FDR Framework 101

A Bloomberg article reports that

European banks are “grossly under- capitalized” and the debt crisis is more serious for the region than the 2008 meltdown as governments are constrained by fiscal pressures, former U.K. Prime Minister Gordon Brown said. 

“In 2008, governments could intervene to sort out the problems of banks,” Brown said at the World Economic Forum in the Chinese port city of Dalian today. “In 2011, banks have problems, but so too do governments.” 

Investor skittishness over Europe’s sovereign debt crisis raised lenders’ funding costs and caused a rout in the region’s banking stocks this month. European Central Bank President Jean- Claude Trichet pressed euro-area governments late yesterday to take decisive action to restore confidence after the ECB extended an emergency lifeline to lenders. 

Brown said that while the ECB is part of the short-term solution, it needs additional assistance. 

The European Financial Stabilization Mechanism, which is run by the European Union’s 27-nation executive arm, is “not enough,” Brown said. “Substantially more resources” are required, including from the International Monetary Fund and lenders including China, he said....

“European banks as a whole are grossly under- capitalized,” Brown said. “We’ve now got the interplay between banks that are not properly capitalized and sovereign debt problems that have arisen partly because we’ve socialized or accepted responsibility for the banks’ liabilities.”

With this background in mind, a quick review of the FDR Framework and how it could restore confidence and help to address the bank and country solvency problems in Europe is useful.

The FDR Framework gets its name from both the President, Franklin Delano Roosevelt, whose administration introduced the philosophy of disclosure to the capital markets and from the framework's focus on financial disclosure requirements.

FDR introduced disclosure of all the useful, relevant information in an appropriate, timely manner to accomplish two linked goals.  First, to restore confidence in the markets.  Second, to keep the government out of making investment recommendations.  Disclosure achieves both of these goals because it allows market participants to analyze the information disclosed for themselves to assess the risk and reward of any investment.

There was one part of the financial system that disclosure could not be introduced to:  banking.  Simply put, without access to 21st century information technology, it is not possible to disclose to all market participants each bank's current asset and liability-level data (all the useful, relevant information) in an appropriate, timely manner.

Instead, his administration set up a system where the government both regulated and supervised the banks.  Included in bank supervision was the idea of bank examiners having access to and looking at the current asset and liability-level data 24/7/365.

Unfortunately, the lack of disclosure also meant that the market participants were dependent on the bank regulators to properly analyze the risk of each bank and convey it to the market.

Besides the historically opaque banks, there was another source of opacity in the financial system.  That source was Wall Street and the products it developed.  As Yves Smith observed on NakedCapitalism, no one on Wall Street was paid for developing low margin, transparent products.

Examples of opaque products Wall Street developed include structured finance securities and exchange traded funds.  While both are conceptually simple, that was before Wall Street engineered opacity into the information needed to value these products.  Neither of these products provide investors with all the useful, relevant information on the underlying "assets" in an appropriate, timely manner so that investors can value the product.

The FDR Framework is the backbone for a financial system based on using 21st century information technology both to facilitate disclosure and the analysis of the disclosure.

Under this framework, governments are responsible for ensuring that every market participants can access all the useful, relevant information in an appropriate, timely manner.  This includes current asset and liability-level data for banks.

Under this framework, market participants have an incentive to assess each investment using the disclosed information because, under the principle of caveat emptor, they are responsible for any gains or losses on the investment.

Previously, this blog discussed how using the FDR Framework, policymakers and regulators in Europe could restore confidence and address the issue of bank and sovereign solvency.  This involves two steps.

Step one is for the policymakers and regulators to issue a statement that describes what the actual condition of each bank is providing as needed the hard facts to back up the analysis (this is something that Societe Generale did recently in a bid to restore confidence).

Step two is for the policymakers and regulators to promise and implement utter transparency (set up a data warehouse where all market participants can access the current asset and liability-level data for each bank).

Setting up this data warehouse is critically important, because market participants will put far more faith in the analysis if they see that the data is going to be released that confirms or debunks the analysis.  The market is likely to give the analysis the benefit of the doubt because not releasing the data suggest there is something to hide.