Sunday, December 18, 2011

Gold-plating bank regulation to mislead public about doing something

The Telegraph carried a column on UK policymakers gold-plating bank regulation by adding on extra regulation in an effort to appease an angry public.

Regular readers know that your humble blogger thinks that 80+% of the banking regulations passed since the beginning of the solvency crisis in 2007 are essentially worthless because they do not do anything that would have prevented the current crisis.

These regulations look even worse when they are compared to requiring banks to provide ultra transparency.  Most of the regulations try to solve in a one-off manner something that ultra transparency addresses directly.

For example, we have the Basel III capital requirements.  This blog has extensively documented how bank capital ratios are meaningless, especially when regulatory forbearance results in overstating both the assets and the equity amounts.

Even if the the financial statements were not distorted, the Bank of England's Andy Haldane suggests that calculating Basel III capital ratios might take upwards of 6 million calculations.  Many of these calculations rely on assumptions provided by the bank.  It is safe to say that banks will not make assumptions that would be unfavorable for their capital ratios.

Requiring ultra transparency allows market participants to apply their own assumptions and calculate bank capital ratios however they would like.  More importantly, it allows market participants to assess the risk of the bank and adjust both the amount and price of their exposure based on this assessment.

Market discipline will drive banks to reduce their risk relative to their capital.  Banks with high risk and low capital will pay a premium to attract funds.  Banks with low risk and high capital will be able to access funds at a much lower cost.

Even when the regulation could have had a positive impact, like the Volcker Rule, it is mind-numbingly complex and so full of loopholes as to effectively neuter the regulation.  The lesson from MF Global is that there are a whole lot of ways to take a proprietary trading position using repurchase agreements.  An area completely untouched by the Volcker Rule.

Instead of the Volcker Rule, ultra transparency requires banks to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.  This exposes the proprietary trading in the repurchase agreements.  More importantly, it exposes this trading to all market participants so that they can use it to adjust the amount and price of their exposures accordingly -- market discipline works to limit the proprietary trading.

The proposed Volcker Rule takes upwards of 300 pages of regulations.  The regulation for ultra transparency can be done in 3 pages or less.

Finally, all these regulations these regulations, including those proposed by the Independent Commission on Banking to ring-fence retail and investment banking, are expensive for the banks to comply with.  The cost estimate for ring-fencing alone runs 7 billion pounds a year.

By comparison, ultra transparency is very, very low cost as it can be done globally for every bank for less than the annual cost of the UK's ring-fencing alone.

Unlike all the proposed regulations, ultra transparency is simple, inexpensive and very effective.  What is there for market participants other than banks not to like?
At 3.30pm on Monday, the Chancellor will rise to his feet in the House of Commons and deliver in comprehensive detail the Government’s response to Sir John Vickers’ Independent Commission on Banking. 
The document that will be published at the same time will be 80 pages long and will go through each recommendation the ICB made on constructing a safer British banking system. It will include a timetable for implementation and pledge that all primary and secondary legislation will be passed before the end of this Parliament – that is, 2015....
The main course tomorrow will, of course, be the Government’s thoughts on the major structural changes the ICB proposed for the UK’s banking sector. This brings us to the knotty problem of the ring-fence, Sir John’s halfway house solution to the structural separation of retail banking and investment banking. 
Under the ICB’s plan, retail operations would be protected behind a “fence” and would have a separate funding structure including equity capital of at least 10pc of risk-weighted assets. There would also be limits on leverage and separate boards.... 
Other special measures unique to the UK include higher levels of loss-absorbing capital (bail-in bonds) than presently proposed by the international Basel III requirements. 
It is such “super-equivalence” – the idea that Britain needs extra protection not contemplated anywhere else in the world – where Mr Osborne’s argument comes unstuck. 
When the Chancellor first launched the ICB process with a view to finally settling the matter of banking reform, it appeared that the UK was bouncing back from recession. Gloom has since descended. 
The Government will admit that the ICB’s structural reforms will increase costs for banks – some argue by as much as £10bn a year though the Government estimate will be nearer £7bn....
There is also the issue of regulatory overload. As the old saying goes, when a regulator sees light at the end of the tunnel, its response is to build more tunnel. 
An opportunity has been missed here ...
As the Financial Services Authority’s report on RBS revealed last week, the authorities could have halted the disastrous acquisition of ABN Amro, but chose not to. 
Suggesting very strongly that financial stability requires an end to reliance on the regulatory system performing its job.  It is only with ultra transparency that this can be achieved.

Regardless of whether there is regulatory oversight or not, market discipline will still be present with ultra transparency.
The ICB was not tasked with looking at broader failures in the financial services sector. It should have been.
They would have undoubtedly found that the financial system failed everywhere there was opacity - structured finance, banks - and nowhere there was transparency - stocks, corporate bonds.
Coincidently, the Lords and Commons joint committee inquiry into macro-prudential regulation will also be published tomorrow. It will raise serious concerns about putting the Governor of the Bank of England in overall charge of the financial regulatory system. The Bank has published nothing about its role in the financial crisis. Transparency is not its strong suit. 
Which is why the Government has to require ultra transparency.
There are certainly problems in the financial services sector, more to do with failures of governance and action rather than failure of the actual regulatory rules. The Government should have been brave enough to say so and put the ICB to rest. That it hasn’t is more to do with politics and pandering to the gallery than the proper functioning of the City.
Actually, the proper function of the City requires the Government to adopt ultra transparency and make it a requirement for any financial institutions doing business in the UK.

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