Thursday, April 21, 2011

The Case for Ending the Financial Regulators Self-Imposed Impossible Task

As discussed in an earlier post, financial regulators face a self-imposed impossible task.  The self-imposed impossible task that financial regulators face is to accurately assess the riskiness and solvency of financial institutions without any help from other financial market participants.

The reason that the other market participants cannot help is that financial regulators retain a monopoly on all the useful, relevant information on a financial institution in the form of its current asset and liability-level data.  Without this data, the other market participants cannot tell if a financial institution is solvent or not. [According to the Financial Crisis Inquiry Commission, this was the reason the interbank loan market froze during the credit crisis.]
    Since their self-imposed task is impossible, financial regulators are prone to failure.  When the financial regulators do fail, the financial system itself is put at risk and taxpayers are put into the position of having to bail it out.

    Ireland is a textbook example of what happens when regulators fail.  The failure to properly assess risk in the banking system combined with the sovereign guarantee of the banking system liabilities threatens the entire Irish financial system.

    That the failure of the financial regulators in their self-imposed task was the factor that jeopardized the entire Irish financial system is not in doubt.  According to an Irish Times article on the Nyberg Report entitled Misjudging Risk:  Causes of the systemic banking crisis in Ireland,
    [T]he regulatory authorities were aware that banks were engaging in "risky" behaviour ahead of the recession but did little to stop it. 
    ... Both the Financial Regulator and the Central Bank either failed to detect or “seriously misjudged” the risks associated with the property boom. Both regulatory bodies were aware of the "macroeconomic risks" and of risky bank behaviour but appear to have judged them “insufficiently alarming” to take major restraining policy measures, his report concluded. 
    ... The report notes that only a small number of individuals working in regulatory authorities saw the risks taken by banks as significant and actively argued for stronger measures to be introduced. However, it says that in all cases they failed to convince their colleagues or superiors of the need to take action.

    ... External organisations such as the IMF, the EU and OECD are also noted for being at most, "modestly critical and often complimentary" regarding Irish developments and institutions.
    Not only did all the national financial regulators fail, but so too did the international financial regulators.

    The failure of the global financial regulators suggests a simple test for predicting if any specific way of reorganizing the banking system will work to prevent taxpayers having to bailout the financial system when the next crisis hits.  The test is
    Had the banking system been reorganized in this way prior to the recent credit crisis, would taxpayers still have been required to bailout the financial system.
    One reform that has been proposed is to ring-fence or legally separate the retail bank from casino banking.  This reform would not have stopped the taxpayers from having to bailout the financial system as the losses in the Irish banking system occurred in the retail bank.  This is not the first time financial regulators have missed losses in retail banking.  In the US for example, there were considerable losses during the credit crisis in retail banking even though the regulators knew what could happen from their previous experience with the Savings and Loan crisis.

    Another reform that has been proposed is to have the banks have capital equal to as much as 20% of assets.  This reform would not have prevented the Irish taxpayers from having to bailout the financial system as the Irish regulators did not step in before the losses in the Irish banking system exceeded 20% of assets.  The additional capital would most likely have allowed the Irish government and its taxpayers to absorb the losses and remain solvent.

    Another reform that has been proposed is to break up the Too Big to Fail.  In the case of Ireland, this would not have helped because all the Irish banks failed.

    Another reform that has been proposed is to establish a council of regulators or to merge the regulators performing bank supervision into the central banking authority.  The report highlights one of the reasons that a council or merger of financial regulators will fail.  Unlike the financial markets where the price is a reflection of everyone's opinion, regulators only speak with one voice.  Even if a few individuals saw the problem, they are always in a minority.  As a result, there is no reason to believe that action would be taken before it is too late.

    Of all the ways to organize a banking system, the way the banking system is currently organized is the worst.  The reason it is the worst is that the regulators maintain a monopoly on all the useful, relevant information on financial institutions.  

    With this monopoly, all other market participants are dependent on the financial regulators to properly assess the riskiness and solvency of the financial institutions.  If the financial regulators do not properly assess the risk and solvency, then market participants mis-allocate capital and taxpayers are on the hook for bailing out the financial system and addressing issues like contagion.

    There is one reform that had it been in place pre-credit crisis would have prevented the reliance on taxpayers to bailout the financial system.  That reform would have been to end the financial regulators' monopoly on all the useful, relevant information.

    From a separate article in the Irish Times on the report on the Irish banking crisis,
    Mr Nyberg said the absence of sufficient information on the underlying quality of loan books at the banks impacted on the options considered by the Government when it decided to introduce the bank guarantee in 2008. 
    “If accurate information on banks’ exposures had been available at the time it seems quite likely to the commission that a more limited guarantee combined with a state take-over of at least one bank might have been more seriously contemplated,” his report said.
    If accurate information on the underlying quality of loan books at the Irish banks would have altered the decision to guarantee all the bank liabilities, it is reasonable to assume that this same information in the hands of market participants would have altered their behavior too.

    If accurate information on bank exposures had been available, the other market participants would not have been dependent on the financial regulators to assess risk and solvency.  They would have done so for themselves since they expected before the credit crisis that they would have had to absorb any losses on their investments.  [We know they would have done so because at Davos this year Jamie Dimon of JP Morgan and Peter Sands of Standard Chartered have said they would use this information to determine who their 'dumbest competitor' is.]

    Given their incentive to avoid losses, the other market participants would have reacted well before the risk of loss would have wiped out their investments.  At a minimum, they would have dramatically raised the cost of funds and reduce the availability of funds to the Irish banks.  This action would have significantly reduce the total losses incurred by the Irish banking system and may have completely eliminated the need for any Irish taxpayer involvement.

    Finally, please note the Mr. Nyberg makes a point of saying that modeling exercises like stress tests do not provide sufficient information on the underlying quality of the assets at the banks and in fact placed the Irish taxpayers and the financial system at greater risk.  According to the first Irish Times article, the report found
    There was almost an element of the Financial Regulator being ‘fobbed off’ by banks that had particularly full confidence in the quality and sophistication of their models and systems.”
    Instead, he called for "accurate information on the banks' exposures" as this would have saved the Irish government from issuing a guarantee the Irish taxpayers could not afford.

    Given the findings of this report apply not only to Ireland but on a global basis, it is completely unacceptable for financial regulators to try to protect their information monopoly and not ensure that all market participants have access to all the useful, relevant current asset and liability level information in an appropriate, timely manner.

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