Wednesday, March 28, 2012

The dangers of our new regulations

In a Financial Times column, Peter Sands, group chief executive of Standard Chartered, takes on the approach to addressing systemic risk employed by the Bank of England's Financial Policy Committee.

Regular readers know that Sir Mervyn King said the approach was 'an experiment'.  An experiment that your humble blogger felt needed to be supplemented with the tried and proven approach of disclosure, specifically requiring ultra transparency.

Not surprisingly, Mr. Sands is nervous about the 'experiment'.
Before the crisis, financial regulation focused on averting the failure of individual banks, and wasn’t much good at that.  
Which of course raises the question of why we would continue to have the stability of the financial system dependent on regulators?
Now there’s much more focus on preventing systemic crises. In the jargon, we’ve moved from focusing on “micro-prudential regulation” to a much greater emphasis on “macro-prudential regulation”....  
Please note that better disclosure helps with both micro-prudential and macro-prudential regulation.

With ultra transparency, each bank is required to disclose on an on-going basis its current asset, liability and off-balance sheet exposure details.  With this information, market participants, including the regulators can independently assess the risk of the banks.

Based on this risk assessment, market participants can then adjust their exposure to each bank to what they can afford to lose.

At the micro-prudential level, this adjustment is called market discipline and acts as a brake on banks taking too much risk.

At the macro-prudential level, this adjustment virtually eliminates concerns about contagion as the failure of one firm will not bring down others.
At Standard Chartered, we are very supportive of the concept of macro-prudential regulation, and the establishment of the [Financial Policy Committee]. We are dismayed, however, by the way it has defined its role....
The FPC’s approach appears simultaneously extremely interventionist and extraordinarily blinkered. 
It wants to be able to vary bank’s capital requirements in aggregate and by sector, and to be able to vary the leverage ratio, with little or no limit on the degree of required variation, or scant requirement to justify the intervention. 
It might not be obvious from the somewhat technical language, but in effect the FPC wants to control how much lending there is in every aspect of the economy, from manufacturing to mortgages, and how much it costs. 
This reeks of 1970s style quasi-nationalisation of the industry.... We know how well that went. 
... there are good reasons to be concerned about this approach. 
First, it represents an extraordinary concentration of power in the FPC. Its decisions will affect the cost of credit for every business or individual in Britain. So you have to be very concerned about its capabilities and accountability....  I think this notion that one committee should be able to anticipate all risks and micro-manage such an important part of the economy is dated and wrong. History suggests direct command and control is as flawed as complete laissez faire
One of the strengths of disclosure is that it lets the market help both the micro-prudential and FPC do its job.  It does this by letting both sets of regulators piggy-back off the market's analytical capabilities.

I know I have made this point many times before, but, for example, Peter Sands and Standard Chartered are better at analyzing HSBC and because of their exposure have more motivation to comprehensively analyze HSBC than the regulators.  The same is true for HSBC analyzing Standard Chartered.

The regulators should tap this analytical expertise to identify risks at individual institutions and to the financial system.
Second, the FPC seems remarkably insouciant about what investors in bank equity and credit will think about their interventions. Already battered by banks’ own mistakes, equity investors will, I think, take one look at the idea of their returns being dictated by the FPC and run a mile.  
This matters. Put bluntly, if investors can’t be convinced that investing in banks will deliver appropriate returns, capital will be sucked out of the industry, causing credit availability to fall and the cost of credit to rise.... 
The FPC will no doubt respond by claiming investors will appreciate the fact that the industry is now much safer and will demand much lower returns. While articulated as if it were a theological certainly, this verges on deliberate self-delusion. There is no evidence that the cost of equity for banks has come down. 
It is doubtful that the cost of equity for banks has come down because under current disclosure practices banks are 'black boxes'.

When market participants cannot assess the risk of investment, they charge more.

If banks provided ultra transparency, market participants could assess the risk of each bank.  Banks with low risk and high returns would see their cost of equity drop while banks with high risk and low returns would see their cost of equity climb.

I suspect the Mr. Sands feels Standard Chartered is in the low risk/high return category and therefore would be happy to provide ultra transparency as it would result in a significant increase in his firm's stock price.
Third, this obsession with controlling what banks do misses the point. Yes, banks can be a source of systemic risk, but they are far from the only one. And trying to manage all types of systemic risk through interventions in the banking system is an odd way of going about it. 
Take property bubbles. Most banking crises have their roots in property asset inflation, whether commercial or residential. For that reason, virtually every country that has an effective macro-prudential framework deploys loan-to-value or loan-to-income limits, in combination with other tools, to constrain lending on property....
A strength of disclosure is that it is easy for market participants to monitor loan-to-value or loan-to-income and see when they move close to bubble territory.  As a result, market participants can cut back on their exposure and naturally apply the brakes.
What worries me as well is that the FPC seems blind to some of the biggest risks to financial stability. Look at the Bank of England, the Federal Reserve and the European Central Bank. 
All three have seen a huge expansion in their balance sheets, are much more leveraged, and have deployed innovative tools on an unprecedented scale. Central banks are in new and uncharted territory, with unpredictable and potentially profound consequences....
There is no reason that their balance sheets should also not be subject to ultra transparency.

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