Thursday, May 19, 2011

UK's Prudential Regulation Authority Adopts Current Asset-Level Disclosure

On May 19, 2011, the Bank of England published its approach to bank supervision under its Prudential Regulation Authority (the "PRA").

In discussing the Principles Underlying the PRA's Approach, the Bank of England and the Financial Services Authority observed under principle 10
That firms should be allowed to fail, so long as failure is orderly, reflects the view that financial firms should be subject to the disciplines of the market.  Consistent with its statutory objective, the PRA will not view the failure of an institution in an orderly manner as regulatory failure, but rather as a feature of a properly functioning market. This is an important change to the statutory basis of prudential supervision.  The PRA will seek to ensure that firms disclose sufficient information to enable the market to make judgements about risk and return.
As regular readers of this blog know, the only way for market participants to have sufficient information to make judgements about risk and return is if the market participants have all the useful, relevant information in an appropriate, timely manner.

When it comes to financial firms, the useful, relevant information is the firm's current asset and liability-level data.
  • This is the data that market participants need to analyze to determine if a firm is solvent [that the market value of the firm's assets exceeds the book value of the firm's liabilities].  
  • This is the data that market participants need to analyze to see if the risk profile of a financial firm is changing and to adjust both the price and amount of their exposure to the change in the financial firm's risk profile.  It is through the adjustment of price and amount of their exposure that market participants exert market discipline on financial firms.
  • This is the data that market participants require if they are going to be willing to once again absorb losses in the case of the failure of a financial firm.  
    • In the absence of this data and the presence of financial regulators issuing assurances about the solvency of a financial firm, investors are unwilling nor is it reasonable to expect them to absorb solvency losses.  
    • In the presence of this data, it is no longer necessary for financial regulators to opine on the solvency of a financial firm.  Under the principle of caveat emptor [buyer beware], investors will use this data to determine the price and amount of their exposure knowing they could lose their investment to insolvency.
For those who would argue that there is a middle ground between what financial institutions disclose now and full disclosure of their current asset and liability-level data, the question is "Why should there be a middle ground?"
  • How can investors exert market discipline without all the useful, relevant information? 
  • Why would investors be willing to absorb solvency losses without the opportunity to analyze all the useful, relevant information prior to making an investment?  
  • Why would investors not expect a bail-out from all solvency related losses when regulators are running stress tests and saying the financial institutions are adequately capitalized? 
  • What benefit is there to the financial markets of not disclosing all the useful, relevant information?
    • Financial institutions would prefer opacity because it limits the market's ability to properly judge and price risk and therefore makes them more profitable.  Why is this good for the financial market and the economy?
  • Why would the financial system be more stable in the absence of disclosure of all the useful, relevant information?  
    • Are regulators better at judging the risk and solvency of a financial institution than its competitors and the market's credit and equity market analysts?

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