Thursday, December 15, 2011

FSA's Lord Turner makes case for ultra transparency: 'regulators not clever enough to see full picture'

In a Reuter's article, the Financial Services Authority's Lord Turner confirms why regulators are a source of financial instability and that their information monopoly must be ended.

As he observed about the incredible complexity of the financial system and how pushing on one part of the system produces unintended consequences for another part of the system,
We're just not clever enough to see it.
Nobody would purposefully build a financial system with a single point of failure that could bring down the entire system.

Yet that is what the regulators did when they developed an informational monopoly on all the useful, relevant information on financial institutions.  This informational monopoly required that they are omniscient and can see all of the risks and interconnections in the financial system and intervene in a timely manner to prevent a financial crisis.

We know how that movie has ended and frankly we were not surprised because nobody can be omniscient.

What anybody building a financial system for the 21st century and beyond should do is give the regulators a task that is possible to achieve.

Fortunately, in giving the regulators their task for the 21st century financial system we also provide the solution for ending our current financial crisis.

Regular readers know that under the FDR Framework our financial system is designed so that
  • Regulators are responsible for ensuring market participants have access to all the useful, relevant information in an appropriate, timely manner; and
  • Market participants have an incentive to use the disclosed information to assess the risk and return on an investment as they are responsible for all gains and losses on their investments under the principle of caveat emptor (buyer beware).
The robustness, resiliency, strength of this financial system is based on the idea that with the ability to assess risk, market participants will limit their exposures to what they can afford to lose.  

For example, contagion is not a problem because even if a participant does bet more than they can afford to lose, the market participants that are exposed to this investor have adjusted their exposures knowing this fact.

Under the FDR Framework, regulators are responsible for disclosure.  In the case of financial firms, this means the regulators require the firms to provide ultra transparency by disclosing on an on-going basis their current asset, liability and off-balance sheet exposure details.  Disclosure that banks made before the advent of deposit insurance and a stronger role for regulators.

With this disclosure, market participants can for the first time in decades assess the risk of each bank and adjust the amount and price of their investments accordingly.

A benefit of ultra transparency is that regulators can incorporate the risk assessment of an individual bank by its competitors and other market experts into its assessment of risk.  Similarly, these market participants can incorporate the findings of the on-site bank examiners into their risk assessments.

One of the largest market participants that can adjust the amount and price of their exposure according to a risk assessment is the regulator -- their exposure takes the form of the deposit guarantee.  As banks become riskier, the cost of the deposit guarantee should increase.

This blog has documented in exhaustive detail how every place in the financial system where there currently is opacity we are experiencing a problem.  This finding is not surprising because market participants do not have the information they need to independently assess the risk.

An example of where the financial system is experiencing an opacity problem is the 'black box' banks.  An opacity problem created by the regulators who did not insist that banks continue to provide ultra transparency as this was a sign of a bank that could stand on its own two feet.

Here, the regulators created an information monopoly that not only prevents the market from being able to independently assess the risk of the banks, but it makes the market reliant on the regulators for properly assessing and communicating the risk of each bank.

In short, regulators created a single point of failure in the financial system and that point of failure failed in the years leading up to the financial crisis that began on August 9, 2007.

Frankly, there is no reason to believe that the regulators can do a better job of assessing risk than the market can.  They do not have the analytical resources that the market does.

Furthermore, by maintaining their information monopoly, the regulators are preventing market discipline.  As regular readers know and Joseph Stiglitz, a Nobel prize winning economist, observed
the “fundamental problem” is that capital markets need information to work properly, yet the Fed [and other financial regulators are] saying, “we believe in capital-market discipline without information.”
Regulators should stop trying to be omniscient and instead focus on what they can control:  requiring ultra transparency and adjusting the cost of deposit insurance to reflect the risk of each bank.

The financial system is fragile again and regulators are not clever enough to see the full picture, with U.S. moves to "starve" watchdogs also not helping, Financial Services Authority (FSA) Chairman Adair Turner said on Thursday. 
"One sometimes feels that this financial system is like some incredibly complicated waterbed, when you try and deal with something here and then something happens at the other end," Turner said in an interview with Prospect magazine. 
"We're just not clever enough to see it," Turner said.... 
He expects global finance to shrink once all the tougher new bank capital and other rules have been applied.

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