Thursday, June 9, 2011

UK bankers' testimony shows why disclosure is best solution

Why is it that economists and the financial regulatory bodies they work for prefer complex solutions that have been shown not to work over simple solutions that have been shown to work?

Currently, there are two complex solutions that have been attracting attention and support from economists and regulators:  ring-fencing and higher capital requirements.  History has shown that neither of these solutions works to prevent a financial crisis.

The ultimate in ring-fencing was the Glass-Steagall Act that separated lending and deposit taking from investment banking and trading.

Did the Act prevent a financial crisis?  No, unless you do not consider the Latin American Debt Crisis and the Savings and Loan Crisis examples of a financial crisis.  What these examples show is that financial institutions that take deposits are perfectly capable of rendering themselves insolvent based on their lending decisions.

Lehman Brothers is the classic example of why higher capital requirements do not work to prevent a financial crisis either.  At the moment the financial markets decided that Lehman was insolvent, it was reporting very high capital ratios.

The Telegraph ran an article on the leading UK bankers testifying before Parliament in which they highlighted how these ideas actually make the financial system riskier.
Bob Diamond, chief executive of Barclays, said the Government-appointed Independent Commission on Banking's (ICB) plans to ring-fence retail banking could make an implicit state guarantee for banks "explicit". 
Stephen Hester, chief executive of Royal Bank of Scotland, said such ring-fencing could introduce "moral hazard" and increase the cost to taxpayers if there were a new crisis. 
"There is a risk of moral hazard if you create a protected beast that the Government will support, while other parts of the banks are made more volatile as there is no way they would be supported," he said. 
The bankers' comments came in evidence to the Treasury Select Committee, which also saw Douglas Flint, chairman of HSBC, and António Horta-Osório, chief executive of Lloyds Banking Group, give their views on the dangers to the UK financial system of some of the proposed changes.
The ring-fencing idea was made in the ICB's interim report published in April where it suggested the UK retail banking businesses of large banks should be put into separate units that could be isolated from the rest of a bank in the event the lender got into trouble. 
In a submission to the Commission released yesterday, HSBC said the proposal risked causing "immense dislocation of funding markets for banks and UK corporates".
By comparison, the simple solution of disclosure combined with principle of buyer beware under the FDR Framework has shown that it works over the last 75+ years.

This solution does not introduce moral hazard.  In fact, it ends the era of bailing out financial institutions because investors know they have access to the data needed to make a fully informed investment decision and therefore willingly, if not happily, accept any losses that result from their investment decision.

This solution does not cause dislocation of funding markets.  In fact, it allows funding markets to properly price risk.

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