Tuesday, September 4, 2012

Bank of England's Andy Haldane calls for simplifying both banks and financial regulatory system

In a very interesting speech at the 2012 Jackson Hole conference, the Bank of England's Andy Haldane made the case for simplifying both banks and bank regulation.

Mr. Haldane questions the wisdom of the expansion of bank regulation that has occurred over the last 50 years.

As noted by the Wall Street Journal,
Tracking regulatory complexity over time, Haldane points out that the Basel rules on capital requirements for international banking went from 30 pages in 1996 to 347 pages in 2004 to 616 pages in 2010. 
Banks complying with the rules a generation ago had to calculate a handful of ratios; now they must calculate several million. 
What once were based on hard numbers now, often, must rely on thousands of guesstimates and dizzyingly complex mathematical models contingent on questionable assumptions.
In short, like the OECD, Mr. Haldane finds that as currently calculated bank capital ratios are meaningless.

But Mr. Haldane does not stop there.

As Philip Aldrick pointed out in his Telegraph column, Mr. Haldane goes on and observes
“Modern finance is complex, perhaps too complex. Regulation of modern finance is complex, almost certainly too complex,” ... “Applying complex decision rules in a complex environment may be a recipe not just for a cock-up but catastrophe. 
“The general message is that the more complex the environment, the greater the perils of complex control. The optimal response ... is to simplify and streamline. Less may be more.” 
Allowing banks to become too complex has also made it near-impossible for investors to exert proper market control. “For investors today, banks are the blackest of boxes. Their multiplicity and complexity have undermined transparency and, with it, market discipline,”
In short, Mr. Haldane sees regulators as contributing to the complexity of modern finance and, more importantly, that complexity undermines transparency and with it market discipline.

Naturally, to restore market discipline Mr. Haldane calls for simplicity and rolling back both regulation and banks along the simpler lines of where they were 50 years ago before we substituted complicated regulations and economic models for transparency.

At this point, regular readers are probably seeing that the bottom line of Mr. Haldane's paper is really a call for a return to the FDR Framework and the era of transparency it ushered in.

Under the FDR Framework, governments are responsible for ensuring that market participants have all the useful, relevant information in an appropriate, timely manner.  If governments adhered to this responsibility, they would immediately drop regulations like the meaningless Basel capital requirements.

Instead, governments would focus on requiring banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  With this information, market participants could calculate Basel capital ratios for each bank if they wanted to as part of their independent assessment of the risk of each bank.

Under the FDR Framework, investors are responsible for all gains and losses on their investment exposures.  This gives investors an incentive to analyze the information disclosed by each bank to assess its risk.

More importantly, the risk of loss of all their investment gives investors an incentive to not have a greater exposure to each bank than the investors can afford to lose given their assessment of the bank's risk.

It is this incentive that ends concerns about financial contagion.  By definition, banks that lend money to or are counter-parties to other banks are investors.  As investors, they have an incentive to limit their exposure to every other bank to what they can afford to lose given the risk of the other banks.

Equally importantly, with ultra transparency, market participants can exert discipline on banks to limit their proprietary betting.  This restraint will give banks an incentive to split off their investment banking units (at least it worked out this way in the 1930s when banks provided this type of transparency as a sign they could stand on their own two feet and self-imposed the Glass-Steagall Act).

Perhaps of greatest importance, with ultra transparency and the FDR Framework, financial regulators can stop pretending they can ensure financial stability and prevent by themselves a financial crisis from occurring.

What they can do by ensuring transparency is promote stability and minimize the impact of a financial crisis by enlisting the assistance of all market participants.

What they can do is act like an investor and protect the taxpayer by adjusting the price of the deposit guarantee to reflect the risk of each bank.

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