Saturday, January 14, 2012

Patrick Honohan: Bank regulators as barrier to ultra transparency

Prior to becoming the Governor of the Irish Central Bank, Professor Patrick Honohan wrote a number of articles that are relevant to our current financial crisis.


I would like to call attention to his discussion of setting financial policy to reduce vulnerability and the political obstacles to effective regulation.
Weak enforcement due to political interference is the Achilles' heel of any regulatory
Early response to emergent banking problems has been repeatedly inhibited by the political
protection against closure which unsound banks and imprudent or self-serving bankers appear to have enjoyed. The resulting delays have deepened the ensuing crisis. 
Designing institutional and political arrangements that will make such protection less
likely is a difficult challenge.
Actually, this is one of the benefits of requiring banks to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.  With this disclosure, market discipline is applied to the banking system.
For one thing, bank intervention is often not seen as a desirable political good. Two of the possibilities that have been suggested to enhance the political desirability of sound
banking and thereby strengthen the hand of the regulator, namely limiting deposit protection and greater disclosure, are worth considering. 
When depositors are fully indemnified from banking failure, the major potential beneficiaries of sound banking are the taxpayers, who represent a normally diffuse lobby. Not only will unprotected but better informed depositors be more cautious about where they place their funds, but they will also see the regulators as their agents and clamour for early regulatory intervention.
Professor Honohan goes on to talk about disclosure.
Is it really a good idea to disclose full details of a bank's balance sheet and income
Many authors insist that this must be so, given the ability of market participants to process information and the distortions that arise when information is asymmetrically distributed. Ensuring prompt disclosure of all relevant information is also a central concern of the regulators of securities markets. 
This disclosure also just happens to be necessary if the invisible hand of the market is going to work properly.

Without ultra transparency into each bank's 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 properly assess the risk of each bank, they cannot properly price their exposure to each bank.
It is noteworthy, however, that not all bank regulators agree. Their concerns appear to be
with the risk of an irrational depositor response aggravating the position of a bank which is suffering from temporary and recoverable weakness.
It is sometimes argued that, by forcing early liquidation of such a bank's portfolio, such depositor withdrawals may impose avoidable social costs. 
Your humble blogger has documented that depositors do not care about the solvency of the financial institution.  They only care that the government is capable of honoring its implied 100% deposit guarantee - note, this covers deposits and not unsecured debt or equity.

Examples of financial institutions operating in insolvency for years include the US Savings & Loans and Security Pacific (losses on it loans to less developed countries exceeded its book equity).
From an analytical point of view, the issue of disclosure is closely related to that of forbearance. If the purpose of non-disclosure is to facilitate the continued operation of a bank which the market would close if it had the relevant information, then it also implies that the authorities (who have the information) are forbearing to take closure action themselves.
It is only regulators who can close an insolvent bank and their are given discretion in choosing when to close an insolvent bank.

Market participants are restricted in what they can do.  Most will require a guarantee and hence limit their investments in insolvent banks to deposits. Others will invest in the equity of the bank if they feel it can restore itself to solvency.

The bottom line is that a bank can continue in operation until such time as its regulator chooses to close it.
Although some theoreticians have dreamed up circumstances under which forbearance would be desirable it is widely accepted that forbearance and non-disclosure weaken incentive structures and ease the work of political lobbyists who would seek to restrain regulatory action. 
In other words, regulators promote the interest of Wall Street's Opacity Protection Team.
Disclosure multiplies the number of watchful eyes and should induce a more cautious
management stance. 
Inevitably, disclosure may shorten the time interval between the emergence of liquidity and solvency problems at a bank, as it will improve the information on which depositors and
other lenders to the bank will base their decisions. 
However, early regulatory intervention in the affairs of an insolvent bank is desirable anyway. Recalling the earlier discussion of contagion, specifically its relative infrequence and the tendency for runs to be focused on banks that are truly insolvent, we conclude that the advantages of extensive disclosure outweigh the risk of some destabilisation.
Please recall, with every bank providing ultra transparency, each bank is able to adjust its own exposures to what it can afford to lose and as a result end the risk of contagion in the financial system.

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