The Shape of Radical Reform for the UK Financial Sector: Updated

It is entirely possible that the UK's Independent Commission on Banking will come back with a radical reform proposal.

To date, the speculation has centered on the idea of ring-fencing the retail banking business from the investment banking business.  One goal of ring-fencing the two business is to insure that if either business fails, it does not take down the other.  Another goal is to insure that the investment bank cannot use the funding subsidy enjoyed by the retail bank to support its casino-like activities.

The head of the Commission has also suggested that emphasis will be placed on higher capital requirements.

Taken together, neither of these reforms is particularly radical nor would they have prevented the credit crisis that began in August 2007.  For this reason, the Independent Commission on Banking might want to adopt a radical reform that would have prevented the credit crisis.

This radical reform is to fully embrace the FDR Framework and its call for current asset-level disclosure by retail and investment banks, in addition to higher capital requirements.

A banking system that could handle all of the payments and credit needs of the UK, or any other country for that matter, does not require financial institutions to take on any positions that could not be publicly disclosed.

As a result, requiring disclosure of current asset-level data has the virtue of driving risk out of both the retail and investment banks as the banks have an incentive to close out any positions that they would not like disclosed.

This is why Bob Diamond, Peter Sands and Jamie Dimon want it.  Not only does providing this data give banks an incentive to reduce risk, but with this data, banks can limit and properly price their exposure to financial institutions that carry too much risk.

Of course the UK banks will protest.  They will go to great lengths to explain why this disclosure will put them at a competitive disadvantage to all of their global peers who do not have to make similar disclosures.

They are highly likely to threaten to leave London.  The proper response is "go and make sure to take your excess risk with you!"

In reality, the desire to leave is a strong signal to the market that the financial institution has something to hide.  The financial institution can expect its cost of funds to increase as the market concludes the financial institution must have more risk than previously believed.

It also sends a strong signal to a potential host country that might greatly complicate the financial institution's ability to relocate.  Does the financial institution's management really believe that any country would want to be in the position of potentially having to bailout a financial institution that was unwilling to disclose its risks?

This radical reform also puts pressure on other countries to adopt current asset-level disclosure.  The question that these countries have to ask is "given that it reduces the risk of our financial system and leaves us with a system that can handle all our payment and credit needs, why shouldn't our financial institutions provide current asset-level disclosure?"