Tuesday, June 26, 2012

Despite failure of Fed, ECB attempts to gain bank supervisory powers

Despite the clear failure of the Federal Reserve in its bank supervisory role both before and after the beginning of the financial crisis, the ECB is attempting to gain bank supervisory authority.

Regular readers know that your humble blogger worked for the Federal Reserve.  Based on my observations then and what I have seen occur since, the combination of monetary and bank supervisory authority in one organization does not result in 1 + 1= 2, but rather 1 + 1= -2.

Ask a simple question:  did combining monetary and supervisory authority result in the US and its banks avoiding the financial crisis?

The answer is an emphatic NO!

Given that the result of combining monetary and bank supervisory authority was a disaster, why should a lender of last resort be involved in bank supervision.  The argument is that the lender of last resort needs the intimate knowledge of a bank it lends money to that can only be gained from supervision.

As everyone other than a current or former central banker knows, 21st century information technology is a substitute for and an improvement on direct supervision.

If banks are required to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details, using 21st century information technology, all market participants, including central banks, can have an intimate knowledge of the bank.  No supervisory authority required.

More importantly, by not having supervisory responsibility, it allows the lender of last resort to be objective.

With supervisory responsibility comes many forms of capture including capture of the monetary authority.

First, there is regulatory capture that takes the form of the banks 'working' with the regulators on how to interpret the bank exposure details.  The Nyberg report on the Irish financial crisis documented how banks use this relationship to influence the regulator's assessment of risk in the banks' favor.

Second, there is the regulatory capture that comes from underestimating the size of the losses at a bank. In this case, the regulator finds itself in an awkward position.  Does it publicly acknowledge that it failed in its supervisory role?

Despite his many contributions in the conduct of monetary policy, Paul Volcker's central bank legacy includes the doctrine of not only not disclosing this information to the public, but trying to find a solution behind closed doors.

As your humble blogger previously discussed, this doctrine was first used when the Loans to Less Developed Countries (LDC) crisis hit.

Rather than acknowledge the losses on the banks' books, the Fed became a charter member of the Opacity Protection Team by actively supporting opacity with regards to the losses.  Specifically, the Fed adopted regulatory forbearance that allowed the banks to engage in 'extend and pretend' activities so as to postpone recognition of the losses.

While this was going on, monetary policy focused on lowering interest rates.  A policy that just happens to boost bank profitability by increasing the interest rate spread between the performing assets on the banks' balance sheet and their cost of funds.

After several years, John Reed at Citi lead the bank write-down of these loans.  Not only did acknowledgement of the losses not result in a run on the banks, but bank stock prices rose.

This was seen by the Fed as confirmation of the Volcker Doctrine.

Unfortunately, what was taken as confirmation of the success of the Volcker Doctrine in fact reflects a complete misreading of what actually happened.

Prior to the LDC crisis, banks disclosed their gross exposures to different countries.  When the crisis hit, bank analysts were able to track the prices at which LDC loans were sold to investors.  By combining the pre-crisis exposures with loan sale prices, the bank analysts could make a guess as to the real value of the loans at each bank.

Despite the fact that the Fed was deliberately assisting the banks in lying about their financial condition, the market had enough information to approximate the losses and their impact.  Clearly, the market was not concerned that this analysis showed that the large money center banks were insolvent.

The reason that bank stock prices increased when the losses were finally announced was that the size of the losses confirmed what the market expected.

Jumping to our current financial crisis, you can see that the Fed is once again implementing the Volcker Rule with expansionary monetary policy.

While I am sure that the banks like how the Fed has responded, why would the EU want to risk this happening with the ECB?

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