Bringing transparency to all the opaque corners of the financial system is a conservative project

MIT Professor Simon Johnson wrote yet another column calling for the break up of the Too Big to Fail banks (his other topic is calling for banks to hold more capital).  What makes this column of interest is that it really makes the case for bringing transparency to all the opaque corners of the financial system.

The columnist George F. Will recently shocked his fellow conservatives by endorsing Richard Fisher, president of the Federal Reserve Bank of Dallas, to be Treasury secretary in a Mitt Romney administration. 

Fisher’s appeal, in Will’s eyes, is that he wants to break up the largest U.S. banks, arguing that this is essential to re- establish a free market for financial services. Big banks get big implicit government subsidies and this should stop. 

Will’s endorsement was on target: The true conservative agenda should be to take government out of banking by making all financial institutions small enough and simple enough to fail. As Will asks, “Should the government be complicit in protecting -- and by doing so, enlarging -- huge economic interests?”

Regular readers know that by failing to fulfill its responsibilities under the FDR Framework government is complicit in protecting the banks.

First, the government fails to ensure that market participants have access to all the useful, relevant information in an appropriate, timely manner so the market participants can independently assess this information and make a fully informed investment decision.

Second, the government offers its own opinion as to the risk of the banks.  Prior to the crisis, financial regulators talked about how risk in the banking system was reduced because of financial innovation.  After the start of the financial crisis, financial regulators talked about how the results of a stress test the regulators ran showed the banks were adequately capitalized.

But Will could have gone further -- much of what Fisher recommends also is appealing to people on the left of the political spectrum. ...

As is transparency and the government fulfilling its responsibilities under the FDR Framework.

Unfortunately, Fisher’s views on “too big to fail” banks draw the ire of powerful people on Wall Street,

Transparency draws the ire not just of powerful people on Wall Street, but also powerful people in Washington (transparency doesn't draw the ire of economists as they assume that it exists).

Unlike the breaking up the Too Big to Fail or higher capital requirements, transparency is a threat to the Blob (aka, politicians, financial regulators, Wall Street and their lobbyists).

As FDR understood, with transparency, the Blob's power is limited.  As a result, policies like adopting the Japanese Model for handling a bank solvency led financial crisis and protecting bank book capital levels and banker bonuses at all costs would not be adopted.

Fisher and Harvey Rosenblum, executive vice president and director of research at the Dallas Fed, have laid the groundwork for a comprehensive reassessment of finance and banking -- and the effects on monetary policy. 

The closest parallel is the rethink that happened during the 1930s, as the gold standard broke down and the world descended into depression followed by chaos. 

But their approach is also reminiscent of the way that monetary policy was reoriented in the early 1980s, as Fed Chairman Paul Volcker and others brought down inflation. 

The world and the U.S. economy have changed profoundly. We need to alter the way we think about the financial system and monetary policy.

Actually, with the FDR Framework, your humble blogger laid the groundwork for thinking about the financial system and monetary policy.

Fisher and Rosenblum have expressed, separately and together, three deep ideas since the financial crisis erupted in 2008. 

First, very large banks are too complex to manage. “Not just for top bank executives, but too complex as well for creditors and shareholders to exert market discipline,” they wrote in a Wall Street Journal op-ed in April. “And too big and complex for bank supervisors to exert regulatory discipline when internal management discipline and market discipline are lacking.” 

Complexity, they say, magnifies “the opportunities for opacity, obfuscation and mismanaged risk.”....

And here is where Fisher, Rosenblum and Mr. Johnson make the case for bringing transparency to all the opaque corners of the financial system.  For banks, transparency requires that they disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Everyone knows that transparency is needed if market participants are to independently assess the risk of an investment and exert market discipline.

Without it, market participants have to rely on a third party for a risk assessment if they are going to invest.  For banks, the third party relied on prior to the financial crisis was the financial regulators.  For structured finance securities, the third party relied on prior to the financial crisis was the rating agencies.

Clearly, both of these were discredited at the start of the crisis as their risk assessments were shown to be wrong.  With their stress tests, the financial regulators have confirmed that their risk assessments have not improved.

As Fisher, Rosenblum and Johnson point out, without this disclosure bankers use complexity, a form of opacity, to magnify the opportunities to profit from opacity, obfuscation and mismanaged risk.  Which further confirms Yves Smith observation on Naked Capitalism that nobody on Wall Street is paid to create low margin transparent products.

Second, too-big-to-fail banks do actually fail, in the sense that they require bailouts and other forms of government support. This is exactly what happened in the U.S. in 2007 through 2009, and it is what is occurring in Europe today....

Regular readers know that a modern financial system is designed so that banks do not require bailouts.

Banks have deposit guarantees and access to central bank funding and as a result, they can continue operating and supporting the real economy when they have low or negative book capital levels.  The deposit guarantee effectively makes the taxpayer the silent equity partner while the bank has low or negative book capital levels.

The reason behind the bailout was the fear of contagion.  One bank would fail and it would bring down the entire banking system.  Contagion only exists when the the government fails to ensure adequate transparency.

Regular readers know that with ultra transparency not only can market participants assess the risk of each bank, but they can adjust their exposure to each bank based on its risk and what the market participant can afford to lose given this risk.

This ends contagion and any excuse for bailing out the banks.

Also, please note that Professor Johnson explicitly says that what we have is a bank solvency led financial crisis as the 'too-big-to-fail banks do actually fail'.

Third, monetary policy cannot function properly when a country’s biggest banks are allowed to become too complex to manage and prone to failure. 

In “The Blob That Ate Monetary Policy,” a Wall Street Journal op-ed published in September 2009, Fisher and Rosenblum pointed out that cutting interest rates doesn’t work when systemically important banks are close to insolvency. The funding costs for banks go up, not down, as a crisis develops....

The funding costs for the banks went up because of opacity.  Specifically, that the banks are 'black boxes' and nobody knows what is hiding on and off their balance sheets.

As the Financial Crisis Inquiry Commission documented, banks with money to lend could not assess the solvency of the banks looking to borrow and therefore they did not lend (aka, the interbank lending market froze).

There is no mystery why the cost of funding went up.  It was the result of opacity.

“Well-capitalized banks can expand credit to the private sector in concert with monetary policy easing,” Rosenblum wrote with his colleagues Jessica J. Renier and Richard Alm in the Dallas Fed’s “Economic Letter” of April 2010. “Undercapitalized banks are in no position to lend money to the private sector, sapping the effectiveness of monetary policy.”

This is a prime example of not understanding that the origination of loans is separate from the funding of loans.  The reason these are separate is that funding for the loan can come from the bank's balance sheet or by distributing the loan through a bank syndicate or by sale of the loan to pension funds, insurance companies, hedge funds or through an asset-backed security.

In our current financial crisis, the reason that lending has slowed dramatically is that the banks were not required to recognize upfront the losses they will ultimately realize on their bad debt exposures.  Instead, the financial regulators adopted forbearance that allowed the banks to engage in 'extend and pretend' techniques that turned bad debt into 'zombie' loans.

The collateral tied up as security for these 'zombie' loans undermines the ability of banks to lend.

Recall that banks are senior secured lenders.  The collateral tied up in the 'zombie' loans artificially increases the value of collateral on new loans (if the collateral were not tied up, the market value of all the collateral would be lower - an example of this is residential and commercial real estate).

The problem for lenders is they know the value of the collateral should be lower, but they just don't know how much lower.  As a result, they are reluctant to make loans.