Sunday, May 13, 2012

Why does the Fed not 'watch the store' on the individual exposures taken by banks?

This past week the Federal Reserve delivered a shock to the financial system that was virtually identical to the shock delivered by the rating agencies in the fall of 2007.

The rating agencies testified before Congress that they did not have access to more timely information on the performance of the collateral backing sub-prime mortgage backed securities than did the buyers of these securities. As a result, the rating agencies were not in a position to make timely adjustments to their ratings based on the performance of the collateral.

Prior to this testimony, market participants assumed, because it is true for other assets that the rating agencies rate, that the rating agencies had access to more timely information.

The impact was to freeze the structured finance market as the buyers who had relied on the ratings being based on current information now knew they could not value the securities because they did not know what they owned. 

The Fed delivered a similar shock when it acknowledged after the JP Morgan trade that it does not view it as its role to approve or reject individual bank exposures.  As a result, despite having access to all the current information about a bank's exposure, the Fed is not in a position to make timely statements about the solvency of the bank.

Since current disclosure requirements leave the banks resembling 'black boxes' and the market now knows that the Fed is not watching the store for how bank's manage their exposures, we can expect buyers to figure out pretty quickly that when it comes to securities, debt or equity, issued by a bank, buyers cannot value the securities because they do not know what they are buying.

By the way, there are several legitimate reasons why the Fed should not approve or reject individual bank exposures.
  • Fed cannot do a better job of assessing risk or valuing exposures than the market.  The market has more resources and expertise and as a result is better at assessing risk or valuing an individual exposure than the Fed.
  • Moral hazard.  If the Fed approves or disapproves of every individual exposure, then the government is on the hook for bailing out the investors should the bank ever lose money.
  • Fed speaks with one voice.  Unlike the market, the Fed speaks with one voice when it comes to discussions of the solvency of the banks.  As the Nyberg Report on the Irish financial crisis noted, this one voice makes it impossible for dissenting opinions to be heard.
Having acknowledged that they do not use their information monopoly, the Fed should end this monopoly.  This is simply done by requiring the banks to provide ultra transparency to all market participants and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

This way the market participants have the data they need to assess and value bank debt and equity securities.

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