Monday, March 21, 2011

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
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 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.

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