Wednesday, May 9, 2012

Sir John Gieve argues for UK regulators toning down bank regulation to help economic recovery

The Telegraph reports that Sir John Gieve, former Deputy Governor and head of financial stability of the Bank of England, said

Britain's regulators should tone down their attacks on the banks, slow the introduction of new financial rules and clarify the future structure of the industry to encourage lending and stimulate growth.
He defended this position by observing

Pressure on liquidity and capital, plus continued debate on what is an allowable banking model, is pushing them to deleverage more than they might be forced to anyway. I think this is an area where the US managed, by being rather over generous on any objective basis, to get their banks out of crisis mode and back into lending mode more than we have. 
"I would be seeing if there were things we could do... that would be more effective than denouncing them for continuing to pay dividends and bonuses, which is a perfectly valid point but in macroeconomics the job is to get the aggregates to move." 
Sir John said banks have been led to believe they must boost their safety buffers, in part by cutting credit. "The rhetoric has been one which says we want to see you go faster and further," he said. Banks have already cut lending to UK companies by £151bn since December 2008, according to official figures. 
Lack of clarity about how banks should be structured in future is not helping, he added. 
With this observation, Mr. Gieve calls into question the whole thrust of regulatory and policymaker efforts to reform the financial system.  Simply put, he sees these efforts as being an obstacle to economic recovery.

Since the beginning of the financial system reform effort, your humble blogger has consistently said that if we do not analyze the causes of the crisis first, we are highly unlikely to adopt policies and regulations that address the causes and are beneficial.  Instead, we are likely to adopt policies and regulations that reflect existing biases.

For example, regulators are biased to the idea that banks holding more capital is the solution and are pushing this forward.  As Mr. Gieve observes, this bias leads to banks shrinking their balance sheets by cutting lending.  As a result, economic recovery is a victim of the regulatory bias.

Was the lack of capital a cause of the financial crisis?  Nowhere is there evidence that this is true.

Discovering the causes of the financial crisis is not hard.  Front and center in the causing the financial crisis were opaque, toxic mortgage backed securities.  These securities gave policymakers and regulators a hint as to where they should start their reform:  addressing the issue of opacity.

Was opacity a cause of the financial crisis?  Everywhere you look there is evidence that this is true.  

However, it is an issue that policymakers and regulators have never addressed (for their part, I have given up on economists other than Joseph Stiglitz making a case for eliminating opacity as these economists don't recognize that valuation and not price transparency is THE necessary condition for the invisible hand to work properly).

Imagine where the economy would be if valuation transparency had been the sole focus of financial reform.
  • Structured finance securities could actually be valued by market participants and as a result the buyers' strike in the ABS market would be over;
  • Banks would be subject to market discipline and as a result they would be reducing their risk profile while selling newly originated loans in the ABS market;
  • Bailouts for banks in a modern financial system would not occur as the banks are designed to absorb the losses on all the excesses in the financial system today and rebuild their capital through retention of future earnings.  Having Wall Street rescue Main Street would have saved the real economy from the damage caused by the excess debt and reduced the need for central bank intervention; and
  • Market participants could actually trust Libor to reflect the cost of funding to the banking system because it would be based on the actual cost of funds by the individual banks.
Unfortunately, as I predicted at the start of the financial crisis, we are not going to achieve any of these until valuation transparency is focused on.

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