Disclosure is the only proven way to restore confidence and liquidity

With Christine Lagarde's call to recapitalized European banks, the solvency crisis that started in 2007 has officially resumed.

In the 1930s, when the global financial system faced a similar solvency crisis, FDR observed that "we have nothing to fear, but fear itself."  He then set about backing up these words.  Specifically, he transformed the financial system from being based on the practice of caveat emptor to being based on the philosophy of disclosure.

The one area where he could not bring disclosure fully to was banking.  The lack of 21st century information technology made it impossible to share with market participants all the useful, relevant information for each bank in an appropriate, timely manner.

Instead, FDR introduced deposit guarantees and enhanced regulation and supervision.  With deposit guarantees, he shifted the risk of loss on deposit investments from the depositor to the government.  With enhanced regulation and supervision, he put in place bank supervision that allowed for examiners to look at all of a bank's useful, relevant information 24/7/365 - to this day, bank examiners still sit full-time in the offices of the countries largest banks looking over everything a bank does from loans to investments and funding.

Given the lack of 21st century information technology, this was the best that FDR and his government could do.  However, it is a solution that is fundamentally flawed.  It creates a systemic point of failure in the financial system by making market participants dependent on the regulator.

This blog has documented a number of ways that failure could occur including:

• The Bank of England's Andrew Haldane provided one in his discussion of the ability of the examiners to transform the data they received from the banks into useful information.

• In Ireland, the Nyberg Report provided another in its observation that the financial regulatory bureaucracy itself is an obstacle because, even when the analysis is correct, the examiner must convince everyone above them in the bureaucracy before action can be taken.

What is clear since the beginning of the solvency crisis is that FDR's solution of enhanced regulation and supervision no longer works and needs to be replaced.

For any doubters, just look at the stress tests. 

European regulators have run stress tests twice.  The first time, banks in Ireland passed the stress test and were nationalized within a couple of months.  The second time, most of the banks passed the stress test and within a couple of months the IMF chief is calling for mandatory recapitalization of the entire sector.

The US experience with stress tests has not been any better.  In 2009, using their monopoly on all the useful, relevant information, the US regulators stress tested Bank of America.  As a result of the tests, BofA had to raise a trivial amount of capital relative to its $2 trillion balance sheet.  In the most recent round of stress tests designed to let banks resume paying higher dividends, the US regulators determined that BofA did not pass, but the regulators did not publicly require that BofA tap the capital markets for additional capital.  Today, some analysts think the capital shortfall could be as high as $200 billion.

There is nothing about the stress tests that suggests they could, would or should restore investor confidence in the banks.  This is not a surprising finding.  Why should investors, including banking counter-parties, trust the regulators after the regulators permitted the financial system to get into so much trouble in the first place?

The failure of the stress tests to restore confidence also confirms FDR's observation that governments should not tell investors what is a good or bad investment, but rather should ensure that investors had access to all the useful, relevant information in an appropriate, timely manner to determine if an investment was a good or bad investment for themselves.

Once again, the global financial system has entered a period of fear.  Banks are limiting the amount of lending to other banks because they cannot tell who is solvent or who is insolvent (another failure of the stress tests).

So how should the financial system be transformed to restore confidence?  By updating FDR's transformation.  Specifically, the financial system has to be based on a combination of the philosophy of disclosure and the principle of caveat emptor.

No longer do financial institutions need to be handled differently.  Today we have low-cost 21st century information technology that makes it feasible to disclose to market participants all the useful, relevant information (current asset and liability-level data for financial institutions) in an appropriate, timely manner.

Providing disclosure to market participants using 21st century information technology eliminates the systemic point of failure in the financial system and increases the stability of the financial system.

Rather than having market participants dependent on regulators, market participants can analyze the facts for themselves and adjust their exposure based on their own assessment of risk.  It is the ability to analyze the facts for themselves that is the source of both investor confidence and market discipline.  

• Investors are more confident when they know what they own.  

• Financial institutions are subject to market discipline when investors can change the amount and pricing of their exposure in response to changes in the financial institution's risk profile.

Rather than having regulators dependent on their own internal analysis or the analysis provided by a bank's management, regulators can turn to third party experts, like a bank's competitors.  This enhances the stability of the financial system.