Tuesday, December 20, 2011

Fed bolsters tools to avert collapse of systemically important firms

Bloomberg reported on the Fed's latest efforts to bolster its tools to avert the collapse of systemically important firms.

Conspicuously absent from its new tool chest was the market.  No place in its proposal did the Fed suggest that it would require systemically important firms to provide ultra transparency by disclosing on an on-going basis their current asset, liability and off-balance sheet exposure details.

Unfortunately, a regulator that failed to prevent the current solvency crisis chose not to add the market's analytical capabilities and market discipline to its tool chest.

One of the tools the Fed is looking to add is to set the maximum exposure that any systemically important firm can have to any other systemically important firm as a percentage of its equity.

Regular readers know that under the FDR Framework, it is the responsibility of each market participant to set both the amount and price of their exposure to any firm based on what the market participant can afford to lose knowing there will be no bailouts.

In order to do this, each market participant needs to be able to assess the risk of every other market participant.  This requires ultra transparency.

Ultra transparency provides Bank A with the ability to control its total exposure to Bank B.  This total includes both direct and indirect exposure (where Bank A is exposed to Bank C which in turn is exposed to Bank B).  With the ability to control total exposure also comes the ability to price for the risk of Bank B.

Without ultra transparency, each systemically important firm is flying blind as to its real total exposure to the other systemically important firms and definitionally mis-pricing its exposures to these firms.

Without ultra transparency, at best, risk is mis-priced across the financial system.  At worst, the blow up of one systemically important firm does in fact bring down all the others.

The Fed would also like to become more proactive and require firms experiencing difficulty to take remedial actions to avert a bigger problem.

If there were ultra transparency, market discipline would do a far better job of this than the Fed ever could.

As this blog has repeatedly observed, if the risk of a systemically important firm were to increase, so too would its cost of funds.  Market discipline through the higher cost of funds acts as a disincentive to increase risk.

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