Saturday, September 15, 2012

Echoing Andrew Haldane, FDIC's Thomas Hoenig calls for rejecting complicated regulations

Former president of the Federal Reserve Bank of Kansas City and acting vice chairman of the FDIC board Thomas Hoenig is the latest to come out in support of the idea of rejecting complicated regulations and substituting regulators for the market.  In his case, he specifically recommended that the US not approve the Basel III capital requirements.

Regular readers know that the Basel III capital requirements represent the pinnacle of regulators replacing transparency in the financial system with complicated rules and themselves.

According to a Wall Street Journal article,
The U.S. should reject new international bank-capital rules, a federal banking regulator said, making the case that they are too complicated and vulnerable to being gamed by "the most brazen and connected banks."
Please re-read the highlighted text as it describes the real problem with most bank regulations.

The problem is that the complicated regulations introduce opacity into the financial system that the most brazen and connected banks then proceed to game.
Thomas Hoenig, a board member of the Federal Deposit Insurance Corp., said in a speech Friday that the U.S. should replace the rules, known as Basel III, with a simpler and, in his view, tougher alternative, if international regulators refuse to do so.... 
In June, U.S. regulators in published draft capital requirements to comply with the Basel III standards. While bankers have been up in arms about the proposal, arguing that it will harm the economy, Mr. Hoenig argues that the rules should be rejected because they are too complex and rely on models that are subjective. 
Bankers "will delegate the task of compliance to technical experts, and the most brazen and connected banks with the smartest experts will game the system," he said. The rules use "highly arcane formulas, suggesting more insight and accuracy than can possibly be achieved." 
In general, this is why formalized capital requirements are a bad idea.  No matter how simplistic the requirement, without knowledge of the bank's exposures capital requirements suggest more insight and accuracy than can possibly be achieved.
Mr. Hoenig said the Basel rules should be replaced with a more simple formula of the ratio of "tangible equity" to "tangible assets." This would measure a bank's equity without goodwill, tax assets or other accounting entries. Tangible assets include a bank's assets minus intangibles. 
Mr. Hoenig's measurement, unlike the Basel rules, wouldn't rely on banks to measure the riskiness of their assets. 
"This simpler but fundamentally stronger measure reflects in clear terms the losses that a bank can absorb before it fails and regardless of how risks shift," Mr. Hoenig said.
At a theoretical level this is true.

In practice, this is not true.

As explained by the OECD, bank capital ratios are currently meaningless.  They are meaningless for a number of reasons.

For example, regulators are currently engaged in regulatory forbearance and as a result banks are using 'extend and pretend' practices to keep a number of zombie loans alive.  This distorts both the numerator (over states equity) and the denominator (over states assets).

The only way to restore meaning to capital ratios and reconnect theory and practice is by requiring the 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 can exert discipline on banks to record a proper valuation for all of their assets.  Since equity is an accounting construct, it will adjust to reflect these values.
Also, in an apparent dig at J.P. Morgan Chase & Co. Chief Executive James Dimon's repeated references to a "fortress balance sheet," Mr. Hoenig said, "there can be no fortress balance sheet without fortress capital."...
There can be no fortress capital without transparency to show that the capital levels reflect the current valuation of the bank's exposures.
Mr. Hoenig's critique of the rules' complexity and opacity is "reasonable" and reflects widespread concerns about how the Basel rules will be implemented, said John Dearie, executive vice president for policy at the Financial Services Forum, a group representing 20 financial chief executives. 
However, the simple approach preferred by Mr. Hoenig also has the potential for problems as it could encourage banks to hold riskier assets. 
"The trick is to identify the appropriate balance and the most effective middle ground," Mr. Dearie said.
Actually, trying to find an appropriate balance and most effective middle ground is an example of the regulators substituting themselves for the market.

It there is ultra transparency, market participants can independently assess the risk of each bank and adjust the amount and price of their exposures based on this independent assessment.

As a result, the market will reward banks that are appropriately capitalized (less risky) with a higher share price and lower cost of funds.  The market will discipline banks with inadequate capital (more risky) with a lower share price and higher cost of funds.

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