Independent Banking Commission and Taking on Too Big To Fail

The Financial Times published an interesting column reviewing how the Independent Commission on Banking took on the Too Big to Fail.

Britain’s Independent Banking Commission has recognised that it is better to create a structure that secures the right incentives than to try to control behaviour arising from the wrong incentives.  

From this description, you would think that the Independent Banking Commission had adopted fully implementing the FDR Framework and stripped the financial regulators of their monopoly on all the useful, relevant information on financial institutions.

'It is better to create a structure that secures the right incentives than to try to control behaviour arising from the wrong incentives' is exactly why the global financial markets based on the FDR Framework combine a philosophy of disclosure with the principle of caveat emptor [buyer beware].  The FDR Framework is a structure that secures the right incentives without trying to control behavior.

... It has also recognised that the objective of regulation is not to prevent bank failures. Governments cannot prevent them – though they can bail out failed banks. Such an objective would stifle innovation and undermine management autonomy and responsibility.

Under the FDR Framework, it is not the objective of regulation or the role of government to prevent bank failures, stifle innovation or undermine management autonomy and responsibility.  The objective of regulation and the role of government is to insure that all the useful, relevant information is accessible to all market participants in an appropriate, timely manner.

This is particularly true of financial innovations.  As Yves Smith observed on NakedCapitalism, Wall Street never rewarded anyone for developing transparent, low margin products.

Furthermore, central to the FDR Framework is the idea of market discipline.  With disclosure of all the useful, relevant information, market participants can analyze the risk of a bank and properly value its securities.  If a bank increases its risk and makes failure more likely, market participants will respond by requiring a higher rate of return to hold its debt and equity securities.  It is management's choice how it responds to this market feedback.

Institutions that run into trouble – like Lehman Brothers and Northern Rock – should be able to fail without unacceptable consequences for the financial system. 

It is only in a financial market which fully implements the FDR Framework and strips the financial regulators of their information monopoly on the useful, relevant information on financial institutions that the unacceptable consequences from failure can be avoided.

Without all the useful, relevant information, it is impossible for market participants to properly analyze and price the risk of a financial institution.  Pricing risk has two components:  amount of exposure to the financial institution and cost of this exposure.  If the amount of risk is underestimated, then market participants will provide too much capital, either debt or equity, at too low a price.

However, if all the useful, relevant information is made accessible in an appropriate, timely manner, then market participants can properly price risk.  Since it is buyer beware, market participants know that they could lose their investment if the financial institution fails.  As a result, they only invest as much as they can afford to lose.

Too big, or too complex, or too diversified, to fail cannot be tolerated in a competitive market economy.  A government backstop gives an overwhelming competitive advantage to large established firms and encourages the kind of risk-taking in which risk-takers receive much of the upside and little of the downside. 

In a competitive market economy with a financial system based on the FDR Framework, the only important 'too' is 'too opaque'.

Where the credit crisis hit the financial system was exactly along the fault lines of too opaque.

• The credit crisis hit the opaque structured finance securities.  Without adequate disclosure of the performance of the underlying collateral, the structured finance markets froze on August 9, 2007 when BNP Paribas announced that it could not value these securities.  

• The credit crisis hit the opaque financial institutions.  As reported by the Financial Crisis Inquiry Commission, in late 2008, financial institutions refused to lend to each other because they did not know what each institution's exposure to structured finance securities was and therefore could not determine who was solvent and who was insolvent. 

A government monopoly on all the useful, relevant information on financial institutions gives these institutions an ability to take risk.  Risk that these financial institutions would not necessarily take if their competitors could properly price their exposure to each other [why else would Jamie Dimon and Peter Sands want to know who their 'dumbest competitor' is?].

So the commission correctly focuses on increasing competition and on the separation of retail and investment banking. The analysis is effective, the direction of travel is right. But are the specific measures they propose sufficient to achieve the outcomes they seek?

Since the commission misses the only important 'too', its proposed cures may or may not be relevant or effective.  What is clear about its proposed cures is that unlike disclosure of all the useful, relevant information these cures do not lead to a race to the top among regulators.

... The other main argument the banks have deployed is better, but not much. They emphasise the costs of the split.

While the cost argument might have some traction when it comes to separating retail and investment banking, it has no traction when it comes to disclosure of all the useful, relevant information.

As this blog has documented, inadequate disclosure for structured finance securities resulted in hundreds of billions of dollars of losses.  The cost of providing the asset-level disclosure that would have prevented these losses is a small fraction of the losses.  Therefore, disclosure of all the useful, relevant information is easily justified looking at a cost/benefit analysis.

But the devil is in the detail .... So their proposal is to rely heavily on a 10 per cent capital ratio on these ring-fenced UK retail banking operations.... Have we not learnt that a capital ratio is an inadequate regulatory tool on its own once the range of balance sheet assets multiplies? 

Unlike capital, ensuring access for market participants to all the useful, relevant information in an appropriate, timely manner is both a necessary and sufficient tool by itself to cover the range of on- and off-balance sheet assets.

It is only with this disclosure that the assets can be valued.  It is only with this disclosure that market participants can properly price their exposure to financial institutions and exert market discipline.  It is only with this disclosure that the market can determine which financial institutions are solvent and which are insolvent.  It is only with this disclosure that governments can confidently seize control of a financial institution and not worry about unacceptable consequences.

We can apply two tests to the proposals. Do market prices reflect an expectation that a failed investment banking division of a conglomerate bank will be allowed to fail? Are these banks beginning the radical simplification of corporate structure needed to make such resolution a realistic possibility? 

The market reaction so far suggests a view that the banks have got away with it. Sir John is
understandably angry at this suggestion, as he stood up to unacceptable pressure from vested interests. But that the outcome is at once radical and weak is a measure of how biased the debate so far has been.

Had Sir John and the commission instead chosen to champion fully implementing the FDR Framework and strip the financial regulators of their monopoly on the useful, relevant information on financial institutions, the market would not believe that the banks have got away with it.

The market reaction would have been that the issue of the best structure for banks had finally been addressed as providing the market with all the useful, relevant information in an appropriate, timely manner is the best structure.