Friday, September 2, 2011

Banks 'still expect taxpayers to pay for their failure' given the regulators' information monopoly

A Telegraph column by Philip Aldrick focused on a comment made by the Bank of England's Paul Fisher that banks still expect taxpayers to pay for their failure.  As this blog has frequently mentioned, banks should feel this way so long as regulators maintain a monopoly on all the useful, relevant information for each bank.

Without this current asset and liability-level data, banks cannot assess the risk of any bank that they do business with and adjust both the price and amount of their exposure according to the findings.  Instead, the banks have to rely on the assurances of the regulators that the other banks are solvent.

This sets up the situation that we are currently in where taxpayers have to bailout the banks because the banks cannot be held responsible for any losses that result from relying on regulatory assurances.

Mr. Fisher's solution is not to end the regulators' information monopoly and the implied taxpayer bailout of any errors made by regulators, but to run stress tests with more onerous assumptions.

Under this solution, regulators continue gambling with the taxpayers' money as the solution still leaves the banks relying on the regulators' assurances of solvency.  If these assurances are incorrect, banks should expect the taxpayers to bail them out.
In a paper published yesterday, Paul Fisher, the Bank's executive director for markets, disclosed that "some banks have told us that they think they should not be required to hold capital and liquidity to deal with such extreme tail events – leaving the public sector to be the capital provider of last resort". 
His comments clash with the public statements of bankers who claim lenders should not be a burden on the taxpayer. 
Earlier this year, Bob Diamond, Barclays' chief executive, told the Treasury Select Committee: "It is not acceptable for taxpayers to bail out banks," adding that "badly managed" lenders should be allowed to fail. There is no suggestion that Mr Diamond is among those to whom Mr Fisher was referring. 
Add Mr. Diamond to the list of bank CEOs calling for a disclosure of all the useful, relevant information so they can determine who their dumbest competitor is and avoid any exposure to them.
Mr Fisher ... claimed the crisis was partially caused because bank bosses "seemed to have had no grasp of how risky their exposures really were".
Without the current asset and liability-level data, bank bosses have no ability to assess how risky their exposures to other financial institutions really are.  The bank bosses are blindly betting with their exposures to other financial institutions based on regulatory assurances.  This is the problem created by the regulators' monopoly on all the useful, relevant information and the publication of assurance by the regulators as to the solvency of each bank!

With the disclosure required under the FDR Framework, this problem goes away.
The reason was the weakness of stress tests, which looked at each bank in isolation and failed to "make consistent assumptions about ... general market conditions". 
This reason appears to highlight one source of errors made by regulators.  After all, it is the regulators who have both the monopoly on the information needed to run the stress tests and oversee the stress tests.
In future, he proposed conducting "extreme stress tests" – including potentially testing banks to destruction. 
"At some level, there is always a stress scenario that forces bankruptcy. Perhaps the greatest sin in the years preceding the financial crisis was blatantly ignoring what really would happen if the 'unthinkable' ... actually happened." 
Actually, the greatest sin in the years preceding the financial crisis was the failure to use 21st century information technology to support disclosure of all the useful, relevant information for each financial institution.

With this information, each financial institution could have protected itself from other financial institutions that took on excessive risk.  A likely result of financial institutions protecting themselves is that the financial crisis would have been far less severe and the financial system would have been far more stable.
Directors’ reluctance to bullet-proof their banks against extreme risks, however, “leads directly to moral hazard and excessive risk-taking”, Mr Fisher said. 
It is not the directors' reluctance to bullet-proof their banks that leads directly to moral hazard and excessive risk-taking.  As your humble blogger has repeatedly said it is the regulators' information monopoly and assurance about the solvency of each bank in the system that leads directly to moral hazard and excessive risk-taking.

The regulators' information monopoly and assurances are a barrier to banks performing their own risk assessment and adjusting the price and amount of their exposure accordingly.  So long as the barrier exists, there will be moral hazard and excessive risk-taking as banks rely on the regulators.
“Tail events seem to happen far more often than people assume and if the risks were properly acknowledged at the outset, many structures would be avoided or risks re-structured so as to limit losses in the event of tail risks. That has obvious implications for financial stability.”
In the absence of all the useful, relevant information in an appropriate, timely manner, financial market participants cannot deal with tail-risk.

The current financial crisis proves this point.  The areas of the financial markets that ceased functioning were all the areas with opacity (for example, structured finance and interbank lending).  The areas that continued to function without government support all were areas with disclosure (for example, equity markets).

2 comments:

Strategist said...

May I suggest you decline to use the term "tail risk", "extreme tail risk" etc - the bankers' own fraudulent terminology, born of the need to obfuscate, not explain, their practices.

As the man says "Tail events seem to happen far more often than people assume".

It's like a bucket filling up slowly with water and then suddenly tipping when full to a certain point. That's not tail risk - it's something inherent in the system.

Richard said...

One of the benefits of disclosure is that investors are able to watch the "bucket filling up slowly" for each financial institution.

As it fills up, investors can adjust both the price and amount of their exposure. The closer to the tipping point, the higher the price and the lower the amount of their exposure. This negative feedback should provide an incentive for bank management to reduce risk.

The regulators' information monopoly makes financial instability (which is what the bucket tipping when full to a certain point is) inherent to the system. Without disclosure, there is no negative feedback loop, aka market discipline.