Bank of England's Chris Salmon: Three principals for successful financial sector reform

The Bank of England's Chris Salmon, Executive Director of Banking Services and Chief Cashier, gave a speech titled:  Three principals for successful financial sector reform.

Principal one:

First, in general it is better to manage the costs of change by having a long-transition period to achieve the preferred outcome, than it is to water down the reform so that change can be implemented more quickly... 

There is one area the Bank has tended to be less persuaded by the benefits of transition periods:  transparency.   

The costs of producing information are obviously much less than those associated with
changing balance sheet structures, and lack of transparency was an important factor in the run up to and during the crisis. 

To give a specific example where a relatively speedy move to greater transparency may help, the FPC has recommended that banks publish leverage ratios from the start of 2013, ahead of the Basel III timetables. These would act as a backstop to capital ratios, which are affected by the risk weights applied to bank assets.   

In making this recommendation the FPC drew on market intelligence which suggested that the
opacity of the methods used to calculate risk weights has dented confidence in the published data.  

Manipulating the calculation of risk weighted assets is one of two reasons that bank capital ratios are meaningless.

The primary reason that bank capital ratios are meaningless is that the Japanese model for handling a bank solvency crisis was adopted at the beginning of the financial crisis and regulators have blessed banks hiding losses on and off their balance sheets (see RBS's Stephen Hester's confession).  As a result, bank book capital has no relation to reality.

The Bank hears multiple arguments against producing data like leverage ratios, ranging from the idea that investors will have difficulty interpreting the data, so disclosure could be destabilising, to the suggestion that investors could calculate simple ratios like this themselves, so they add little value.  And sometimes both arguments are put forward at the same time!

The 'investors are stupid and would have difficulty interpreting the data, so disclosure would be destabilizing' is one of the favorite arguments put forth for retaining opacity by the Wall Street Opacity Protection Team.

In the Bank’s view investors need to be presented with a range of information, which allows them to build their own picture of a firm. Some of these may be less sophisticated investors than others, but if we are to reduce the dependence on ratings agencies, more data, must in general be a good thing.

At the high end of the 'range of information', Mr. Salmon appears to recognize the need for ultra transparency and having the banks disclose on an on-going basis their current asset, liability and off-balance sheet exposure information.

In his own words, there are investors who are "sophisticated" and this disclosure would "allow them to build their own picture of a firm".

An example of these sophisticated investors would be banking competitors who currently have a tendency to freeze the interbank lending market because they do not have the data to build their own picture of a firm and assess its risks and the probability of repayment.