Tuesday, November 29, 2011

Regulatory discretion and lying about the financial condition of banks

The financial regulators, including the Fed, have proved once again that the cover-up is worse than the initial problem.

The number one responsibility of financial regulators is to ensure the safety and soundness of the financial system.  The financial crisis showed a significant failure of regulatory supervision in performing this responsibility.

In two must read articles, the NY Times and Bloomberg have documented how the financial regulators used regulatory discretion to cover-up this failure with the results being that banks lied about their financial condition to the market.  
  • The NY Times article by Gretchen Morgenson and Louise Story reveals that the Office of Thrift Supervision oversaw IndyMac mis-stating its capital.
  • The Bloomberg article by Bob Ivry reveals that the Fed provided the banking industry with secret below market price loans at the same time bank executives were representing how healthy they were to the financial markets.
Regular readers know that trust in our financial system is built on disclosure.  Specifically, it is built on the idea that market participants will have access to all the useful, relevant information in an appropriate, timely manner.

This information, which auditors certify as accurate, is used by market participants to independently assess the risk of an investment and to adjust the amount and price of any exposure.

Here we have specific examples where regulators blessed mis-representations that were substituted for the useful, relevant information.  Doing so directly undermined trust and confidence in the financial system.

In fact, given the regulators' willingness to bless mis-represent of the financial condition of the banks in 2008-2009, how do we know that anything banks say about their financial condition today is true?

Regulators were provided with discretion when it comes to the timing of when they close a financial institution.  As this blog has repeatedly observed, so long as a bank's deposits are insured and the central bank is willing to lend against good collateral, an insolvent bank can remain open indefinitely.

Regulators were not provided with discretion when it comes to disclosing the true financial condition of the banks.  

The introduction of deposit insurance and increased regulatory oversight following the Great Depression did not change that fact that disclosure of all the accounts fit to print was still the sign of a bank that could stand on its own two feet.  

If we are ever going to restore trust and confidence in the financial system, we must require that all banks provide ultra transparency.  The banks must disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

Until this is done, there is no reason to believe that the financial disclosures being made by the banks represent anything other than some rosy scenario dreamt up by the financial regulators.

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