Neil Barofsky with Bill Moyer: Normal functioning capital markets require transparency

In the second part of his interview with Bill Moyer, Neil Barofsky lays out how normal functioning capital markets rely on transparency that the Too Big to Fail banks are not required to provide (hat tip Jesse's CAFÉ AMÉRICAIN).

BILL MOYERS: It was puzzling to outsiders like me that you had TARP money being used to concentrate further the size of these banks. 

NEIL BAROFSKY: And the granddaddy of all those transactions, Bank of America acquiring Merrill Lynch. And the important thing to remember here is this is not banks gone wild, banks taking the money and saying, "Party time, we're going to consolidate." They did this with the encouragement of the government. And in Bank of America, a little bit with a gun to the head to complete that transaction. 

This was the government policy created by the architects, Ben Bernanke who is chair of Federal Reserve, Tim Geithner, who was then the president of the New York Fed before becoming Treasury Secretary, and Hank Paulson. Their solution originally was to further concentrate the industry, to make the too big to fail banks bigger. 

The theory was you take a healthier bank and mix it up with a failing bank and you get something somewhere in between, which is better overall for the system. Which may have had some validity in the very, very short term, but has put us on a path, I believe, to being even more dangerous. 

Because you have institutions now that are just monstrous in size, over $2 trillion in assets by certain measures, close to $4 trillion by other measures. Terrifying. The idea that any of these institutions could ever be allowed to fail is pure fantasy, at this point. 

BILL MOYERS: Are you suggesting that we could have another crash? 

NEIL BAROFSKY: I think it's inevitable. I mean, I don't think how you can look at all the incentives that were in place going up to 2008 and see that in many ways they've only gotten worse and come to any other conclusion. 

BILL MOYERS: What do you mean incentives in place? 

NEIL BAROFSKY: So in a normal functioning capitalist utopia, where, you know, most markets are that don't have this too big to fail, this presumption of government bailout if a firm like a Citigroup amasses massive amounts of risk. And in so doing, they keep razor-thin capital to absorb potential losses, which basically means they're just borrowing tons and tons of money. 

And not have a lot of their own money at stake, but it's mostly borrowed money. And it is very opaque. It's not very transparent about how they're running their business. 

You would expect that creditors, people lending them money, counterparties, those on the other sides of their transactions would either stay away or really exact a premium. 

But the presumption of bailout changes that on its head and actually makes it go in the other direction. 

So it removes the incentive of the other market participants to impose what's known as market discipline. Because that's ideally in a capitalist society what happens is that the lenders and creditors and counterparties say, "Hey, we're not going to do business with you unless you clean house, slim down, be more transparent." 

But when there's a presumption of bailout, that disappears. Because all those other market players can feel safe in the presumption that if anything goes bad at Citigroup, Uncle Sam is going to come in and make their bets whole. 

Then you have the very real incentive for the executives at that institution to then pile on risk. Because they know that if the bets go well in the short term, they get paid. And they get paid very richly. But if it blows up and the risks go bad, no worry, the taxpayer's going to be on the other side of that bill. 

That's what happened to Fannie Mae and Freddie Mac, before they collapsed. That's what happened to our biggest banks and global banks before they collapsed. And if you maintain that system, it is foolhardy to think that those incentives and pressures are not once again going to carry the day.

Please re-read the highlight text as Mr. Barofsky lays out the case for why we need to require the banks to provide ultra transparency if we are ever going to end Too Big to Fail.

As he says, with the current absence of transparency, banks are 'black boxes' remember, market participants would normally charge a very large premium for doing business with these banks or they would stay away from them altogether.

However, the policy makers' and financial regulators' willingness to let the banks continue to be black boxes and bail them out changes the behavior of market participants.  Knowing that the government is going to protect them if the banks collapse, market participants are willing to fund the banks at rates that are far below what the banks should pay given their risk.

This insures that we will have another financial crisis.

The only way to end this way of doing business is to require the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, market participants can independently assess the risk of the banks and adjust the amount and price of their exposure to each bank to reflect its risk and the market participant's ability to absorb losses given this level of risk.

This ends financial contagion and any excuse for a government bailing out its banks.