Moral responsibility from next round of stress tests puts Fed on the hook for $5 trillion in off-balance sheet exposures

As Fed Governor Daniel Tarullo was discussing the next round of stress tests, US bank counter-parties were smiling.

Why?

Because when the Fed signs off on the next round of stress tests and says that firms like JP Morgan and Goldman are adequately capitalized and can pay a dividend, the Fed takes on the moral responsibility for making good on their derivative books.

Please re-read the preceding sentence.  While doing so remember that banks use credit default swaps to 'hedge' their positions and after Greece there is good reason to believe that credit default swaps will not act as a hedge and pay out.

As regular readers know, 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.  The corollary to this is that governments are suppose to make sure that they never offer an opinion on an investment.

It is up to the other market participants, since they are responsible for all gains and losses on their investments, to decide for themselves how much, if any exposure they want to an investment.  They do this by using the disclosed information to assess the risk of the investment and then adjusting their exposure based on the result of this analysis.

Currently, banks are not required to disclose all their useful, relevant information in an appropriate, timely manner.  The Bank of England's Andy Haldane observed that they are a 'black box'.

Banks are a black box that only the regulators can look into.

As a result of their access to all the useful, relevant information, when the regulators conduct a stress test and say that banks are solvent and adequately capitalized, market participants rely on them.

It is this reliance on the regulators properly assessing the riskiness of the banks that creates moral responsibility.

Specifically, governments are morally responsible for bailing out the investors/derivative counter-parties in the event that the bank becomes insolvent because the investors/derivative counter-parties relied on the government's representation that the bank was solvent.

This is the problem of governments offering an investment opinion.

The only way to get the Fed off the hook for the $5 trillion in bank derivative exposure is to require that the bank's disclose on an on-going basis their current asset, liability and off-balance sheet exposure detail.  With this data, market participants can assess the risk and take on the responsibility for any gains and losses on their exposures to the banks.