RBS reports highlights unacceptable risk of relying on regulators alone and not in combination with market discipline

The bottom-line of the Financial Services Authority's report on Royal Bank of Scotland is it highlights that it is an unacceptable to the global financial system to rely on regulators alone to prevent excessive financial risk from destroying the financial system.

The report highlights why ultra transparency is needed to end regulatory oversight as a substitute for market discipline.

By requiring banks to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details, regulators make it possible for market participants to exert market discipline on banks.

Without this level of disclosure, market participants are forced to rely on regulators to properly assess this data and convey the actual riskiness of each bank.  The report highlights numerous reasons why the regulators might fail to properly assess the data and even more reasons why they might not convey the actual riskiness of each bank.

A Guardian article on the report reveals how hard it will be to get regulators to give up their information monopoly and stop gambling with financial stability.

The Financial Services Authority has criticised the "light touch" regulation that was encouraged by the Labour government as it called for an overhaul of the rules regulating bankers. 

In a long-awaited 452-page report into what went wrong at Royal Bank of Scotland, Lord Turner, chairman of the FSA said ... 

"In a market economy, companies take risks on behalf of shareholders and if they make mistakes, it is for shareholders to sanction the management and board by firing them. 

"But banks are different, because excessive risk-taking by banks, for instance through aggressive acquisitions, can result in bank failure, taxpayer losses, and wider economic harm. Their failure is a public concern, not just a concern for shareholders," he added....

What makes banks different is that the regulators actively assist them in withholding all the useful, relevant information on each bank from market participants.

In the absence of disclosure of each banks' current asset, liability and off-balance sheet exposure details, market participants do not have the information they need to assess the risk of each bank.

If market participants cannot assess the risk of a bank, they cannot exert market discipline... fire the board or management for excessive risk taking.

RBS chairman Sir Philip Hampton said: "Taxpayers should never have had to rescue RBS. The FSA are right to have given the British public its assessment of events and factors that led to RBS requiring government assistance. The FSA's views are an important contribution to the debate on how banks should be managed and regulated in the future."

The report is very important because its seals the argument for requiring banks to provide ultra transparency to all market participants.

Turner ... cites six reasons for the bank's collapse: 

• significant weaknesses in RBS's capital position, as a result of management decisions and permitted by an inadequate global regulatory capital framework
•over-reliance on risky short-term wholesale funding, which was permitted by an inadequate approach to the regulation of liquidity
• concerns and uncertainties about RBS's underlying asset quality because of little fundamental analysis by the FSA
• substantial losses in credit trading activities, which eroded market confidence and both the bank and the regulator underestimated how bad the losses were
• the ABN Amro acquisition took place with "inadequate due diligence"
• an overall systemic crisis in which the banks in worse relative positions were extremely vulnerable to failure. RBS was one such bank....

Ultra transparency would have positively addressed everyone of these reasons before these reasons allowed RBS to collapse.

Turner admits to failings at the FSA. "The report concludes that the FSA was too focused on conduct regulation at the time and its prudential supervision of major banks was inadequate. The FSA operated a flawed supervisory approach which failed adequately to challenge the judgment and risk assessments of the management of RBS. 

"This approach reflected widely held, but mistaken assumptions about the stability of financial systems and existed against a backdrop of political pressures for a 'light touch' regulatory regime," he said.

There is no doubt that the FSA operated a flawed supervisory approach.  However, the cure is not to make the regulators the sole body that can challenge the judgment and risk assessments of management.  This solution suggests that the regulators are still better than the market at analysis.  This is simply not believable or true.

The solution is requiring banks to provide ultra transparency.

Lord Turner does everyone a great service by acknowledging that regulators operate against a backdrop of political pressure.

The only way to eliminate political pressure in the assessment of the risk of banks is by requiring banks to provide ultra transparency.  Market participants, who are not subject to political pressure, will use the data to assess the riskiness of the banks.