Monday, May 23, 2011

The Economist Magazine calls for new model of bank supervision

The Economist Magazine ran a special report in which it discussed a number of shortcomings of the current system of regulating banks and the need for a new model of bank supervision.

BANKING CRISES OF the sort that affect a large part of the world, slowing global economic growth, freezing finance and crimping international trade, are mercifully rare.... The costs of any such meltdowns are difficult to estimate... It is not just a question of totting up the direct costs of bailing out the banks or transferring debt from private balance-sheets onto those of the state. There is also the toll of broken lives, lost homes...
Most of the time, though, banks do not blow up. When things go well, they help to produce growth and wealth. They also make people’s lives easier.... 
Regulators and their political masters now have to ensure that the benefits of a vibrant and innovative banking system are ever more widely spread and meltdowns become ever rarer. ...
Yet there are still fundamental flaws in the global financial system. All the measures that regulators are putting in place to try to make banks safer, such as higher capital requirements, stricter regulation and limits on risk-taking, need to be tested against a simple question. If all other safeguards have come to naught, can big financial institutions be allowed to go bust (or be saved without asking taxpayers to stump up)? ....
Regulators are finding it hard to crack this problem... because they are being excessively cautious, seeking certainty before they act. Like a jury in a criminal trial, they are looking for evidence that is beyond reasonable doubt. 
Actually, the FDR Framework has 75+ years of evidence that shows it solves the regulators' problem.

As this blog has documented on several occasions [see here, here, here, here and here for example], it it the regulators' monopoly on all useful, relevant information for financial institutions that is the source of financial instability and the reason that it is impossible to let big financial institutions go bust.

This monopoly forces market participants to be dependent on the regulators.  This monopoly prevents the market participants from performing their risk management function and properly adjusting both the price and amount of their exposure based on the risk of a financial institution.  

If the regulators were to give up their monopoly on all the useful, relevant information, they would be able to let banks go bust again.  The FDR Framework explains why through its combination of disclosure to market participants of all useful, relevant information in an appropriate, timely manner with the principle of caveat emptor [buyer beware]. 

With access to all useful, relevant information, market participants can now evaluate the riskiness of an investment in a financial institution.  With the ability to do their homework, the market participants accept all the gains or losses on any investment knowing the investment was made under the principle of caveat emptor.

It is the ability to control exposure combined with the acceptance of losses that allows financial firms to go bust without causing a financial crisis.  Financial firms can go bust again because market participants only have as much exposed to a financial firm as they feel comfortable losing.

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