Tuesday, April 5, 2011

Greenspan and Frank are both wrong: What It Takes to Reform Finance

For those of you who may have missed it, Congressman Barney Frank responded with an op-ed in the Financial Times to the column written last week by former Fed Chairman Alan Greenspan.

Congressman Frank defends the position that we can reform finance and offers up the Dodd-Frank Act as proof of that.  He cites various aspects of the Act to rebut the claims by Mr. Greenspan.
Since the passage of the Wall Street Reform and Consumer Protection Act, known as Dodd-Frank, many commentators have suggested ways in which it might be improved.
Since Congressman Frank asked, the FDR Framework will be used to show what it would take to reform finance versus what the Act delivers.
But until last week no one had seriously suggested that we should have done nothing in response to the financial crisis.  
The issue is not whether something should have been done in response to the crisis, the issue is 'Was what was done an appropriate response to the crisis?'

Congressman Frank would say yes.  Chairman Greenspan would say emphatically no.
Yet, writing in these pages, Alan Greenspan suggests that we should not even have tried. By and large, he says, things went well over the long period of deregulation and light-touch oversight, and he argues that the global financial system is now so “unredeemably opaque” that policymakers and legislators cannot hope to address its complexity.
A previous post on Chairman Greenspan's column noted that his focus on the "unredeemably opaque" set of interactions between market participants is misguided.

It is not the set of interactions that should be focused on.  It is the conditions under which each interaction takes place.  Under the FDR Framework, the conditions under which each interaction takes place in our capital markets are governed by the principles of a philosophy of disclosure combined with caveat emptor [buyer beware].
Mr Greenspan is wrong on both counts. ...  The assertion that regulators can never get “more than a glimpse” of the financial system is self-fulfilling if regulators are not given the mandate or the tools to do so, or if they fail to use the tools they have. 
Congressman Frank is right in saying that relying solely on the market to police itself did not work.  However, he and the Act are are wrong in focusing solely on the regulators for policing the market.  Under the FDR Framework, it is a combination of the regulators and the market participants that are responsible for policing the market.

Under the FDR Framework, regulators have two very distinct roles:

  • Ensuring that all useful, relevant information is accessible by all market participants in an appropriate, timely manner; and
  • As an investor, since that is the position the government is in as a result of its insuring deposits and guaranteeing mortgages, using this information to both evaluate the risk of and manage the amount and pricing of the insurance and guarantees.
    • Requiring banks to hold more capital is an example of regulators acting as an investor and adjusting both the amount and pricing of the government's exposure for risk.

When the roles of the regulators are looked at in this way, it becomes clear what regulators did leading up to the crisis and what they are currently doing that was not addressed in the Act.  Specifically, regulators have been and currently are acting as gatekeepers to the current asset and liability-level information for both financial institutions and structured finance securities. 

As gatekeepers, regulators violate their role under the FDR Framework of ensuring that market participants have all the useful, relevant information in an appropriate, timely manner. 

  • As gatekeepers, regulators have and continue to contribute to the misallocation of capital.  Without this information, investors cannot properly evaluate the risk of investing in financial institutions or structured finance securities.
    • As gatekeepers, the regulators make all other financial market participants dependent on them for accurately evaluating the risk of financial institutions and structured finance securities.  History shows that the regulators have not always been able to accurately evaluate the risk [for example, Less Developed Country lending debacle, Savings & Loan Crisis, and the recent credit crisis].
  • As gatekeepers, regulators have and continue to contribute to financial instability.
    • As gatekeepers, the regulators do not get the benefit of the expertise of all the other financial market participants in evaluating the risk of financial institutions and structured finance securities.
Congressman Frank continues

Economist Mark Zandi notes that one of the mistakes leading to the crisis was that, despite having authority to set mortgage lending standards, the Fed “just never acted on it. That was a clear policy decision”. When technology can track billions of transactions in real time, a failure to pierce the opaqueness of the system is mostly a question of will, not capacity.
Congressman Frank is right that it is a question of will, not capacity.

Under the FDR Framework, what market participants require is visibility and access to all the useful, relevant information in an appropriate, timely manner.  It is the responsibility of the market participant to do their homework on this information as they know that it is buyer beware when they make an investment. 

The question is 'Will regulators stop acting as gatekeepers and require financial institutions and structured finance securities to disclose all the useful, relevant information in an appropriate, timely manner?'

Congressman Frank then continues with a list of tools that have been provided to regulators by the Act.  There is one tool that needs to be highlighted as it shows the Act's reliance on the regulators and its non-compliance with the FDR Framework.
... The law also increases transparency through a new office of financial research, to give regulators access to information about the entire financial system.
Congressman Frank goes on and highlights how the Act prescribes one-off regulatory solutions for problems created by the regulators acting as gatekeepers of all the useful, relevant information instead of curing the problems by disclosure of all the useful, relevant information.
Institutions able to create risk and then shed it, along with the collapse of prudent underwriting, contributed to the crisis. So we have also ensured that the “originate to distribute” model, which allowed banks to expand their lending businesses with little risk, will be replaced by one in which all lenders have skin in the game. 
This, combined with the new Basel III capital standards and the ability of regulators to insist on even greater capital, will ensure more prudent and productive lending. 
Finally, Congressman Frank touches on the issue of the size and profitability of the financial sector.

This blog has frequently noted Yves Smith's observation that no one on Wall Street is paid to develop low margin, transparent financial products.  The profitability is in the opacity.

Under the FDR Framework, it is the role of the regulators to require that all financial products disclose all the useful, relevant information in an appropriate, timely manner so that investors can make a fully informed investment decision.

If the regulators shine sunlight into these products, it is reasonable to expect that investors will require a more appropriate return for the risk they are assuming.  As a result, the profitability and ultimately the amount of capital in the financial sector will decrease.
Mr Greenspan ends his article by worrying that these tools may reduce the size of the financial sector as a share gross domestic product. But as Adair Turner, chair of Britain’s financial regulator, and others have noted, growth in the relative size of this financial sector may just divert capital from productive activity to speculation, resulting in lower living standards and efficiency. 
This “financialisation” of developed economies is a question that deserves thoughtful, careful attention. Pending its outcome, however, policymakers must ensure that whatever its size, the financial sector is operating transparently under clear rules that protect taxpayers and promote the stability and growth of the broader economy.

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