Why the G20 Leaders and their Financial Regulators Cannot Rein in Bankers

In a CNBC article, Bankers Running Rings Around Regulators, Gordon Brown sheds light on what the G20 leaders were thinking and doing at the start of the credit crisis.  Even more importantly, he shows the dependence of regulators on the surviving bankers for guidance in how the regulators should respond to the credit crisis.

Stephen Lewis, Chief Economist at Monument Securities, discusses how listening to the surviving bankers assured that reform would not address the heart of the problem.

As long time readers of this blog know, the heart of the problem is the failure by the regulators to insure that all useful, relevant information is made accessible to all market participants on an appropriate, timely basis.  This applies equally to structured finance securities and current asset/liability level data at financial institutions.  All useful, relevant information is needed if market participants are going to be able to analyze the risk and properly price investments in structured finance securities or financial institutions.

Last weekend Brown admitted the great and the good meeting at the G20 that week in March 2009, when global equity markets bottomed, didn’t really understand what was going on. 

“We didn't understand how risk was spread across the system, we didn't understand the entanglements of different institutions with the other and we didn't understand even though we talked about it just how global things were, including a shadow banking system as well as a banking system,” said Brown in a speech in New Hampshire in the United States. 

"That was our mistake, but I'm afraid it was a mistake made by just about everybody who was in the regulatory business," he said. 

This admission is stunning and definitely worth reading a second time.

Here is a key figure in the global response to the credit crisis admitting that the G20 leaders and their financial regulators didn't really understand what was going on and made a mistake.

Then to get out of having to take responsibility for the failure to understand what was going on, he offers up the excuse of nobody understood where risk was in the system and how market participants were interconnected.  How could the G20 leaders and their regulators be blamed for their not having solved these incredibly complicated problems?

It is most definitely true that the G20 leaders and their regulators had no idea how the global financial system actually worked when the credit crisis began.  The leaders and regulators did not understand that since World War II the global financial system has been based on the FDR Framework and its philosophy of disclosure combined with the principle of caveat emptor (buyer beware).

If the leaders had understood the principles underlying the FDR Framework, they would have seen that opacity drove both Wall Street's profitability leading up to the credit crisis and the freezing up of the financial system.

• As noted by Yves Smith, nobody on Wall Street was paid for designing transparent, low margin products.

• As noted by the Financial Crisis Inquiry Commission, the financial system froze when nobody could figure out a) the value of the opaque structured finance securities and b) the solvency of any entity holding these securities.

If the G20 leaders and their regulators had understood the principles underlying the FDR Framework, the regulators would have focused on their responsibility to ensure that all market participants had access to all the useful, relevant information in an appropriate, timely manner.  At a minimum, this would have greatly reduced the severity of the credit crisis.

Instead, given their lack of understanding of the principles underlying the global financial system and

...aware of the fact that they where ill-equipped to make tough decisions on banking, the politicians turned to those bankers lucky enough to have survived for advice on change the rules. 

“Needless to say, the advice they received, while recognizing the political necessity of offering a few banker-bashing concessions, strongly favored preserving the structure of the banking system in its pre-disaster form. The politicians were warned that any other course would threaten global economic stability” said Lewis. 

Since before the credit crisis began, your humble blogger was warning about opacity in structured finance securities and advocating a simple fix.  Subsequent to BNP Paribas' August 9, 2007 acknowledgement that it could no longer value structured finance securities, your humble blogger and the simple fix were the subjects of articles in the mainstream media.

Your humble blogger also spent a great deal of time and effort reaching out to the regulators and the G20 leaders.

Given that enforcement of the FDR Framework would eliminate their profits from opacity, it is no surprise that the banks were not fans of the FDR Framework and instead pushed to have the financial system restored to its pre-crisis opacity driven form.

By adopting the bankers' advice and failing to enforce the FDR Framework, the G20 leaders and their financial regulators have added at least $1 trillion to the cost of the credit crisis that must be paid by taxpayers.

The subsequent piecemeal approach to banking reform has been unsatisfactory according to Lewis. 

“A striking example has been the Dodd-Frank legislation in the USA, which has required banks to desist from proprietary trading in capital market instruments. Dodd-Frank has failed to please anybody, however, partly on account of the arbitrary distinctions it draws between those activities that are proper to banking and those that are not, and partly because it is already seen to be failing as a means of preventing the revival of market practices that led to the 2007-08 crisis,” Lewis said.

Whether the reforms in place or to be put in place can prevent another crisis remains a big doubt. 

“I think we have seen this movie before” said Ted Price, from Canada’s Office of the Financial Institutions last month. “But the amazing thing is we continue to expect a different ending.” 

The Dodd-Frank Act created the Office of Financial Research.  The focus of this office is to look at risk and the interconnectedness of the financial system.

The proponents of this office envisioned it being like the national weather service.  Collecting, analyzing and disseminating information.

Unfortunately, the banks were able to add to the mandate of this office.  To preserve opacity in the financial system and effectively neuter the office, the banks added that all data collected by the office is confidential.

While the office could collect all the current asset and liability level data from Goldman Sachs, it could not share this data with the market participants who would have an incentive to and knowledge of how to analyze this data and turn it into useful information.

Instead, the office will have to rely on its in-house experts.  The problem is attracting experts.  While there are plenty of PhD's who claim to be an expert, if an individual is really good at turning this data into useful information, the individual could earn far more money working on Wall Street.

Lewis said a number of investment banks are now taking on more risk in order to meet profit targets. 

“They do not apparently regard a reduction in those targets as an acceptable trade-off for operating in a safer financial system. As long as banks are driven by short-term profitability goals, it seems, there will be a bias in the financial system towards undue risk-taking and a significant chance that another systemic crisis will erupt,” he said. 

“It will not make any difference to systemic risk that rules on pay have been introduced. If bankers do not know where future dangers to profitability lie, they will not know what to avoid, however they are paid,” he added. 

The FDR Framework has an enforcement mechanism to restrain risk taking.  When market participants have all the useful, relevant information, they are able to analyze and properly price the risk of these banks.  If a bank chooses to increase its risk profile (and market participants believe that the taxpayers will not bailout the bank if it fails), the bank's cost of debt will increase and its stock price will fall to compensate investors for the higher risk.  It is this increase in cost of funds and falling stock price that restrains bank risk taking.