Saturday, November 5, 2011

Bank analyst Mike Mayo issues 'buy' on detailed disclosure by banks

The Wall Street Journal carried an article by long-time bank analyst Mike Mayo that discusses why Wall Street cannot handle the truth and what has to change to avoid the next financial collapse.

Regular readers will be familiar with many of his suggested changes as they are embodied in the FDR Framework.
To fix the banking sector, should we rely more on government regulation and oversight or let the market figure it out? Tougher rules or more capitalism? 
Right now, we have the worst of both worlds. We have a purportedly capitalistic system with a lot of rules that are not strictly enforced, and when things go wrong, the government steps in to protect banks from the market consequences of their own worst decisions. To me, that's not capitalism. 
It's easy to understand the appeal of certain regulation. If we'd had the right oversight in place, we would have limited the degree of the financial crisis, which included bailouts measured in hundreds of billions of dollars and millions of people losing their homes due to foreclosures.
But we also would have sacrificed innovations in credit and a vibrant financial sector. 
Moreover, the real problem with regulation is that it often doesn't work very well, in part because it's always considering problems in the rearview mirror. The financial system today is almost dizzyingly complex and moving at light speed, and new rules tend to address fairly precise things, like banning specific types of securities or deals.
The problem with regulation is that it requires three elements to be in sync for it to be effective.  First, it must be focused on the right issue.  Second, compliance must be monitored.  Third, it must be enforced.
The more effective solution would come from letting market forces work. That doesn't mean no rules at all—a banking system like the Wild West, with blood on the floor and consumers being routinely swindled. We need a cultural, perhaps generational, change that compels companies to better apply accounting rules based on economic substance versus surface presentation. 
Even in 2011, some banks were woefully deficient in detailing the amount of their securities and loans that are vulnerable to the ravages of the European financial crisis. The solution is to increase transparency and let outsiders see what's really going on. 

What we need is a better version of capitalism. That version starts with accounting: Let banks operate with a lot of latitude, but make sure outsiders can see the numbers (the real numbers).
The FDR Framework is the better version of capitalism that Mr. Mayo calls for.

Under the FDR Framework, governments are responsible for ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner.  For banks, this is their current asset, liability and off-balance sheet exposure detail.  With this detail, Mr. Mayo would know the amount of each bank's securities and loans that are vulnerable to the ravages of the European financial crisis.

Under the FDR Framework, market participants are responsible for all gains and losses under the principle of caveat emptor (buyer beware) and they therefore have an incentive to use the disclosed information.
It also includes bankruptcy: Let those who stand to gain from the risks they take—lenders, borrowers and bank executives—also remain accountable for mistakes.... 
A better version of capitalism also means a reduction in the clout of big banks. All of the third-party entities that oversee them need sufficient latitude to serve as a true check and balance. 
My peer group, the army of 5,000 sell-side Wall Street analysts, can help lead the way to provide scrutiny over the markets. Doing this involves a culture change to ensure that analysts can act with sufficient intellectual curiosity and independence to critically analyze public companies that control so much of our economy.
Here is confirmation that market participants will use the detailed data if it is disclosed.

Equally importantly, here is confirmation that the regulators could tap into a vast pool of analytical talent to help them perform their job if the detailed data were disclosed.  These analysts could help them identify individual bank risks as well as systemic risks.

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