At its core, regulatory forbearance is all about misleading market participants

With the SEC suing the former heads of Fannie Mae and Freddie Mac, the issue of the role of regulators in the disclosures made by financial institutions has moved front and center.

Regular readers know that I think that financial institutions should be required to provide ultra transparency.  When financial institutions disclose on an on-going basis their current asset, liability and off-balance sheet exposure details, market participants have access to all the useful, relevant information.

In the absence of ultra transparency, financial institutions and regulators can play games with disclosure.

For example, there is regulatory forbearance.  Simply put, regulators practice forbearance when they allow banks to postpone recognition of losses.

A classic example of this is extend and pretend.  Here, the bank will lend a borrower more money so that they can pay this money back to the bank on a loan that would otherwise be non-performing.  The bank claims the loan is performing in its financial statements while it is hoping that something will occur that will bail the bank out of a bad position.

To illustrate extend and pretend, this blog cited the example of loans to less developed countries in the 1980s.  Regulators allowed these loans to be carried on the banks' balance sheets at par while there was an active market for trading the loans that valued them at 60% of par.

Ultimately, the banks wrote the loans down to this market value.  However, until they took a write-down, banks overstated both their assets and book equity.

Why did the regulators not require the banks to write-down the loans to less developed countries?  By not doing so, weren't the regulators effectively putting their stamp of approval on misleading financial disclosures?

Regulators defend actions like this by saying that if the market participants 'knew' it could cause a run on the bank.  They make this argument even though they know that it is soundly refuted by empirical evidence.

Depositors have not run on the US banks since the Great Depression because they know that there is an implied guarantee on ALL of their deposits.  When the solvency crisis erupted in 2008, the first thing the US government did was to hike the formal deposit insurance limit and institute programs to protect even the junior unsecured debt holders from losses.

Which leads back to the question, why do regulators not want market participants to have the information they need to assess the risk of each bank?

Rather than hazard a guess as to the answer, suffice it to say, by playing games with disclosure, regulators have gambled with financial stability and frequently lost.