Regulator explains why new model of bank supervision based on ultra transparency needed

The Guardian carried an interesting interview with a regulator at the UK's Financial Services Authority.

During the interview, he confirms what your humble blogger has said in earlier posts is wrong with the financial regulatory model.  Specifically, regulators do not publicly disclose the risks the banks are taking despite their monopoly on all the useful, relevant information.

Since the information monopoly makes market participants dependent on the regulators to assess the risk of the banks, the failure to communicate the true risk means that the market participants mis-price their exposures to the banks relative to the risk of the banks.  Typically, too much exposure at too low a price.

He also confirms that it is not the regulator's role to approve/disapprove of any position a bank takes and the regulator tries to insure that the bank has enough capital to absorb any loss that might result from the position.

"The biggest surprise for readers if they saw what I see? The sheer size of the financial sector and range of products and services; how big these banks are and how interconnected the financial system has become. 

This was something that came to light in the immediate aftermath of the collapse of Lehman Brothers. Take the payment system that you and I rely on in our everyday lives, the plumbing of the financial system if you will. This has become so intricate and interconnected that contagion can spread rapidly. 

The payments system is like a giant spider's web with the central bank at the centre with rings of banks going out. If several of these banks are suffering a crisis at the same time, you begin to worry about whether the day-to-day running of the economy is under threat. Derivatives also threw a lot of uncertainty during the crisis....

In describing the interconnectedness of the financial system, he identifies one of the primary reasons for requiring banks to provide ultra transparency.

It is important that each bank has access to the information it needs on every other bank to adjust its exposure to these banks to reflect what it can afford to lose given these banks' risks.

By adjusting their exposure to what they can afford to lose, the banks reduce the risk of contagion.

"The big UK banks have, on average, 20 regulators permanently assigned to them. For global banks with a big UK presence, it can be five to 10 people. It's the same for insurance companies, asset management firms and so forth.....

If there were ultra transparency, how many people would be looking at the big banks?  First, there are the competitors, then there are analysts, then ...

There is a reason that markets do a better job of analyzing data and why the regulators' monopoly on all the useful, relevant information that would be available through ultra transparency must be ended.

"However, there are only so many ways you can ask the same question about the risks firms are exposed to. At some point you can arrive at an impasse; we can't predict the future either....

Please note that assessing the riskiness of a bank does not require predicting the future.  It involves understanding how much the bank could lose. 

"One interesting dilemma for regulators is that you can bring about the thing you are trying to prevent, simply by talking about it. 

Say, we are worried about sovereign debt in southern European countries and we feel our banks should try to lower their exposure there – not lend money to businesses in these countries, for instance. If we actually come out and do this, that almost starts the problem by creating panic. And you can be sure that the prime ministers of these countries will be on the phone to our prime minister right away. Even though we are independent, that pressure will come down on us. 

"Another thing is that, if we tell banks to get rid of, say, some of the government bonds they have from a particular country, that will drive down the price of those bonds, lowering the value of their remaining bonds and actually perpetuating the problem.

Confirmation of why the regulators do not approve or disapprove of a position taken by the bank and that the focus is on trying to answer the question of 'does the bank have enough capital to absorb any losses coming from the area of concern'. 

"No, of course I don't like being called an idiot. There are bright people working across the financial sector who missed a lot of tell-tale signs and got caught up in the credit bubble. There were mistakes made by both sides. 

Banks have been so wrong about their risks. There was a clamour for light-touch regulation, to leave the industry in peace, because they knew best. 

People blame the regulators for missing all sorts of things in years past, and there were regulatory failures. 

But the senior management and risk people inside the banks themselves, they should have caught them in the first place. Then again, those risk officers who did issue warnings in those years may have been let go.

Confirmation of why there needs to be ultra transparency so that the market can assess the risk of the banks.