prevent the financial regulators from being a source and perpetuator of financial instability?

The simple solution proposed under the FDR Framework is to provide all market participants with the current asset and liability level data so they can do their homework. [please see the following article for a discussion on how this could be effectively and efficiently done using the shadow banking system as an example.]

The goal is to get a stable banking system without the economic distortions caused by the regulators' information monopoly.  Markets, and the global banking system is a market, function best when ALL market participants, including regulators, have access to the same useful, relevant information in an appropriate, timely manner.

As has been said previously on this blog, by providing this data to the other market participants, the global regulators get to piggyback off of their analysis.  For example, they can compare their analysis to JP Morgan's.  If the results differ, it would be informative for the regulators to understand why.

NY Fed Moves Closer to Adopting FDR Framework

Bloomberg published an article on the reorganization of the NY Fed's supervision area.  The bottom line to the reorganization is that it adopts two of the FDR Framework's insights:

• The useful, relevant information is current asset and liability level data; and 

• The more eyeballs looking at the data from different perspectives, the better.

However, the reorganization stops well short of actually adopting the FDR Framework.

The Federal Reserve Bank of New York, which oversees some of the largest U.S. financial firms, has reorganized its bank supervision group to strengthen its oversight capabilities.

...“Some of this is about changing a mindset internally, as well as reflecting externally that we have a broader mandate now under Dodd-Frank,” Sarah Dahlgren, who became head of the group on Jan. 1, told Bloomberg News on March 18 when asked about the changes. “We’re going to have to increase resources.” 

... The Fed bank has moved specialists from the supervision group’s risk management function to its relationship management teams, according to two people familiar with the reorganization who declined to be identified because the changes haven’t been made public officially. The relationship management teams are responsible for covering specific institutions, such as Citigroup Inc. (C), while the risk analysts provide “cross- institutional analyses,” according to the New York Fed’s website. 

The risk analysts will relocate from the New York Fed’s 33 Liberty Street headquarters in downtown Manhattan to on-site locations at the financial firms, increasing the number of on- site staff and giving the risk analysts better access to the institutions, according to the two people familiar. 

The New York Fed has also created a new senior supervisory officer role within the relationship management teams. The senior supervisory officers will act as a liaison between the regulators and senior management of the financial institutions, and will also focus on piecing together the firms’ business strategy, revenue sources and risk management. 

In addition, the New York Fed created new so-called business line specialists on the relationship management teams. 

... “This is really part of taking the lessons learned from the crisis and trying to fit those into what we need to do differently in light of the changes under Dodd-Frank,” said Dahlgren. 

Regulators as Source and Perpetuator of Financial Instability

In his speech, Banking:  From Bagehot to Basel and Back Again, Mervyn King, the Governor of the Bank of England, observed,

Of all the many ways of organising banking, the worst is the one we have today. 

Why?

A market economy has proved to be the most reliable means for a society to expand its standard of living. But ever since the Industrial Revolution we have not cracked the problem of how to ensure a more stable banking system.

Why is the banking system unstable?

As discussed in the post, Bank Capital and Bank Runs, banks are unstable because depositors and investors have no way of knowing if a bank is solvent or not.  If doubt about a bank's solvency is raised, the best course of action for the depositor and investor is to withdraw their funds as quickly as possible - this is referred to as a run on the bank.

To limit bank runs, the US government adopted deposit insurance.  This eliminated the solvency issue for retail customers [the depositors], but not for wholesale customers [investors].  The Financial Crisis Inquiry Commission documented how wholesale customers, including other banks, withdrew their funds because they could not determine if a bank was solvent or not.

How does the FDR Framework address this instability?

The FDR Framework provides the solution.

Our financial markets are based on the idea of combining the notion of disclosure with caveat emptor [buyer beware].  As the FDR Framework puts its, governments are responsible for disclosure and investors are responsible for doing their homework [trust, but verify].

To fulfill its disclosure responsibility, government must do two things:

• ensure market participants have access to all the useful, relevant information in an appropriate, timely manner; and

• avoid endorsing specific investments.

When it comes to the banking system, the government does not do either of these things.

• The lack of information so that investors can do their homework was discussed in the post on hedge fund manager Paul Singer on Too Big to Fail and the Next Financial Crisis.  The lack of information so that banks can limit their exposure to, in Jamie Dimon's words, "their dumbest competitor" was discussed in the post on Davos.   

• Governments actively endorsing specific investments was discussed in the post on Stress Tests and Too Big to Fail.  

The result of the government's failure to fulfill its disclosure responsibility is that the instability of the banking system is increased and not decreased.

Why doesn't the government fulfill its disclosure responsibility?

One part history.  One part the failure to adhere to the FDR Framework.

In discussing the FDR Framework, this blog has highlighted how the absence of 21st century information technology in the 1930s required the government, with its exposure through deposit insurance, to take on the monitoring, analysis and discipline role for financial institutions that the financial markets would otherwise perform.

The regulators had to do this because they did not have the alternative of financial institutions disclosing all the useful, relevant information in an appropriate, timely manner to market participants.

For regulators operating in the 21st century, disclosing this information is a viable option. [please see the following article for a discussion on how this could be effectively and efficiently done using the shadow banking system as an example.]

What is the result of regulators not disclosing all this information?

As predicted by the FDR Framework, by not disclosing all the useful, relevant information they have access to, regulators are an obstacle to markets functioning properly.

For example, they engage in stress tests in an effort to restore market confidence.  In reality, the stress tests only serve to perpetuate the notion of Too Big to Fail.  How can an investor be expected to be willing to take a loss investing in a bank when 1) the investor does not have access to all the useful, relevant information in an appropriate, timely manner to analyze and 2) the regulators are saying that the bank is in excellent financial shape because it passed a stress test?

It is the regulators who are perpetuating and increasing instability in the banking system.

Regulators do this by acting as gatekeepers and maintaining information asymmetry between the information provided to the markets and the current asset-level data the market participants want and need if they are to analyze each financial institution and correctly price risk.

How do regulators increase instability in the financial system?

If only the regulators look at current asset-level data, the banking system has a critical weakness.  It is dependent on the regulators to be right in their analysis.  Since there is no back-up, if the regulators fail, the system is prone to crashes.

We know the financial system is prone to earthquakes when they are the only market participant with access to current asset-level data.  We had the U.S. Savings & Loan Crisis, the Less Developed Country Debt debacle, Long Term Capital Management meltdown, and of course the sub-prime wipeout.  

Please note, these failures occurred when the monetary authority and supervisory authority were combined (the Fed) or when they were separate (the BoE and FSA).  

Given this history of not spotting problems before they threatened to become systemic issues, why should the market believe that the regulators will not fail in the future?  

Your humble blogger prefers not to let the regulators gamble on redemption (when only they can see the current asset-level data, their reputation is redeemed until the next crisis hits).

The source of instability is a structure where only the regulators get to see the current data.  If the data were made available to the market, everyone would get to see what is going on.  This would allow the market to contribute to analyzing the data and taking corrective action before the problem threatens the financial system.

Rather than provide all the current asset-level data, why can't regulators provide a summary?

Anything less than providing all the current asset-level data means that regulators are substituting their analytical abilities for the analytical abilities of the market.

Regulators claim to have learned their lesson from the credit crisis when it comes to analyzing current asset-level data.

For example, the Fed put over 100 of its PhDs on the stress test.  They requested more asset level data than they had ever requested before from the banks so they could double check the results to the stress tests that the banks were reporting.

All of which leaves one question unanswered:  why would Jamie Dimon believe that a regulator could do a better job of analyzing this asset level data and the risk of his competitors than his organization could?


Are you recommending getting rid of the supervisory function?

Absolutely not!

The goal is to get a stable banking system without the economic distortions caused by regulator enforced information asymmetry.  Markets, and the global banking system is a market, function best when ALL market participants, including regulators, have access to the same useful, relevant information in an appropriate, timely manner.

As has been said previously on this blog, by providing this data to the other market participants, the global regulators get to piggyback off of their analysis.  For example, they can compare their analysis to JP Morgan's.  If the results differ, it would be informative for the regulators to understand why.