Regulators snooze while banks gamble

In his Bloomberg column, Jonathan Weil looked at how US bank regulators appear to snooze while banks gamble.

This is particularly troubling as he notes the regulators have a monopoly on all the useful, relevant information in an appropriate, timely manner and bankers point to this to suggest to market participants that everything is okay because the regulators are aware of what is happening.

Regular readers know from previous posts (see here and here) that the longstanding Fed policy is

• that it is not their role to approve or reject individual trades at banks, rather

• their job is to ensure that banks have sufficient capital to absorb losses.

It is not a question of the regulators being asleep.  The regulators don't see it as their job to 'watch the store' as the banks are gambling or to blow the whistle on these activities.

This policy leaves a large gap between what the market assumes is meant by supervision and what is actually happening.

The market assumes that the regulators are looking at the banks constantly and stepping in proactively when they see something that might cause a problem.  This is simply not true.

The last time the market discovered such a large gap between what is assumed was happening and what was actually happening was with the rating agencies and subprime securities.  The market assumed that the rating agencies had current information and would change their ratings on a timely basis.  The reality was the rating agencies had the same out of date information the market had.

When the market discovered what reality actually was, the result was the structured finance market froze.

The question is what will happen when the market discovers that regulators do not actually proactively step in with the Too Big to Fail banks, but rather wait until a position blows up?

As Mr. Weil points out, there must be a better solution for protecting the public from banks gambling.  He makes a number of suggestions and concludes with ultra transparency.

Don’t worry your pretty little heads, JPMorgan (JPM) Chase & Co. Chief Financial Officer Douglas Braunstein seemed to assure listeners on the bank’s quarterly earnings conference call last month. Regulators knew everything JPMorgan’s chief investment office was doing, he said. 

“We are very comfortable with our positions as they are held today, and I would add that all of those positions are fully transparent to the regulators,” Braunstein said April 13. “They review them, have access to them at any point in time,” and “get the information on those positions on a regular and recurring basis as part of our normalized reporting.” 

This is a clear statement of the financial regulators' information monopoly and JPMorgan's ability to make this information available for anyone to see at any point in time (like say 'daily').

Bottom-line, the regulators have access to all the useful, relevant information in an appropriate, timely manner.  Information that is not available to market participants so they can independently assess the risks the bank is taking.

In other words: Clearly there wasn’t a problem, because if there was, the regulators would have seen it.

Seen it and acted on it!

The banks would have market participants believe that the regulators both see what is going on and act if there is a problem.

Regulators will act if there is a problem, but not as quickly as many market participants would assume they do.

This is a very important point and is best illustrated by an example.

In the mid-1980s, I worked for a bank that purchased $3 billion of 30 year US Treasury bonds.  Shortly after the purchase, interest rates started to rise and the market value of the bonds started to decline.  The Fed did not step in until the decline in market value exceed one-half of the bank's book capital.

And of course, by all indications, they didn’t see it, even though they were embedded in JPMorgan’s offices.... Once again, regulators seem to have been oblivious to huge risks at a bank they were supposed to be overseeing.

Could be a case where they saw the risk, but did not act based on the size of the loss relative to JPMorgan's capital base.

To JPMorgan, however, they also have served a valuable purpose. 

Having regulators around the clock at JPMorgan reinforces market expectations that the government has an obligation to stand behind the bank should it run into more serious trouble....

Please re-read the highlighted text as this is the same moral obligation that the government takes on every time the Fed runs a stress test and announces that the banks passed.

We have come to expect similar ineptitude from the Fed, the Office of the Comptroller of the Currency and other agencies charged with keeping large banks safe. They failed to prevent the last banking crisis; their policies even helped cause it.

Nonetheless, the U.S. Congress responded by doubling down on regulators’ abilities to stop the next crisis when it passed the Dodd-Frank Act in 2010. 

That law expanded the regulators’ oversight responsibilities. The biggest banks have gotten bigger since then, and now enjoy the official distinction of being “systemically important.” 

There must be a better system for protecting the public....

Then maximize transparency: The investments that banks make with federally insured deposits shouldn’t be a secret. Detailed disclosure of these holdings -- at least monthly, maybe even daily -- should be mandatory, so that markets can catch whatever the regulators miss. 

JPMorgan just gave the country a $2 billion warning. There’s no sense waiting for a bigger one.

With detailed disclosure provide by ultra transparency, markets can catch the gambling that the regulators intentionally miss!