The regulatory diversion: No banking rule can protect against a credit mania

In a column discussing the Volcker Rule, the Wall Street Journal editorial staff lays out why ultra transparency is required for banks, structured finance securities and all the other opaque corners (like the setting of the Libor interest rate) of the financial system.

Simply, they observe that no banking rule can protect against a credit mania fueled by bad policy.

The question is protect whom?

The banks, the other market participants or both?

As regular readers know, under the FDR Framework, all market participants, including banks, are responsible for gains and losses on their exposures.  As a result, it is the responsibility of each market participant to be sure that they do not have more at risk than they can afford to lose even in the presence of a credit mania.

This puts a damper on credit manias.

In order for market participants to be able to manage the risk of their exposures, they must have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess risk.

This is where ultra transparency comes in.

Could even Paul Volcker draft a Volcker Rule? Team Obama and Democrats in Congress couldn't figure out how to turn his sensible idea—prohibiting banks from gambling with taxpayer money—into law....

Rather than trying to craft a complex rule for prohibiting banks from gambling with taxpayer money, maybe it might make more sense to try letting market discipline discourage such gambling.

With ultra transparency, market participants can exert discipline on the risk profile of a bank by the way they adjust both the amount and price of their exposure to the bank.  A higher risk profile will see a higher cost of funds.  While a lower risk profile will see a lower cost of funds.

According to the former Federal Reserve Chairman, "simplicity and clarity are challenging objectives, which for full success, require constructive participation by the banking industry. As I have suggested elsewhere, there should be a common interest in an approach that, to the extent feasible, is consistent with the banks' broader internal controls and reporting systems."...

Ultra transparency easily meets Mr. Volcker's objectives of simplicity and clarity.  Furthermore, ultra transparency is consistent with the banks' reporting systems.

Now even Mr. Volcker seems to be conceding that this sausage, [the Volcker Rule], can only be made if more bankers are invited to join the federal cooks in the kitchen. 

Expect complexity, disparate treatment, regulatory arbitrage, higher costs and—perhaps the most dangerous Washington creation of all—the illusion of safety that only regulation can provide....

Unlike the Volcker Rule and the rest of the regulatory diversion embodied in the Dodd-Frank Act, ultra transparency does not create the illusion of safety that only regulation can provide.

Market participants know that they must protect themselves and hence they have an incentive to use the data to independently assess risk.

The larger problem with the Volcker Rule to-and-fro is that it furthers the great deception of the financial crisis—that it was all caused by a lack of such rules, and so can be fixed by still more rules.  

Mr. Volcker himself understands this isn't true and has acknowledged that his rule, even if someone could figure out how to draft it, would specifically not have prevented the 2008 disasters at AIG and Lehman Brothers. 

But most of the political and regulatory class still promotes the fiction that the only sinners were greedy bankers who simply need more political supervision.... 

However it is written, the Volcker Rule is at bottom a diversion from the real solutions that would protect taxpayers from a repeat.... 

Allowing regulators and bank lobbyists to negotiate for years in the gray areas will not protect either taxpayers or an economy...

As your humble blogger has repeatedly observed, ultra transparency is the solution.

It would have prevented the 2008 disasters known as AIG and Lehman as market participants would have stopped funding these organizations at a much lower risk profile.

It lets the regulatory class subject the greedy bankers to more supervision.  This supervision is now done by the market and the regulators can use the analysis done by the market in support of their supervisory responsibilities.

It protects taxpayers from a repeat as market participants have an incentive and the information they need to exert market discipline and prevent the repeat.  However, if there is a repeat, banks can absorb the losses on any excesses in the financial system today.  Those with a viable franchise will be able to rebuild their book capital through future retained earnings.  Those banks without a viable franchise will be closed.

Finally, it ends regulators and lobbyists negotiating for years in a grey area.  The regulation requiring ultra transparency could be written on one page.