Shunning a proven tool, Sir Mervyn King says new financial stability tools are 'an experiment'

A Telegraph article reports how the head of the Bank of England, Sir Mervyn King, describes the tools chosen by the Financial Policy Committee to promote financial stability as 'an experiment".  Specifically,

the central bank knows "absolutely nothing" about how the policy instruments its new watchdog, [the Financial Policy Committee], has asked for to combat systemic financial risks will work in practice, and that it will need to win a battle of hearts and minds when it starts using them.

And what exactly are the unproven tools that have been asked for to prevent another financial crisis?

The FPC is seeking from parliament the power to ensure banks have countercyclical capital buffers, the ability to force banks to hold more capital against exposure to specific sectors judged risky and the power to set leverage ratios.

Of these tools he observes,

"One thing I want to stress is that this is an experiment. It really is an experiment," he said of the policy instruments at a conference in Washington on Saturday. 

"We know absolutely nothing about how these instruments are going to work. It is very important that we play it safe and be cautious."

If he is worried about playing it safe and this is a concern that all of us share, then why did the Financial Policy Committee not chose to have "Direction over disclosure requirements"?

As regular readers of this blog know, for the last 70+ years the dividing line between financial stability and instability has been disclosure.

• Those areas of the financial system which are characterized by disclosure (where market participants have access to all the useful, relevant information in an appropriate, timely manner)  have been stable even in the presence of instability in other parts of the financial system for the last 70+ years.

• Those areas of the global financial system which are characterized by opacity (where market participants do not have access to all the useful, relevant information in an appropriate, timely manner) have been prone to instability.  

In fact, the current financial crisis occurred and is still occurring in those areas characterized by opacity like banking and structured finance.

The reason that the Financial Policy Committee elected to gamble with financial stability and not have "Direction over disclosure requirements" was laid out in its statement from its March 16, 2012 meeting.

In principle, powers to require financial institutions to publish consistent information in a timely manner about their activities could be a powerful tool in fostering awareness of risks in the financial system and allowing market participants to take appropriate mitigating actions, thus enhancing market discipline.  

In reality, requiring financial institutions to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details will allow market participants to independently assess the risk of each bank and to take appropriate actions with regards to the amount and pricing of their exposure to each bank.

This would bring market discipline to the banking system for the first time since the introduction of deposit insurance in the 1930s.

Disclosure issues had accounted for a significant part of the Committee’s deliberations over the past year and the Committee was engaged through several channels in promoting transparency to enhance financial stability.   

But the Committee recognised that a general power to set disclosure requirements may not meet the test set by HM Treasury that powers of Direction should be specific.   

The Committee agreed that, at some point in the future, it might need to be able to compel specific disclosure to mitigate systemic risk. 

So a key question was whether HM Treasury might be prepared in this particular area to ask Parliament to grant the FPC a broad power of Direction over disclosure, within any appropriate constraints, without knowing what specific future disclosure the FPC would judge necessary to tackle systemic risks.

In short, the FPC has no intent of using the authority to compel disclosure until after the next financial crisis.

However, the whole point of disclosure is that it prevents the next financial crisis from occurring in the first place because, as the FPC observed, it fosters awareness of the risks in the financial system and allows market participants to take appropriate mitigating actions.

Please re-read the highlighted text because by not asking for and then using authority to compel disclosure the FPC is gambling with financial stability.

If the FPC had disclosure authority, it would be expected to use it.  This expectation of use would raise the question of what is all the useful, relevant information that needs to be made available in an appropriate, timely manner for banks and structured finance securities.

As this blog has said many times, the answer to this question is ultra transparency.

Returning to the Telegraph article,

Like other central banks, the Bank of England is grappling with how to spot potentially systemic risks to the financial system and wider economy even as other indicators of health, such as inflation, are under control.

Actually, your humble blogger is less interested in whether central banks can spot potential systemic risks than in putting into place disclosure which has proven successful over the last 70+ years in helping market participants avoid these risks and the related financial instability these risk cause in the first place.

Sir Mervyn said that the FPC narrowed its choice of instruments to three because it will be important to explain to parliament and the wider public why it is or isn't using them. 

"If we are to maintain the ability to act independently and make unpopular decisions, it will be pretty crucial to explain what we are doing and why," said Sir Mervyn. "Setting realistic expectations of what can be achieved is an important ingredient."

If the FPC had the authority to compel disclosure, but did not use it, when the next financial crisis emerged from an opaque corner of the financial system, it would be very difficult to explain to parliament and the wider public why the FPC did not compel disclosure.

Not having the authority to compel disclosure provides two benefits to the FPC

• It allows the FPC's to gamble with financial stability.  If it identifies and heads off a source of financial instability, it is a hero.  

• If not, it also preserves the FPC's ability to say that the next financial crisis isn't its fault because it emerged from an opaque corner of the financial system.

This head the FPC wins, tails the taxpayer loses is simply a variation of what the banks also do under the cover of opacity.