Former Fed Governor Kevin Warsh says ramped up disclosure needed for banks

In her NY Times column, Gretchen Morgenson asks former Fed Governor Kevin Warsh about the policies being pursued to reform the financial system, particularly the big banks.  To address the big bank problem, he said

their disclosures must be subject to new and ramped-up transparency requirements so investors can differentiate strength from weakness.

Your humble blogger welcomes Mr. Warsh in his call for ultra transparency.

Regular readers know that the only way that investors can differentiate strength from weakness in the banks is if each bank discloses on an on-going basis its current asset, liability and off-balance sheet exposure details.  With this data, investors can independently assess each bank.

Absent ultra transparency, investors do not have the data needed to properly assess the banks.  As the Bank of England's Andrew Haldane says, bank disclosure leaves them resembling 'black boxes'.

Big banks are bigger than ever, and they exert enormous power over regulators and lawmakers. Increasingly, smaller institutions can’t compete. 

So it was refreshing last week to hear Kevin M. Warsh, a former Fed governor, speak candidly and critically about the government backing that continues to support our largest banks. Equally refreshing were his prescriptions for eliminating the too-big-to-fail problem. 

“We cannot have a durable, competitive, dynamic banking system that facilitates economic growth if policy protects the franchises of oligopolies atop the financial sector,” Mr. Warsh told an audience at the Stanford Law School on Wednesday night. “Those ‘interconnected’ firms that find themselves dependent on implicit government support do not serve our economy’s interest.”.... 

Put simply, Mr. Warsh does not believe that higher capital standards for banks and greater regulatory scrutiny will be enough to prevent future taxpayer-financed bailouts. 

“At core, I’m worried that the Dodd-Frank Act doubles down on regulators, gives up on markets and outsources capital requirements to an international standards group in Basel, Switzerland,” he said in an interview last week. 

Please re-read the highlighted text as it as Mr. Warsh confirms what your humble blogger has been saying about 1) regulators as a source of financial instability because they are a single point of failure, 2) the meaninglessness of capital standards, and 3) the need to let the market help in preventing the next financial crisis.

Importantly, none of these responses have moved us closer to “ridding the United States financial system of large, quasi-public utilities atop the sector,” he said. 

Mr. Warsh does not prescribe breaking up giant institutions. Rather, he says their disclosures must be subject to new and ramped-up transparency requirements so investors can differentiate strength from weakness....

I have also never argued for breaking up the giant institutions.  Like Mr. Warsh, I realize that with ultra transparency, market discipline will be brought to the banking sector.

As a result, not only will investors distinguish between strong and weak institutions, but they will also price their exposures to all banks based on the riskiness of each bank.  This will put pressure on banks to become less risky.

 “Still, disclosure practices by the largest financial firms remain lacking, and the periodic reporting overseen by the Securities and Exchange Commission tends to obfuscate as much as inform.”

Regulators must require clearer and more expansive disclosures so that the financial statements and associated risks of large and complex companies can be assessed, Mr. Warsh said. 

If investors had more detailed information from these institutions, they would very likely sell their shares and debt if they took too many risks. This would hold the managers of these institutions accountable for reckless behavior by making them pay more to fund their businesses.

Please re-read the highlighted text because it repeats the arguments I have been making since the beginning of the financial crisis.