Tuesday, July 24, 2012

John Kay: Need to return to markets built on trust, not prescriptive regulation

In his Financial Times column, John Kay looks at the failure of prescriptive regulations to control bad behavior in the financial system and argues for restoring a trust based financial system.

Regular readers know that the key to a trust based financial system is transparency.

Specifically, ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner.  Under the FDR Framework, ensuring transparency is the responsibility of the government.  

Under the FDR Framework, market participants have the incentive, but not the obligation, to use this information as they are responsible for all gains and losses on their investments.

There are many ways for market participants to use this information.  Some are capable of assessing the information themselves.  Others hire experts to assess the information for them.

Ultimately, the basis for trust in the system is that market participants are able to independently assess each investment and they trust this assessment.

Enron is the classic example of why all the useful, relevant information must be disclosed even if most market participants don't use it.  It only took one money manager to read the footnotes to Enron's financial statements to realize Enron was a house of cards.  

In the 1970s and 1980s, financial market regulation largely abandoned a system structured to limit conflicts of interest, which encouraged businesses to build reputations on their performance of specialist functions. 
The new approach was based on behavioural regulation, designed to combat inappropriate incentives by detailed prescriptive rules. The outcome is regulation that is at once extensive and intrusive, yet ineffective and largely captured by financial sector interests.
Please re-read the highlighted text as Professor Kay makes a very important point about how the current practice of regulations is both ineffective and largely captured by financial sector interests.

Behind the failure of the current practice of regulation is that it substitutes detailed prescriptive rules for transparency.

Everyone knows that sunshine is the best disinfectant.

The detailed prescriptive rules were drafted to perform the same tasks as transparency and not surprisingly are not as effective as transparency.
Such capture is sometimes crudely corrupt, as in the US where politics is in thrall to Wall Street money. 
The European position is better described as intellectual capture. Regulators come to see the industry through the eyes of market participants rather than the end users they exist to serve, because market participants are the only source of the detailed information and expertise this type of regulation requires.
With transparency, everyone would have access to the detailed information.  As a result, Wall Street's purchase of Washington would be neutered.  As a result, regulators could access end user expertise and not just the expertise from the firms being regulated.
This complexity has created a financial regulation industry – an army of compliance officers, regulators, consultants and advisers – with a vested interest in the regulation industry’s expansion.
Please re-read the highlighted text as Professor Kay has just described why the financial regulation industry is also known as Wall Street's Opacity Protection Team.

When there is transparency, most of the extensive detailed prescriptive rules become unnecessary.  As a result, to protect itself, the financial regulation industry protects opacity.
In regulation also we need to go back to a simpler structure, serving the users of equity markets – savers and companies....
We need to go back to a transparent financial system.  To do this requires the creation of the "Mother of All Financial Databases".  At a minimum, this data warehouse should contain:

  • All the current global asset, liability and off-balance sheet exposure details for each bank; and
  • Current performance information on the assets backing structured finance securities (this information should be reported on an observable event basis where every activity like a payment involving the underlying collateral is reported before the beginning of the next business day).

This data warehouse should be coordinated and overseen by a firm with no conflicts of interest with existing market participants.
The events of the past few weeks may have been a watershed in British attitudes to financial services. Public opinion finally understands that the sector’s problems are not the byproduct of unpredictable events but arise from a wrong turning in the culture of an industry that has come to prioritise transactions and trading over trust relationships. 

The only way to restore those trust relationships is by restoring transparency to the financial system and creating the 'Mother of All Financial Databases' so that market participants can Trust, but Verify.

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