Saturday, August 27, 2011

Fed and other regulators need policing says Brown University economist Ross Levine

Yahoo carried a very important article on Brown University economist's Ross Levine and a paper he presented at the 2011 Jackson Hole conference on the Fed and other financial regulators needing policing.

This blog identified this issue and began discussing how the FDR Framework handles this issue months ago in posts titled regulators as source and perpetuator of financial instability and the future of finance: the end of opacity and the mother of all databases.

From regulators as source and perpetuator of financial instability:

In his speechBanking:  From Bagehot to Basel and Back Again, Mervyn King, the Governor of the Bank of England, observed,
A market economy has proved to be the most reliable means for a society to expand its standard of living. But ever since the Industrial Revolution we have not cracked the problem of how to ensure a more stable banking system. 
 Why is the banking system unstable?
As discussed in the post, Bank Capital and Bank Runs, banks are unstable because depositors and investors have no way of knowing if a bank is solvent or not.  If doubt about a bank's solvency is raised, the best course of action for the depositor and investor is to withdraw their funds as quickly as possible - this is referred to as a run on the bank.

To limit bank runs, the US government adopted deposit insurance.  This eliminated the solvency issue for retail customers [the depositors], but not for wholesale customers [investors].  The Financial Crisis Inquiry Commission documented how wholesale customers, including other banks, withdrew their funds because they could not determine if a bank was solvent or not.

How does the FDR Framework address this instability?

The FDR Framework provides the solution.

Our financial markets are based on the idea of combining the notion of disclosure with caveat emptor [buyer beware].  As the FDR Framework puts its, governments are responsible for disclosure and investors are responsible for doing their homework [trust, but verify].

To fulfill its disclosure responsibility, government must do two things:

  • ensure market participants have access to all the useful, relevant information in an appropriate, timely manner; and
  • avoid endorsing specific investments.
When it comes to the banking system, the government does not do either of these things. 

The result of the government's failure to fulfill its disclosure responsibility is that the instability of the banking system is increased and not decreased.

Why doesn't the government fulfill its disclosure responsibility?

One part history.  One part the failure to adhere to the FDR Framework.

In discussing the FDR Framework, this blog has highlighted how the absence of 21st century information technology in the 1930s required the government, with its exposure through deposit insurance, to take on the monitoring, analysis and discipline role for financial institutions that the financial markets would otherwise perform.
The regulators had to do this because they did not have the alternative of financial institutions disclosing all the useful, relevant information in an appropriate, timely manner to market participants.

For regulators operating in the 21st century, disclosing this information is a viable option. [please see the following article for a discussion on how this could be effectively and efficiently done using the shadow banking system as an example.]

What is the result of regulators not disclosing all this information?

As predicted by the FDR Framework, by not disclosing all the useful, relevant information they have access to, regulators are an obstacle to markets functioning properly. 
For example, they engage in stress tests in an effort to restore market confidence.  In reality, the stress tests only serve to perpetuate the notion of Too Big to Fail.  How can an investor be expected to be willing to take a loss investing in a bank when 1) the investor does not have access to all the useful, relevant information in an appropriate, timely manner to analyze and 2) the regulators are saying that the bank is in excellent financial shape because it passed a stress test?

It is the regulators who are perpetuating and increasing instability in the banking system. 

Regulators do this by acting as gatekeepers and maintaining information asymmetry between the information provided to the markets and the current asset-level data the market participants want and need if they are to analyze each financial institution and correctly price risk.
How do regulators increase instability in the financial system?

If only the regulators look at current asset-level data, the banking system has a critical weakness.  It is dependent on the regulators to be right in their analysis.  Since there is no back-up, if the regulators fail, the system is prone to crashes.

We know the financial system is prone to earthquakes when they are the only market participant with access to current asset-level data.  We had the U.S. Savings & Loan Crisis, the Less Developed Country Debt debacle, Long Term Capital Management meltdown, and of course the sub-prime wipeout.  

Please note, these failures occurred when the monetary authority and supervisory authority were combined (the Fed) or when they were separate (the BoE and FSA).  

Given this history of not spotting problems before they threatened to become systemic issues, why should the market believe that the regulators will not fail in the future?  

Your humble blogger prefers not to let the regulators gamble on redemption (when only they can see the current asset-level data, their reputation is redeemed until the next crisis hits).

The source of instability is a structure where only the regulators get to see the current data.  If the data were made available to the market, everyone would get to see what is going on.  This would allow the market to contribute to analyzing the data and taking corrective action before the problem threatens the financial system.

Rather than provide all the current asset-level data, why can't regulators provide a summary?

Anything less than providing all the current asset-level data means that regulators are substituting their analytical abilities for the analytical abilities of the market.

Regulators claim to have learned their lesson from the credit crisis when it comes to analyzing current asset-level data.

For example, the Fed put over 100 of its PhDs on the stress test.  They requested more asset level data than they had ever requested before from the banks so they could double check the results to the stress tests that the banks were reporting.

All of which leaves one question unanswered:  why would Jamie Dimon believe that a regulator could do a better job of analyzing this asset level data and the risk of his competitors than his organization could?
Are you recommending getting rid of the supervisory function?

Absolutely not! 

The goal is to get a stable banking system without the economic distortions caused by regulator enforced information asymmetry.  Markets, and the global banking system is a market, function best when ALL market participants, including regulators, have access to the same useful, relevant information in an appropriate, timely manner.

As has been said previously on this blog, by providing this data to the other market participants, the global regulators get to piggyback off of their analysis.  For example, they can compare their analysis to JP Morgan's.  If the results differ, it would be informative for the regulators to understand why.
From the Future of Finance:  the End of Opacity and the Mother of All Databases:

The future of finance is the elimination of opacity throughout the financial system by using 21st century information technology.

This statement is the logical conclusion of the Bank of England's plan to substitute market discipline for bank examination.  As discussed in an earlier blog, Bank of England Adopting 21st Century Oversight of Financial Institutions,  the current model of bank examination does not work.

The current bank examination model, as practiced by regulators like the Financial Services Authority and Federal Reserve, involves sending out large numbers of examiners to look through the banks' books, demanding lots of detailed information for their internal review and asking the banks to run stress tests on assumptions the regulators provide.  A key feature of this model is that no detailed information is shared with the markets.

If this model looks like it parallels how the rating agencies operate, it does.   The parallel in the US goes all the way to the issuance of a CAMELS rating by the regulator.  A CAMELS rating is for regulators eyes only and is a reflection of a bank's overall condition in the areas of capital adequacy (C), asset quality (A), management (M), earnings (E), liquidity (L) and sensitivity to market risk (S).

Just like the ratings produced by the rating agencies, since the markets do not have the information to do their own homework, the markets have to trust that the regulators get their ratings right.  Unfortunately, recent history shows that regulators were just like the rating agencies and they did not always get their ratings right.

According to a WSJ article

"a top Bank of England official, Andy Haldane, said the new regulator will curtail the FSA's practice of dispatching dozens of examiners to banks to collect loads of granular information... Mr. Haldane noted that ... they rarely yield much useful information for regulators, who can find themselves overwhelmed by the quantity of data."
Mr. Haldane identified the flaw in the bank examination model and the reason that regulators need to have banks disclose more information to the markets.

The markets are not overwhelmed by the quantity of data disclosed by financial institutions.  There are a number of market participants who are able to and have an incentive to analyze all of the individual asset level data these institutions could provide and turn it into useful information.

... On February 23, 2009, in a Wired article, Daniel Roth provided the support for Mr. Haldane's observation and solution in much more detail.  

"Even the regulators can't keep up. A Senate study in 2002 found that the SEC had managed to fully review just 16 percent of the nearly 15,000 annual reports that companies submitted in the previous fiscal year; the recently disgraced Enron hadn't been reviewed in a decade. We shouldn't be surprised. While the SEC is staffed by a relatively small group of poorly compensated financial cops, Wall Street bankers get paid millions to create new and ever more complicated investment products. By the time regulators get a handle on one investment class, a slew of new ones have been created. 'This is a cycle that goes on and on—and will continue to get repeated,' says Peter Wysocki, a professor at the MIT Sloan School of Management. 'You can't just make new regulations about the next innovation in financial misreporting.' 
That's why it's not enough to simply give the SEC—or any of its sister regulators—more authority; we need to rethink our entire philosophy of regulation. Instead of assigning oversight responsibility to a finite group of bureaucrats, we should enable every investor to act as a citizen-regulator. We should tap into the massive parallel processing power of people around the world by giving everyone the tools to track, analyze, and publicize financial machinations. The result would be a wave of decentralized innovation that can keep pace with Wall Street and allow the market to regulate itself—naturally punishing companies and investments that don't measure up—more efficiently than the regulators ever could.
Tracking Wall Street's complex inventions may be difficult for regulators, but it's a snap given the right software....When data is kept under lock and key, as mysterious as a temple secret, only the priests can read and interpret it. But place it in the public domain and suddenly it takes on new life. People start playing with the information, reaching strange new conclusions or raising questions that no one else would think to ask. It is impossible to predict who will become obsessed with the data or why—but someone will.

'People care about money,' Tim Bray, director of Web technologies at Sun Microsystems says. 'There's money in money and substantial personal upside to someone who can mine the data and uncover the truth.'"

Regular readers know that the best way to police the Fed and other financial regulators when it comes to their regulatory function is to require that all current asset and liability-level data is disclosed to the market participants in an appropriate, timely manner.  With this data, market participants can Trust, but Verify what the regulators say and do.

From the article on Professor Levine's paper:
Global financial regulators are likely to impede growth rather than foster it unless they are better policed, an economist warned policymakers on Saturday. 
While regulatory reform since the 2007-09 financial crisis has given added clout to government regulators, the concentration of power is likely to do more harm than good unless the regulators themselves are subject to proper oversight, Brown University economist Ross Levine said in a paper presented at the Kansas City Federal Reserve Bank's annual meeting here. 
"As more responsibilities are heaped on official regulatory agencies, it is unclear whether they have either the capabilities or the incentives to properly shape the incentives of financial systems," he said in the paper. 
A case in point is the Fed itself, which won new authority over large financial institutions in the Wall Street reform legislation passed last year. 
Central bank regulators do not lack in integrity, he said, but nevertheless relying on the "moral compass" of regulators does not guarantee they will do the right thing. 
"People flow between the Fed and the financial services industry, raising concerns that this 'revolving door' threatens the Fed's independence and its ability to represent the broad interests of the public," Levine said in the paper "And, the daily interactions between regulator and regulated can influence the perspectives of regulators, such that regulators take a narrow, skewed view of regulatory policies." 
The Fed has drawn sharp criticism from politicians at home and abroad who say the central bank's super-easy monetary policy is driving down the dollar and pushing up the price of global commodities. 
Levine's critique of the Fed is different because it is focused on the bank's regulatory role. It is notable because it paints the world's most influential central bank and other U.S. regulators with the same brush as government financial watchdogs in countries around the world. 
Oversight of regulators is critically important for promoting economic prosperity, Levine said, because without effective regulators, the financial system will not operate correctly and will drag on growth. 
"This lesson is as applicable today for the United States as it is for countries with less well-developed institutions," he wrote.

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