Monday, July 9, 2012

Libor-gate could finally trigger banking reform

The Libor interest rate manipulation scandal reveals just how little has been accomplished in making the financial system safer with the bank reforms put forward under the Dodd-Frank Act and the Vickers Commission.

Neither would have moderated the impact of the opaque, toxic structured finance securities that precipitated the financial crisis.

Neither would have limited the size of JP Morgan's credit default swap trade.

Neither would have prevented banks from manipulating Libor.

Neither would change the culture of the banks, in particular the privatizing of the gains and the socializing of the losses.

In fact, what all the reforms pursued to date show is just how much control bankers have over politicians and financial regulators.

As pointed out by Liam Halligan in his Telegraph column, the Libor-gate scandal represents an opportunity to put in place real reform.

Regular readers know that real reform is bringing transparency into all the opaque corners of the financial system.

Transparency that provides market participants with all the useful, relevant information in an appropriate, timely manner so that investors can make fully informed investment decisions.

Transparency that market participants can use to value and monitor what is happening with their investments.

For banks, transparency would be the requirement that they disclose on an ongoing basis their current asset, liability and off-balance sheet exposure details.

For structured finance securities, transparency would be the requirement that these securities provide observable event based reporting.  Any activity like a payment or default involving the underlying collateral would be reported to market participants before the beginning of the next business day.

History has shown that it is only with transparency that sunshine can act as the best disinfectant.

History has shown that it is only with transparency that opaque securities don't exist, markets can exert discipline on banks to restrain their risk taking, interest rates can be based off of actual transactions and the culture of banking can be changed.

The type of transparency your humble blogger is advocating is much different than 'price' transparency.  My focus is on transparency that supports valuation and monitoring.

The investment cycle highlights the difference between 'valuation and monitoring' transparency and 'price' transparency.

The first step of the investment cycle is to independently assess the risk of and value a security.  Next is to compare this valuation with the price being shown by Wall Street.  Last is to make a buy, hold or sell investment decision based on the difference between the valuation and Wall Street's price.

What the banks managed to do over the last 30 years is to create large areas of the financial system (think the banks themselves and structured finance securities) where investors cannot independently assess the risk and value the securities due to opacity.  Investors simply do not have access to all the useful, relevant information in an appropriate, timely manner.

The result of opacity has been these areas of the financial markets have frozen as investors have realized they do not know what they own.

Fixing the financial system requires valuation and monitoring transparency.

It is simple and eliminates the need for much of either the Dodd-Frank Act or the Vickers Commission 'reforms'.

No comments: