Regulators should keep it simple

In his Financial Times column, Sebastian Mallaby picks up on the Bank of England's Andy Haldane's call for simplicity and uses it to explain why the regulators' current risk mapping strategy is flawed.

Regular readers will recall that in calling for simplicity Mr. Haldane was calling for rolling back both regulation and banks to where they were 50 years ago before we substituted complicated regulations, complicated economic models and the regulators themselves for transparency.

Mr. Mallaby recognizes that the current focus by regulators on risk mapping is the extreme in complexity, opacity and regulators taking on to themselves a task better performed by the market.

At the extreme of 50 years ago, we had banks voluntarily providing ultra transparency and disclosing on an ongoing basis their current asset, liability and off-balance sheet exposure details.  

With this disclosure, market participants were responsible for making sure they didn't have more exposure to any bank than they can afford to lose as they were required to absorb the loss.  As a result, market discipline was exerted on banks to restrain their risk taking and contagion didn't exist.

This was a financial system that did not rely on the regulators.

Today, we are at the other extreme.  Regulators have done everything they can to make the financial system dependent on them. For example, regulators are collecting and analyzing data behind closed doors rather than requiring the banks to provide this data to the market participants.  

The regulators are analyzing this data to uncover risks.  Once uncovered, regulators are then suppose to take action to neutralize each risk before they can become a problem.  

We saw this extreme where the regulators effectively create complexity and opacity didn't work in the run up to the financial crisis.  As Mr. Haldane pointed out, there is no reason to believe that adding more complexity and more opacity will work out any better at preventing the next financial crisis.

The crisis has shown that economic performance ought to be judged in terms of risks as well as quantities. In pure quantity terms, gross domestic product growth in the US, Britain or Spain was robust in the years up to the crisis. But adjusted for risk, these countries’ records were considerably less good. 

Just as sophisticated fund managers have long measured their performance by some version of the Sharpe ratio – returns divided by the risks taken to generate them – so policy makers must learn to risk-adjust macroeconomic performance. 

If risk is important, the case for a data revolution seems clear....

The case for a data revolution is clear.  The revolution is the return to providing the data to all market participants and not just the financial regulators.

The trouble is that harvesting good data is no small challenge....

This is a point your humble blogger has been making since before the financial crisis began.  Banks make money from opacity so they fight providing good data tooth and nail.  Financial regulators have an information monopoly and they are reluctant to give it up.

In a thoughtful paper, three proponents of a neo-Kuznets revolution – Markus Brunnermeier, Gary Gorton and Arvind Krishnamurthy – suggest a different way of tackling the data gap. 

Rather than asking dozens of unfocused questions, regulators should ask financial companies to estimate how they would fare under various stress scenarios: a change in one-year loan rates, a panic in the repo market, or some combination of such shocks. 

But this approach presumes that companies can calculate the answers. In practice, a shock in one corner of the system can generate aftershocks in unexpected places. How is a bank or hedge fund supposed to pinpoint its expected losses in the face of such feedbacks?

Actually, this proposal is nothing more than a red herring not to require transparency.

Market participants do not care how a financial company thinks it will fare under various stress scenarios.  What market participants care is to have all the useful, relevant information so the market participants can independently assess the financial companies under stress scenarios that the market participant chooses.

This is why we need transparency and not the complexity and opacity currently being provided by the financial regulators.