Group think: The Bank of England's Financial Policy Committee and bank capital

I am several weeks late in calling readers attention to a very important article in the Telegraph on group think and the Bank of England's Financial Policy Committee (FPC).

The FPC is charged with promoting financial stability.  Given this responsibility, it is a very encouraging sign that the members are aware of the risks of group think blinding them to the source of the next financial crisis.

Group thinks happens when the desire for harmony in a decision-making group overrides a realistic appraisal of the alternatives.  One of the primary causes of group think is when the group members share educational backgrounds and face highly stressful external threats after recently experiencing failure.

The question is will they realize that the most dangerous form of group think is close-mindedness where they rationalize away warnings because they challenge informed opinion and the group's assumptions?

This type of group think occurs when there is broad agreement on conventional wisdom, particularly when this conventional wisdom is supported by academic studies that assume their conclusion.  As a result, no one bothers to check to see if this conventional wisdom or the academic studies are actually supported by the facts.

Examples of this sort of conventional wisdom include and are certainly not limited to:  house prices in the US always increase and financial engineering transfers risk out of the banking system into the hands of market participants who are better able to hold it.

Regular readers know that rationalizing away a challenge to the group's assumptions runs wild when it comes to the issue of bank capital.  Specifically, many financial regulators and economists actually think and are on record saying that a meaningless, highly manipulated number is important.

Fed Governor Daniel Tarullo said

regulation of banks' capital remains the single most important element of prudential financial regulation.

In fact, bank capital is about as meaningless and highly manipulated a number as you can find anywhere in the financial world.  But don't take my word for it.  According to the OECD's Blundell-Wignall,

The core Tier 1 ratio is a ratio of two meaningless numbers, which itself is a meaningless number because banks can alter the ratio themselves.

Your humble blogger also does not think bank capital is important, but then besides working for the Federal Reserve, I worked in the capital management area of a bank.

Let me share with you an e-mail I sent to a member of the FPC in response to the Telegraph article:

I read with great interest your statements in the Telegraph about being wary of and trying to prevent group think on the Financial Policy Committee.  These statements were catching in light of the discussion on bank capital and restoring confidence in the financial system. 

The statements released by the Financial Policy Committee show massive group think when it comes to bank capital and restoring confidence in the financial system. 

Before I explain why, let me tell you a little about myself.  I am one of the handful of individuals who publicly predicted the financial crisis.  What separated me from most of the others was I did not trade on the call (my pocketbook being worse for that, but conscious being better), rather I proposed a simple method for moderating the impact of the crisis. 

You can trust me when I tell you I have had nothing put push back from Wall Street and the financial regulators on my proposed solution. 

Now let me explain.  You are probably familiar with Walter Bagehot, the author of Lombard Street.  He had a number of remarkable things he said with his observation on bank capital being relevant for the FPC:  "A well-run bank needs no capital.  No amount of capital can rescue a badly run bank." 

This statement suggests the question:  how do we know who is a well-run bank and who is a badly run bank? 

The answer to this question comes from FDR and a small bank in Illinois.  FDR introduced the global financial system to the philosophy of disclosure.  Simply put, he made it the government's job to ensure that market participants had access to all the useful, relevant information in an appropriate, timely manner. 

When it comes to banks, what would useful, relevant information be?  We know it is not regulators saying they are solvent.  They said this before the financial crisis and look how much money has been injected into them.  They have said this after numerous stress tests and Europe is still bailing out the banks. 

A small bank in Illinois answered the question in the 1930s when it published all of its accounts.  When asked why, the head of the bank replied that transparency was the mark of a well-run bank that could stand on its own two feet. 

Why does disclosure restore confidence in banks and the financial system?  With disclosure, market participants can assess the risks for themselves.  They trust their own assessment and as a result can make portfolio management decisions like buy, hold and sell. 

In markets characterized by opacity (think bank stocks and structured finance securities), the markets are essentially frozen because there is no useful, relevant information to perform the independent analysis on. 

Even though several individuals on the FPC know about my suggestion to require disclosure of each bank's current asset, liability and off-balance sheet exposure detail, my bet is no-one on the FPC suggested it as an approach to restoring confidence.  A sure sign of group think and unfortunately why the financial crisis continues.