Friday, March 25, 2011

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?


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.

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