FDIC's Hoenig says complicated rules and regulatory supervision not ending bank risk taking

As reported by Bloomberg, FDIC board member and former president of the Federal Reserve Bank of Kansas City Thomas Hoenig says that complicated rules and regulatory supervision are inadequate for stopping banks gambling using FDIC-insured funds.

Mr. Hoenig proposed a modern Glass-Steagall and the separation of investment and commercial banking as the solution.

It is always nice to have someone of Mr. Hoenig's stature agreeing with your humble blogger's analysis that complicated rules and regulatory supervision are a major source of instability in the financial system.

Over the last 50 years, complicated rules and regulatory supervision have become a substitute for transparency and market discipline.

Both the complicated rules and the regulator's monopoly on all the useful, relevant information in an appropriate, timely manner have combined to make banks 'black boxes' to other market participants.

Since the banks are black boxes, the markets are dependent on the regulators properly assessing the risk of each bank and communicating this risk.  As Professor John Kay observed the other day, there is no reason to believe that no matter how well intentioned that the regulators will be able to properly assess the risk of each bank.

As the Nyberg Report on the Irish Banking Crisis showed, even if the regulators properly assess the risk of each bank, there are significant barriers to their communicating this risk to the market.

In short, a financial system dependent on complicated rules and regulatory supervision is prone to crash.

Fortunately, our financial system was not designed to be dependent on complicated rules and regulatory supervision.

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner.  In the case of banks, this information is disclosed if banks are required to provide ultra transparency and report all of their current global asset, liability and off-balance sheet exposure details.

Under the FDR Framework, market participants are responsible for all gains and losses on their exposures.  As a result, market participants have an incentive to use the disclosed information to independently assess the risk of each bank.

Market participants can then adjust their exposure, both amount and price, based on this risk assessment to the amount that the market participant can afford to lose given the risk of the bank.  As a result, banks can go out of business without bringing the entire financial system down.

Returning to the original design of the FDR Framework is simple.  Governments just need to focus on providing access to all the useful, relevant information in an appropriate, timely manner.  Market participants will do the rest.

If big U.S. banks are not forced to sever their investment arms from traditional banking, they will return to behavior that led to the 2008 credit crisis, said Federal Deposit Insurance Corp. board member Thomas Hoenig. 

“The behavior and practices leading to this crisis will soon reemerge and these highly complex, more vulnerable firms will have an even more devastating effect on the economy,” Hoenig said in remarks yesterday at the Exchequer Club in Washington. 

“Activities leading to the crisis continue today -- and continue to be subsidized -- well after the lessons should have been learned.” 

Regulators should reinstate a separation between commercial banking and brokerages, a kind of “modern version” of the Glass-Steagall Act to separate commercial banking from brokerage operations ... The public safety net should not protect the banking industry’s trading risks...

Regular readers know that the reason these activities continue today is the lack of transparency.  If banks were required to provide ultra transparency, market participants could see exactly what proprietary trades the banks had entered.

Knowing the trades, the market has any number of ways to reduce their profitability.  This is best illustrated by imagining playing poker and you have to play so that everyone can see your cards.  Naturally, the other players will use this information in betting against you.

Hoenig said major banks have “misled the markets regarding interest rates” and that “firms using FDIC-insured funds continue to make directional bets on asset values and global events.” 

He said the 2010 Dodd-Frank Act and its so-called Volcker rule to ban banks from proprietary trading was insufficient and that the government safety net will still cover swaps trading and market making, “much of which could become veiled prop- trading.”

Mr. Hoenig is right that the Volcker Rule plus regulatory supervision won't work.  The big banks understand how to game the system.

However, the Volcker Rule plus ultra transparency will work.  At a minimum, the regulators can use the market's analytical capability to identify trades that violate the ban on proprietary trading.

The big banks won’t “come along willingly” but should be forced to, Hoenig said. 

“It is alarming that CEOs of some financial firms fail to grasp why they are trusted so little nor appreciate the reputational damage they caused their industry,” he said.

The banks are going to fight providing ultra transparency tooth and nail.

However, the only way to restore trust in banks is to require that they provide ultra transparency.  Market participants know that sunlight is the best disinfectant.