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.