Monday, December 12, 2011

RBS report makes the case for ultra transparency [updated]

The Financial Services Authority's report on the failure of RBS makes the case for requiring banks to provide market participants with ultra transparency by making on-going disclosure of their current asset, liability and off-balance sheet exposure details.

Like the Nyberg Report on the Irish Financial Crisis, the FSA report documents why giving financial regulators a monopoly on all the useful, relevant information creates financial instability.  This financial instability is the direct result of market participants being dependent on the financial regulators to accurately assess this information and communicate the risk of each bank.

Just like in Ireland, the bank, RBS, was able to lobby against and suppress anything resembling a negative assessment.

Fixing the financial system requires eliminating for all time the ability of banks to lobby their regulators and as a result have markets misinformed about the true risk of the banks.

This can only be achieved by requiring ultra transparency which shatters the regulators' information monopoly and allows the market to make its own assessment of the risk of each bank.

A Telegraph article highlights the main points of the FSA report.

Why Royal Bank of Scotland failed:- Significant weaknesses in RBS’s capital position
- Over-reliance on risky short-term funding
- Market fears about RBS’s asset quality
With ultra transparency, fear would have been replace with knowledge.

With ultra transparency, market participants could monitor each bank's asset quality and if they see an increase in risk exert market discipline.  It is this market discipline that would have prevented excessive risk taking in the first place. 
- Substantial losses from credit trading
- The acquisition of ABN Amro
- The systemic financial crisis
- Underlying deficiencies in the way RBS was run 
What needs to change:- Greater personal responsibility for bank executives and directors in future failures. Must risk “personal consequences”.
- Rules to put emphasis on executives and boards to avoid bank failures.
- Rewards for bank executives must take more account of risk and be different from those for senior managers at non-bank businesses.
- Increased powers to ban those involved in failures from working in the financial services industry.
- Greater powers to block bank takeovers in future.
No surprises here.  Regular readers did not expect that the FSA would voluntarily give up its information monopoly.

The FSA recommendations go along way towards showing just how ineffective a regulator it is. 
How the FSA got it so wrong:- Regulator had just six staff overseeing RBS in August 2007. It now has 23.
Excuse me, but if there were ultra transparency, I would be willing to bet that the number of market participants 'overseeing' RBS would be multiples of the staff that FSA has assigned.

One of the major problems with regulators having an information monopoly is that they have to replace the analytical ability of all the market participants.  No matter how well intentioned, for obvious reasons they cannot do that.

The time has come to let the market analyze each bank's risk and for the regulators to piggy-back off of the market's analysis. 
- FSA officials were barred from meeting one-on-one with RBS’s non-executive directors.
- Regulator was never given full access to RBS’s “Board pack” containing detailed financial information on the bank.
- Regulators warnings to board were removed by Sir Fred Goodwin from a letter to the RBS board, as where concerns about the corporate lending risks the bank was taking.  
- FSA did not challenge strongly enough “vigour of pushback” by RBS against its oversight.
A prime example of a bank suppressing regulatory oversight.

Clearly the system must be change by offering ultra transparency so that bank's can no longer suppress regulatory oversight.  Even if they did, it wouldn't have as large a negative effect as banks would still be subject to market discipline (something they are currently not subject to as it is blocked by the regulators' information monopoly).
- Regulator was worried about being accused of “heavy-handed, gold-plating”.
Just like the Nyberg report finding in Ireland, regulators are seen as heavily influenced by politics.  They are run by political appointees and have to report to politicians.

The result is that they are sensitive to being accused of 'heavy-handed, gold-plating' and as a result do not communicate the true risk of the banks to the market.

Requiring ultra transparency ends this.

The Guardian article titled Financial Services Authority caught napping over Royal Bank of Scotland really drives home the need for requiring banks to provide ultra transparency.
A series of regulatory failings by the Financial Services Authority in the run up to the taxpayer bailout of Royal Bank of Scotland will be revealed today ...
Scheduled for release at 6am, the FSA's report will repeat its findings from a year ago that "bad decisions" rather than "dishonesty" led to the near-collapse of the bank in 2008 – a conclusion that City sources believe will make it difficult for the business secretary to use his powers to bar Goodwin or other former board members. 
FSA chairman Lord Turner, who has been critical of the "light touch"approach to regulation that was endorsed by Gordon Brown, will again highlight this as one of the reasons the regulator allowed RBS to get so close to the brink of collapse.
The problems created by light touch regulation would not have been nearly so bad had banks been required to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

Market participants could have analyzed this disclosure and assessed the riskiness of each bank.  Based on this assessment, market participants could have adjusted the amount and pricing of their exposure to each bank.

As a result, market participants would have only had at risk what they could afford to lose and there would have been no need for a bailout.
This conclusion will allow the chancellor to blame the previous government for the taxpayer bailout and support his arguments for breaking up the FSA.... 

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