Tuesday, September 18, 2012

John Kay effectively calls for FDR Framework if you want reform

In his Financial Times column, John Kay concludes that a new, simpler approach to building a resilient financial system is needed and this approach must be based on the principle that the most effective bank supervisors are not financial regulators but rather other banks.

Regular readers know that this resilient financial system is what your humble blogger has been calling for the FDR Framework.

Regular readers also know that the only way to implement Professor Kay's principle is to require banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

It is only with this information that each bank can independently assess the risk of every other bank and adjust their exposure to each of the other banks based on the risk of these banks.
the right long-term response is not to try to stop future bank failures, but to construct a global financial and economic system that is robust to individual bank failures....
We actually have this system in place if the financial regulators and policymakers do not interfere.

As the Bank of England's Andrew Haldane observed in his speech at the 2012 Jackson Hole Conference, over the last 50 years the financial regulators have interfered.  Specifically, bank regulators have replaced transparency and market discipline with complex regulations, opacity and ineffective supervision.
It has proved difficult to find executives and management systems able to control the risk exposures of large financial conglomerates: even the halo above Jamie Dimon looks tarnished. 
To believe that the control these managers failed to establish will be achieved by the supervisory efforts of junior officials in public agencies is a delusion.  
Even if regulators had the technical competence, they do not have the political backing. Hotlines from bank boardrooms to ministerial offices are answered as promptly as ever. 
Please re-read the highlighted text as Professor Kay makes a very important point about why bank regulatory supervision is destined to be ineffective.
Public opinion excoriates regulators for their ineffectiveness as it nurtures exaggerated expectations of what future regulation might achieve.
Actually, it is the politicians and financial regulators that exaggerate expectations of what future regulation might achieve.

A classic example of this is the Dodd-Frank Act which doubles down on regulators and has as cheerleaders the politicians, the US Treasury Secretary and the financial regulators.
Establishing bodies with grand-sounding responsibilities for global financial stability represents only a tiny step towards these goals.
Regulation based on target capital ratios not only failed in the past, but will fail again in the future. Not because the fine print of the risk weighting is defective, but because any target will be gamed by those who observe its letter rather than its spirit.
Regulation based on target capital ratios also fails because it is written by the banks for the banks.  The whole idea behind the target capital ratios is to let banks increase and hide the amount of leverage and risk they have on their balance sheet.
The achievement of the regulatory reform agenda has been to ensure that when the next financial crisis occurs it will not take exactly the same form it did in 2007-8. 
The objective of preventing individual bank failures will largely be accomplished, but by socialising much of the downside risk in the financial system, rather than by addressing the underlying issues. 
The socialization of losses is the direct result of the choice by policymakers and financial regulators to interfere at the beginning of the financial crisis and protect bank book capital levels.

Without this interference, banks would absorb the losses they are designed to absorb and the real economy would be protected from the negative impact of these losses.
Effective reform should aim at structures, not at intensified supervision. 
Resilient systems are simple ones. 
The most effective supervisors of financial institutions are not bureaucrats but other financial institutions. 
These principles should be fundamental to a new approach and they have wide implications.
Please re-read the highlighted text again as Professor Kay is calling for the FDR Framework.

The FDR Framework is a resilient structure because it assigns achievable tasks.

Governments are responsible for ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner.  In the case of banks, this is the information disclosed through the requirement of ultra transparency.

Market participants, including other financial institutions, are responsible for all gains and losses on their exposures.  This gives market participants the incentive to use the disclosed information to independently assess the risk of each bank and to adjust their exposure to what they can afford to lose given the risk of each bank.

Please note, under the FDR Framework, governments are not suppose to provide investment advice.  This principle is currently being violated as banks are 'black boxes' and governments are providing investment advice by saying after stress tests that they are solvent.
Bad lending in the US mortgage market and the creation of debt instruments were only proximate causes of the 2007-8 crisis. The establishment of complex financial conglomerates, whose assets and liabilities were mainly the liabilities and assets of other financial conglomerates, created a structure in which minor disruptions were likely to have large and unpredictable consequences throughout the financial system. 
This issue cannot be addressed by establishing committees to watch it happen. To respond by public insurance of the structure is dangerous, not just because it imposes obligations on taxpayers but because it largely relieves private actors of the obligation to monitor their own counter-party risks. 
Alan Greenspan expressed puzzlement that shareholders and managers of banks had not controlled risk more effectively. But shareholders who provide less than 5 per cent of the capital of a business are not equity participants, but owners of a call option: in turn, corporate executives with bonuses and remuneration plans hold options on these options. 
How can we expect stability when volatility increases the value of the instruments owned by the people who make or influence all important decisions? 
The true equity participants in highly geared ventures are the owners of debt who are now reassured that the businesses in which they invest are “too big to fail”....
The only way that the owners of the debt can exert the restraint on risk that Professor Kay calls for is if they have ultra transparency and can independently assess the risk of each bank.  With ultra transparency comes market discipline.  Something that is currently missing from the banking industry.
Until politicians are prepared to face down Wall Street titans on that issue, regulatory reform will not be serious.

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