Tuesday, April 10, 2012

Monitoring Financial Stability or the 'Devil is in the Details'

In his speech at the Federal Reserve Bank of Atlanta's Financial Markets Conference, Chairman Bernanke looks at monitoring financial stability.

He begins by acknowledging that the 'Devil is in the details'.

Yes it is Mr. Chairman and it is in those details that can only be seen through the adoption of ultra transparency.

It is only by providing market participants with access to ultra transparency in all the currently opaque corners of the global financial system that market discipline can be used to enforce financial stability.

It is only when each market participant has all the useful, relevant information in an appropriate, timely manner so they can independently assess the risk of their exposures that market participants can exert market discipline and adjust their exposures to what they can afford to lose given the level of risk.

It is only when ultra transparency is adopted that the regulators monitoring financial stability can look for where Wall Street has introduced opacity and systemic risk into the financial system and remove the opacity and its related systemic risk.

I've outlined a number of ongoing efforts, both domestic and international, to bring the shadow banking system into the sunlight, so to speak, and to impose tougher standards on systemically important financial firms.
Missing from Mr. Bernanke's list were ultra transparency and market discipline.
But even as we make progress on known vulnerabilities, we must be mindful that our financial system is constantly evolving, and that unanticipated risks to stability will develop over time. Indeed, an inevitable side effect of new regulations is that the system will adapt in ways that push risk-taking from more-regulated to less-regulated areas, increasing the need for careful monitoring and supervision of the system as a whole.
Yes indeed, Wall Street is very inventive when it comes to creating opacity and systemic risk.  Hence the reason that the regulators have to always be on guard to be sure that the sunlight of ultra transparency shines in every areas of the financial markets.
At the Federal Reserve, we have stepped up our monitoring efforts substantially in recent years, with much of the work taking place under the auspices of our recently created Office of Financial Stability Policy and Research. 
We conduct an active program of research and data collection, often in conjunction with other U.S. and foreign regulators and supervisors, including our fellow members on the FSOC. 
In addition, by making use of resources throughout the Federal Reserve System, we are developing a framework and infrastructure for monitoring systemic risk. 
Our goal is to have the capacity to follow developments in all segments of the financial system, including parts of the financial sector for which data are scarce or that have developed more recently and are thus less well understood. 
The straightforward way to achieve the goal is the adoption of ultra transparency.  That way, not only can the Fed see what is going on, but so too can market participants.  Since they have money at risk, they have an incentive to act well before a risk gets out of hand.
This work complements and is closely coordinated with our efforts, mentioned earlier, to supervise systemically important banking organizations from a macroprudential perspective. 
For example, based on public data, we develop and monitor measures of systemic importance that reflect firms' interconnectedness and their provision of critical services.
Regular readers know that the issue of interconnectedness goes away when financial markets are subjected to ultra transparency.  When market participants have the data they need to independently assess risk, they have the ability to adjust their exposures so that they do not have more exposure than they can afford to lose.

When regulators, like the Fed and FSOC, instead have a monopoly on all the useful, relevant information in an appropriate, timely manner, we end up gambling with financial stability.  If the regulators fail to properly assess or communicate risk, the market ends up mis-allocating capital relative to risk and susceptible to a financial crisis.
Unfortunately, data on the shadow banking sector, by its nature, can be more difficult to obtain.
Actually, between the Fed and SEC, it would be easy to require the disclosure of this data to all market participants.
Thus, we have to be more creative to monitor risk in this important area. We look at broad indicators of risk to the financial system, such as measures of risk premiums, asset valuations, and market functioning. We try to gauge the risk of runs by looking at indicators of leverage (both on and off balance sheet) and tracking short-term wholesale funding markets, especially for evidence of maturity mismatches between assets and liabilities. We are also developing new sources of information to improve the monitoring of leverage. For example, in 2010, we began a quarterly survey on dealer financing (the Senior Credit Officer Opinion Survey on Dealer Financing Terms) that collects information on the leverage that dealers provide to financial market participants in the repo and over-the-counter derivatives markets.  In addition, we are working with other agencies to create a comprehensive set of regulatory data on hedge funds and private equity firms....
Since the beginning of banking and certainly during the Great Depression, the indicator of a potential for a run was the market value of the assets was less than the book value of the liabilities.  Leverage has little or nothing to do with this.

By requiring ultra transparency, market participants can exert discipline on banks so that banks do not take on positions that result in the market value of their assets falling below the book value of their liabilities.
In the decades prior to the financial crisis, financial stability policy tended to be overshadowed by monetary policy, which had come to be viewed as the principal function of central banks.
It was natural at the Fed that monetary policy overshadowed financial stability.  For the last 2+ decades, the chairman of the Fed has been trained as an economist.

Monetary policy involves operating with assumptions and models economists are trained to think about and use.  In fact, they choose to become macro economists because they personally like working with assumptions and models.

Financial stability focuses on details.  Everything that big picture macro economists like the Chairman hate.  I say this because he confessed as to how boring he found Supervision and Regulation.

To deal with the fundamental incompatibility between macro economists and the Devil is in the Details supervision, I have argued for requiring ultra transparency be adopted across the financial system.

With ultra transparency, market participants can protect themselves and not have to rely on macro economists who dislike looking at the details.

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