Wednesday, May 18, 2011

Donald Kohn and the BoE's Financial Policy Committee could use a lesson in the FDR Framework

Testifying before British MPs at a confirmation hearing for the Bank of England's new Financial Policy Committee, Mr. Kohn demonstrated why he and other financial regulators could use a lesson in the FDR Framework.

According to a Financial Times article,
Speaking to British MPs at a confirmation hearing on Tuesday, Mr Kohn nevertheless said his experience would be valuable for the Bank of England, where he has been appointed to a new committee with powers to guide UK financial stability
“I believe I will not make the same mistake twice,” he said. 
This suggests an acknowledgement of what mistake he made is coming...
Mr Kohn has been appointed to the Bank’s new Financial Policy Committee, which will soon have powers to change system-wide UK financial regulations and even limit borrowing by households and companies if it thinks there are threats to financial stability. 
Having been a strong advocate of the Greenspan doctrine not to burst asset bubbles but to mop up any mess after a crash, Mr Kohn recanted much of his previous view in front of MPs.
Apparently the mistake was in not bursting the asset bubbles but instead waiting to mop up any mess after a crash.

However, the alternative of central bankers and financial regulators popping asset bubbles sooner is a non-starter.

As this blog has gone to great lengths to document (see discussion of the Nyberg Report on Ireland) and explain, there is an institutional reason that central bankers and other financial regulators do not burst asset bubbles sooner.
  • First, the regulators have to come to a consensus that there is a bubble.  Some analysts in one part of the regulatory bureaucracy might think that there is, but it is a long way from their belief to convincing the entire regulatory body to share their view and take action. 
  • Second, the regulators need evidence that the bubble is harmful.  Without this, politicians are likely to crackdown on the regulators as all that is visible to the politicians is the benefits of the asset bubble.
Returning to the FT article
He said he had “learnt quite a few lessons – unfortunately” from the financial crisis, including that people in markets can get excessively relaxed about risk, that risks are not distributed evenly throughout the financial system, that incentives matter even more than he thought and transparency is more important than he thought
And here is where the lesson in the FDR Framework comes in.  These are not separate, but issues that are all linked logically together under the FDR Framework.

As regular readers of this blog know, the FDR Framework makes the financial regulators responsible for ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner.  This is the transparency that he learned is important.

Under the FDR Framework, market participants, particularly investors, are responsible for analyzing this information to assess the risk of any investment knowing that it is buyer beware for any investment they make.

The requirement to ensure transparency is placed on financial regulators because there are market participants who benefit from opacity.  This is where incentives matter comes in.  The way these market participants benefit from opacity is that opacity makes it impossible for investors to properly analyze and price risk.
Similar to Mr Greenspan’s 2008 comment that the former Fed chairman had erred in presuming banks were able to act in their shareholders’ interests, Mr Kohn said: “I placed too much confidence in private market participants to police themselves”.

Actually, the financial crisis did not show that confidence in private market participants to police themselves was misplaced.

What the financial crisis showed was that since the financial regulators have an informational monopoly on all the useful, relevant information for each financial institution, other financial market participants are dependent on the regulators' assessment of the risk of the financial institutions.  When the financial regulators under-estimate the risk of the financial institutions, so do the other market participants. 

As predicted by the FDR Framework, without the useful, relevant information, the other market participants cannot exert any market discipline or police the financial institutions themselves should the risk profile of the financial institution change. 

The former Fed official was willing to offer an apology... 
“I deeply regret the pain that was caused to millions of people in the US and around the world by the financial crisis ... Most of the blame should be on the private sector: the people that bought and sold those securities, on the credit rating agencies that rated them. But I also agree that the cops weren’t on the beat,” he said 
“The regulators were not as alert to the risks as they could have been and, to the extent they saw the risks, were not as forceful in bringing them to the attention of management, or taking actions, as they could have been. All this with 20/20 hindsight obviously.”
Actually, it is a matter of public record that your humble blogger using the FDR Framework saw the problems in the financial system before the financial crisis and recommended steps that would have reduced the severity of the crisis.

Your humble blogger would be willing to sit on or consult with the BoE's Financial Policy Committee as it is clear that the committee could benefit from the insights of the FDR Framework.

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