The FDR Framework Answers the Question: Who Will Guard the Financial Guardians

The Telegraph ran an interesting series of articles on the Bank of England.  Topics covered included how the BoE added to its regulatory responsibilities without anyone asking what was the BoE's contribution to the financial crisis (here), can the BoE succeed in preventing future financial crises with these new powers (here) and who is in charge of the major functions performed by the BoE (here, here and here).

Damian Reece wrote the capstone article in which he asked "who will guard the guardians at the Bank of England?" In the absence of the adoption of disclosure as required under the FDR Framework, the answer is no one.

The recent credit crisis demonstrated why having no one guarding the financial guardians is a problem.

In the US, the Federal Reserve had essentially the same functions as the newly enhanced BoE prior to the credit crisis.  Having all the functions under the Federal Reserve did not prevent the credit crisis from hitting the US.

Who will guard the financial guardians?

When disclosure as required under the FDR Framework is adopted, the answer is the other financial market participants.

What is the FDR Framework?

The FDR Framework, which has been the basis for the global financial system for the last 75+ years, combines the philosophy of disclosure and the practice of caveat emptor (buyer beware).  In modern times, this is also known as trust, but verify.

Under the FDR Framework, all market participants have access to all the useful, relevant current asset and liability-level data for each financial institution in an appropriate, timely manner.

This represents the end of the financial regulators', including the BoE's, information monopoly.  With the end of this monopoly comes the end of the financial instability and the mis-pricing of risk caused by regulators.

Under the current system where financial regulators have an information monopoly, there are many ways that regulators contribute to financial instability and the mis-pricing of risk including:

• As Andrew Haldane of the BoE observed and the Nyberg Report on the Irish Crisis discussed, regulators do not always correctly analyze the risk of a financial institution.  By definition, this causes risk to be mis-priced because the information monopoly forces other market participants to be dependent on the regulators (how can they verify that the regulator is wrong); and  

• Even if the analysis is correct, the information monopoly allows regulators to misrepresent the condition of a financial institution and gamble on redemption for insolvent financial institutions.  The Savings and Loan Crisis in the US went on for several years before the government finally moved to close the insolvent institutions.

How do other market participants guard the BoE?

Under the practice of caveat emptor, investors and competitors, who are exposed through the interconnectedness of the financial system, have an incentive to analyze the data and understand the riskiness of each financial institution.  Based on their analysis, they adjust both the price and amount of their exposure to any financial institution.

Market participants adjusting both the price and amount of their exposure to any financial institution has many beneficial implications for the financial system.

• It introduces market discipline to financial institutions by establishing the link between the riskiness of the financial institution and its cost of and access to funds.

• It re-establishes that investors and not taxpayers are on the hook for losses.

• It ends regulatory gambling on redemption as it is obvious to all market participants when a financial institution is insolvent and should be closed by regulators.

• Regulators can use a financial institution's cost of funds relative to its peers as both an early warning device of increased risk at a financial institution and as a trigger to tell them when to step in and close the financial institution.

• It ends taxpayer bailouts.  

From the Telegraph article,

[N]o [regulatory] system will ever be perfect.

That is why fully implementing the disclosure requirement of the FDR Framework is critical.

A key difference this time round will be that the failure of a bank, or other major institution, will be assumed. However, regulators will be given the tools to deal with such a failure and resolve outstanding liabilities without creating the sort of system-wide risks witnessed in 2008.

Simon Johnson likes to ask if anyone believes that Goldman Sachs could be resolved if it fails.  He reports that no one does.  He extends this observation to cover the other Too Big to Fail banks like RBS, Lloyd's and HSBC.

It's inevitable retail deposits will have to be ring-fenced, presumably doing away with the need for depositor insurance.

A ring-fence for retail deposits is a nice concept.  However, this only works if the assets on the other side of the balance sheet are restricted to cash or very short duration UK government securities.  If the eligible assets include loans, then it is possible to sink the ring-fenced retail deposits with credit losses.

The Bank will retain a lender of last resort capability to inject emergency liquidity into the system. 

An advantage of adopting the full disclosure requirement under the FDR Framework is that it also applies to assets like structured finance securities.  With this disclosure, the market can value the assets.  As a result, the BoE can once again lend freely against only good collateral.

But with banks forced to adopt effective resolution procedures, their own failings can be visited upon shareholders and creditors, rather than the taxpayer, so reducing the previous system's moral hazard where a bail-out was always assumed. 

Actually, the previous system did not assume a bail-out.  What created the moral hazard at the beginning of the credit crisis was a) governments injecting funds into the banks without first wiping out the existing shareholders and unsecured creditors and b) regulators administering stress tests and claiming that the results showed the banks to be solvent.

... But clearly there are still issues. How this new, all-powerful Bank is made accountable is key among them. Quis custodiet ipsos custodes? It's fine to say it will be answerable to Parliament. There is an assumption that somehow Andrew Tyrie's Treasury Select Committee (TSC) will do the job. 

But with the best will in the world, as constituted, the TSC will be a flimsy device. The amount, detail and complexity of the Bank of England requires a rather more robust watchdog than a horseshoe of MPs who may or may not turn up for hearings, depending on constituency pressures and other Westminster distractions.