Saturday, October 13, 2012

Banking reform fails because focus is not on valuation transparency

Since the early 1930s, the financial systems of most western nations have been based on the FDR Framework.  This framework combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).

Banking reform since the beginning of our current financial crisis has failed because it does not embrace this framework.

To date, banking reform, particularly as exemplified by the Dodd-Frank Act in the US, the Vickers Commission in the UK and most recently the Liikanen Commission in the EU, has substituted complex rules and regulatory oversight for disclosure and transparency.

This banking reform has substituted knowably weaker prohibitions on proprietary trading (the Volcker Rule) or ring-fencing for disclosure and transparency.

Does anyone really believe that it was Glass-Steagall which separated commercial and investment banking and not the combination of the philosophy of disclosure with the principle of caveat emptor that kept the financial markets functioning smoothly for the 7 decades preceding our current financial crisis?

If there is anyone who thinks the credit belongs to Glass-Steagall, they should look at which portions of the financial system froze and remain frozen as a result of the current financial crisis.

A hint:  interbank lending and private label mortgage-backed securities.

What characterizes these two areas of the financial system and all the others that are not working properly is opacity.  The Bank of England's Andrew Haldane says current disclosure practices by banks leaves them resembling 'black boxes'.  Your humble blogger says current disclosure practices by structured finance securities leaves them resembling 'brown paper bags'.

What characterizes the areas of the financial system that functioned throughout the financial crisis and are still working is the existence of disclosure and valuation transparency.

Regular readers know that with valuation transparency market participants have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess an investment and make a fully informed investment decision.  This is also the necessary condition for the invisible hand to work properly.

With valuation transparency, market participants can successfully complete the first step of the investment process:  independently assess the risk and value of an investment.

The second step in the investment process is to compare this independent assessment of value against the price being shown by Wall Street or the City.

The third and final step in the investment process is to make a buy, hold or sell decision based on the difference between the independent value and the price shown.

It is this investment process that allows the market to exert discipline.  The investment process does this by putting downward pressure on stock prices and upward pressure on the cost of debt for firms whose risk exceeds their expected returns.

Returning to bank reform, we see that the reforms effectively substitute regulators for market discipline.

If there is any lesson to be learned from our current financial crisis, the lesson is that by design regulators are subject to being captured by the banks.  For example, regulators have political masters who are easily captured by the banking lobby.

Because they are subject to capture by the banks, regulators are the very last market participants to be able to exert discipline on the banks.

Since the beginning of the financial crisis, I have been advocating bringing valuation transparency to all the opaque corners of the financial system.  Not only will this unfreeze these frozen markets, but it will also bring in the benefits of sunshine as the best disinfectant and address the culture of bad banker behavior.

The Guardian ran an article that highlighted why complex rules and regulatory oversight don't work.
The government is facing mounting pressure to spell out precisely what activities it regards as high-risk "casino-style" investment banking – which are to be ringfenced from traditional savings and loans to safeguard the banking system. 
Publishing a draft banking reform bill , Treasury minister Greg Clark said: "We want to ensure that taxpayers are protected whilst retaining our status as a global financial centre....  
But Andrew Tyrie, the MP leading the scrutiny of the government's banking reforms as chairman of the parliamentary commission on banking standards, is annoyed at the lack of clarity in the bill. ... 
"The draft bill appears to leave a lot of detail to be determined in secondary legislation. We will press vigorously to find out what that is going to contain. Only by doing so will anyone – the industry, bank customers, parliament and the public – be able to find out what this legislation really means for them." 
Despite the importance of this legislation, MPs have less time to scrutinise the proposed laws than is typical as all sides recognise the need to get the bill into law as quickly as possible.... 
Last month Volcker told one newspaper: "In my experience ring-fencing is not terribly effective ... It only works in fair weather, but doesn't work in foul weather. They have already run into problems and they are bound to run into more. 
"John [Vickers] and I have the same concerns in mind. But the logic would be to separate the two parts of banking, not to keep them within the same institution. I find it puzzling to suggest that within one organisation you can have a branch that is entirely independent of another subsidiary, with the confidence that never the twain shall meet?"

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