Monday, September 10, 2012

Echoing Andrew Haldane, Kenneth Rogoff calls for 'a simpler more transparent system'

In his Guardian editorial, Harvard economics professor, Kenneth Rogoff calls for restoring sanity to financial market regulation by focusing on a simpler and more transparent financial system.

It is always nice to have another well-known individual come out in support of your humble blogger's call for bringing transparency to all the opaque corners of the financial system.
People often ask if regulators and legislators have fixed the flaws in the financial system that took the world to the brink of a second Great Depression. The short answer is no....little has fundamentally changed. 
Legislation and regulation produced in the wake of the crisis have mostly served as a patch to preserve the status quo. Politicians and regulators have neither the political courage nor the intellectual conviction needed to return to a much clearer and more straightforward system.
The Financial-Regulatory-Academic complex (FRAC) has been impervious to change even with a financial crisis.  In fact, financial regulation hasn't been fixed, but rather made much more complicated.

Professor Rogoff's observation is a damning critique of the Dodd-Frank Act.
In his recent speech to the annual, elite central-banking conference in Jackson Hole, Wyoming, the Bank of England's Andy Haldane made a forceful plea for a return to simplicity in banking regulation
Haldane rightly complained that banking regulation has evolved from a small number of very specific guidelines to mind-numbingly complicated statistical algorithms for measuring risk and capital adequacy....
Mr. Haldane agrees with my observation that the change from a small number of very specific guidelines to complicated statistical algorithms and capital adequacy reflects the substitution of regulators and rules for transparency.

This is a very important observation as bringing transparency to all the opaque corners of the financial system is the simplest regulation with the biggest positive impact.

With transparency comes the ability of the market to analyze what is going on and to enforce discipline where it is needed.
As Haldane notes, even the celebrated "Volcker rule," intended to build a better wall between more mundane commercial banking and riskier proprietary bank trading, has been hugely watered down as it grinds through the legislative process. The former Federal Reserve chairman's simple idea has been co-opted and diluted through hundreds of pages of legalese.
Regular readers recall that your humble blogger has said that the Volcker rule could be reduced to two pages.

Two pages is amble to cover the statement that banks are not allowed to take proprietary positions and to require banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details to prove it.
The problem, at least, is simple: as finance has become more complicated, regulators have tried to keep up by adopting ever more complicated rules. It is an arms race that underfunded government agencies have no chance to win....
The problem is that the regulators engage in adopting ever more complicated rules in the first place.  These rules are themselves a form of opacity that the industry wants.  Passing the rules puts the regulators in the position where only they can enforce the rules.

By focusing on ensuring transparency, the regulators are doing their jobs as originally conceived under the FDR Framework.
Around the same time, in the mid-1990s, academics began to publish papers suggesting that the only effective way to regulate modern banks was a form of self-regulation. Let banks design their own risk management systems, audit them to the limited extent possible, and then severely punish them if they produce a loss outside agreed parameters. 
Many economists argued that these clever models were flawed, because the punishment threat was not credible, particularly in the case of a systemic meltdown affecting a large part of the financial system. But the papers were published anyway, and the ideas were implemented. It is not necessary to recount the consequences.
Here is an insider describing what is wrong with the Financial-Regulatory-Academic complex.

As I have previously said, there are no standards for economic peer reviewed journals.

Let us examine Professor Rogoff's example to show why.  Academics suggested that the only effective way to regulate modern banks was a form of self-regulation.  The tell-tale sign that this suggestion is not worth a warm bucket of spit is linking only effective way to regulate with self-regulation.

If there is anything that the economics profession should understand, it is the FDR Framework.  Like all of economics, the FDR Framework is based on the simple idea that buyers need to have access to all the useful, relevant information in an appropriate, timely manner so they can make a fully informed decision.

Without transparency, the invisible hand does not operate.

Without transparency, market discipline is not possible.

As everyone knows, the bright light of transparency is the best disinfectant.

It is a pillar of economics and our financial system that transparency and market discipline is the most effective way to regulate.

Proposing this isn't true is the equivalent of saying that opaque markets where the invisible hand cannot operate are more effective than transparency market with the invisible hand.
The clearest and most effective way to simplify regulation has been advanced in a series of important papers by Anat Admati of Stanford (with co-authors including Peter DeMarzo, Martin Hellwig, and Paul Pfleiderer). Their basic point is that financial firms should be forced to fund themselves in a more balanced fashion, and not to rely so heavily on debt finance....
Professor Admati would be the first to tell you that you need transparency before worrying about how a bank funds itself.

The OECD has highlighted that the current black box disclosure provided by banks renders both the numerator (book capital) and the denominator (assets) of capital ratios meaningless.  Until all the losses that are hidden on and off the balance sheet are known, which can only be accomplished with ultra transparency, capital ratios will continue to be meaningless.
Of course, it is not easy to legislate financial reform in a stagnant global economy, for fear of impeding credit and turning a sluggish recovery into a full-blown recession. And, surely, academics are also to blame for the inertia, with many of them still defending elegant but deeply flawed models of perfect markets that create an illusion of safety for a system that is in fact highly risk-prone....
It is hard to overcome the Financial-Regulatory-Academic complex.
A simpler and more transparent system would ultimately lead to more lending and greater stability, not less. It is high time to restore sanity to financial-market regulation.

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