Tuesday, October 23, 2012

Time to rethink regulatory reform and replace it with ultra transparency

The American Banker ran an interesting article on all the complex rules that are being implemented as a result of the Dodd-Frank Act and Basel III and asking if there is a better solution.

Regular readers know that all these complex rules and increases in regulatory oversight are a substitute for the simple solution of transparency and market discipline.

As I have said numerous times, with the exception of the Consumer Financial Protection Bureau and the Volcker Rule, Dodd-Frank should be repealed.

It should be replaced with an Act that brings transparency to all the opaque corners of the financial system.  At a minimum, this Act should
  • Require that banks provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  This is the data market participants need to independently assess the risk of the banks and exert discipline to restrain risk taking.
  • Require that structured finance securities provide observable event based reporting on all activities like a payment or default involving the underlying collateral before the beginning of the next business day.  This is the data that investors need to know what they own.
Utilizing 21st century information technology, all of this disclosure can be centralized in the 'Mother of All Financial Databases' and made available to all market participants.

Market participants have an incentive to use this data because there is money to be made from using it.
  • For example, banks with deposits to lend can use this data to assess the risk of banks looking to borrow.  With this assessment, the interbank lending market can reopen.
  • For example, market participants can calculate Libor because they have access to all of the interbank transactions.
Regular readers know that unlike complex rules and regulatory oversight, transparency and market discipline have pass the test of time.
How ripe is the moment? Even lawmakers who voted for the 2010 reform law are open to improving it. 
"Congress never gets it right, when you're looking at massive reform legislation, the first time through," Sen. Mark Warner, D-Va., told The Hill newspaper last week. "You directionally head in an area and then you come back, two years, three years hence to do a corrections legislation."...
Ammunition for anyone seeking change arrived Monday from Karen Shaw Petrou of Federal Financial Analytics.... 
Her stark conclusion: even if regulators did everything called for in Dodd-Frank, and did it perfectly, financial services supervision would still be a mess. Throw Basel III in the mix and it just gets worse. 
The end-result of numerous agencies pumping out massive rules to meet statutory deadlines will be a tangle of contradictory mandates that will be tough to enforce and impossible to comply with....
Please re-read the highlighted text as Ms. Petrou makes the case for restarting financial reform with a simple focus on bringing transparency to all the opaque corners of the financial system.

As I have documented on this blog, simply bringing transparency back to the opaque corners of the financial system will go a long way towards fixing all of the problems that financial reform is suppose to address.

Transparency has one more advantage over loophole ridden complicated regulations that the industry will render irrelevant.  Transparency has been shown to prevent a financial crisis in the first place.  


Per Kurowski said...

By allowing banks to hold much less capital when lending to “The Infallible” than when lending to “The Risky”, the regulators allow banks to earn immensely higher risk-adjusted returns on their equity when lending to “The Infallible” than when lending to “The Risky”.

That is dangerous because it makes “The Infallible” so much riskier for banks than they normally are… and excessive exposures to these has always been the origin of major bank crises.

That distorts the economic efficient resource allocation banks are supposed to do, by disfavoring more than normal the lending to “The Risky”, the group that includes small businesses and entrepreneurs.

And, that regulatory discrimination is also, simply put, odiously immoral.

Per Kurowski
A former Executive Director at the World Bank (2002-2004)


Richard Field said...

As I have said previously, the Basel bank capital regulations are there to 'hide' the amount of leverage the banks are using to generate their Return on Equity.

My preference for ultra transparency is that it shows just how much risk the banks are taking.

As for lending to small businesses and entrepreneurs, this has unfortunately been a casualty of a) regulators requiring banks to hold 'higher' book capital levels since the start of the crisis and b) the freezing of the structured finance market.

Lending to these would return if transparency in the form of observable event based reporting was brought to structured finance and restarted this market.