BIS chief economist calls for "simple, not simplistic" bank regulations

The Wall Street Journal reports that in defending Basel III the BIS chief economist called for "simple, not simplistic" bank regulations.

Regular readers know that bringing transparency to all the opaque corners of the financial system fits this description.

For example, requiring banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details would be a simple, not simplistic bank regulation to promulgate.

Transparency is an eloquent solution, but it is far from simple or simplistic.

In fact, transparency is very complex.  It is much like the math that stands behind the equation E = MC^2.

We know transparency is complex because the regulators whose sole responsibility is to ensure transparency failed to do so with both banks and structured finance securities ranging from covered bonds to securitizations.

From the perspective of market participants, with the advent of 21st century information technology and programs like IBM's Watson, they now have so much processing and analytical capabilities available to them at reasonable costs that they can handle ultra transparency by banks and make sense of the granular level exposure data.

Global bank supervisors and policy makers must press ahead implementing new rules aimed at reining in risk and leverage in the financial system despite concerns about their economic impact, a top official at the Bank for International Settlements said. 

In an interview with The Wall Street Journal, BIS chief economist Stephen Cecchetti said the new regulations, known as Basel III, are necessary to protect banks and keep the global economic recovery on track. 

"It is also really important that there be global agreement on the standards and that the standards be implemented uniformly and in a timely fashion, otherwise you run a risk of a race to the bottom," ...

One of the nice elements of ultra transparency is that it is easy to implement uniformly and it promotes a race to the top.

What country wants its banks to be hiding the risks on and off their balance sheets?

In a speech to the ECB conference, Mr. Cecchetti called for "simple, but not simplistic" bank regulations. Specifically, he said the financial system must be able to withstand the failure of any single institution, derivatives should be cleared through a central counterparty and new financial instruments must be tested before being adopted. Capital regulations "must be risk-sensitive, but simple," he said, and institutions should have leverage ratio constraints "as a backstop."...

How does transparency meet the criteria laid out by Mr. Cecchetti?

Simple.  Check.

The financial system must be able to withstand the failure of any single institution.  Check.

With ultra transparency, market participants can independently assess the risk of each bank.  They can then use this assessment of risk to adjust their exposure to the bank to what the market participant can afford to lose given the risk of the bank.  This ends the risk of financial contagion and makes the financial system robust to the failure of any single or multiple institutions.

Derivatives should be cleared through a central counter-party. Ultra transparency goes one better.  It makes the bank disclose its entire book of derivatives.  As a result, anybody that might become a counter-party can assess the risk of the bank and adjust their exposures accordingly.

New financial instruments must be tested before being adopted.  Check.  If the financial instrument is not transparent, it should not be allowed to be offered.

For example, any structured finance security ranging from covered bonds to securitizations should not be allowed to be offered unless it provides observable event based reporting.  In order to know what they own, investors need current information on the underlying collateral performance.  This can only be delivered if every activity like a payment or default involving the underlying collateral is reported before the beginning of next business day.

Capital should be risk-sensitive and every institution should have a leverage ratio constraints.  Check.

With ultra transparency, market participants can independently assess the risk of each bank.  Based on this assessment they can exert discipline to restrain risk taking by the bank.  This is easily done because the riskier the bank is the more market participants will charge for funds.

Mr. Cecchetti denied that Basel III would undermine the U.S. economy. "A safe and resilient banking system is to everyone's benefit," he said. 

"I have no doubt that any individual banker of head of a financial institution would rather that things be done somewhat differently," he added, "but the job of the authorities is to protect the public interest and the system as a whole."

Actually, the job of the authorities under the FDR Framework is to ensure that there is transparency and that market participants have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess the information and make a fully informed investment decision.

The result of providing transparency is that the banking system is made safe and resilient for everyone's benefit and the financial system's stability is not dependent on regulators being perfect.