Sunday, November 27, 2011

Measuring financial contagion - Simon Johnson on banks disclosing their 'exact exposures'

In his NY Times Economix column, Simon Johnson discusses the need for banks to disclose their 'exact exposures' so that market participants can assess and exert market discipline on the banks.

Regular readers are very familiar with the argument Professor Johnson makes as it touches on many of the central themes addressed in detail on this blog.  In particular,
  • Bank runs -- when market participants do not know which banks are solvent and which are not and there are questions about the strength of the sovereign's deposit guarantee;
  • The cost of opacity -- in the form of bank bailouts and losses on opaque structured finance securities;
  • How regulators create financial instability by preserving their monopoly on all the useful, relevant information on financial institutions -- market participants are dependent on the regulators to properly assess this information and convey it;
  • Moral hazard in the form of an obligation to bailout investors from potential losses after regulators use their information monopoly to conduct stress tests and say the bank is solvent;
  • The need to require banks to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details;
  • If market participants are unable to understand a bank's disclosed data, this is a diagnostic tool that tells the regulators the bank must reduce its complexity until market participants can understand its disclosed data;
  • How the risk of financial contagion is virtually eliminated as market participants will adjust their exposures based on the risk of each bank; and
  • The return of market discipline -- it will put pressure on banks to reduce their risks as high risk banks will find they face high funding costs.

Gotta give the guy credit for recognizing a good idea!

People see one bank failure and fear the consequences – hence, panics and runs on the bank. 
Anyone who thinks that we solved this problem with forward-thinking central banks or fiscal interventions has not been paying close attention – either to the United States or to Europe – over the last three years. 
We really need transparency on the exact exposures of banks. To whom have they lent and on what basis? 
Just telling supervisors does not help us at all, because sharing information only behind closed doors is just another potential mechanism for regulatory capture. 
For large financial institutions – those with more than $100 billion in total assets – everything should be out in the open. 
If you want to operate in relative secrecy, stay small. 
The costs of today’s opaqueness are huge, creating the basis for the plea, “Save us or you’ll lose the world.” 
And if the published information is too complex for outsiders to understand, big banks must be forced to simplify their operations until they become sufficiently transparent. Potential contagion risks must be measurable and apparent to the marketplace, including to independent analysts who have access only to public information. 
Needless to say, if any institution poses major contagion risks, as measured on this basis, it should be forced to become safer. 
Richard W. Fisher, president of the Federal Reserve Bank of Dallas, spoke recently about what he called the “pernicious problem” of too-big-to-fail financial institutions, “in a culture held hostage by concerns for ‘contagion,’ ‘systemic risk’ and ‘unique solutions’”: 
“Invariably, these behemoth institutions use their size, scale and complexity to cow politicians and regulators into believing the world will be placed in peril should they attempt to discipline them. They argue that disciplining them will be a trip wire for financial contagion, market disruption and economic disorder. Yet failing to discipline them only delays the inevitable – a bursting of a bubble and a financial panic that places the economy in peril.” 
You can only discipline a big troubled bank if you understand and can measure the consequences of its failure.

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