For banking regulation, simpler is better

The Bloomberg editors became the latest to call for simpler banking regulations observing that complex regulations can overwhelm the regulators.

Regular readers know that the simplest bank regulation with the biggest impact 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.

This simple regulation triggers a number of positive outcomes.

First, it subjects the banks to market discipline as market participants can now independently assess each bank and adjust their exposures accordingly.

In adjusting their exposures, market participants end the risk of financial contagion as they adjust their exposures to what they can afford to lose given the risk.

In adjusting their exposures, market participants restrain risk taking by the banks as higher risk will immediately translate into a higher cost of funds.

Second, it gives the banks an incentive to clean-up their balance sheets.  As a result, banks stop practicing 'extend and pretend' and deal with their bad debt.  This relieves the real economy of the debt service burden on the bad debt and this money can be redirected back to reinvestment and growing the economy.

Third, it brings in sunshine as the best disinfectant to eliminate bad behavior by bankers.

Fourth, it lets the regulators withdraw all those complex rules/regulation and regulatory oversight that were put in place as a substitute for transparency and market discipline.

More than four years after a financial breakdown plunged the world economy into the worst slump since the Great Depression, efforts to build a stronger global system of bank regulation are barely inching forward. Regulators seem overwhelmed by the complexity of their own reforms. 

To make faster progress toward a safer system, governments must aim for greater simplicity....

Nothing is simpler or more powerful than requiring ultra transparency.

As Andrew Haldane of the Bank of England recently explained, the [Dodd-Frank] rule-making could ultimately amount to 30,000 pages. Many of those pages are the result of banks’ efforts to insert exceptions and caveats. 

The worst effect of the growing complexity -- aside from delay -- may be that the rules, once written, won’t work. Rules that differ in myriad ways from country to country widen the scope for regulatory arbitrage. Beyond that, the financial crisis belies the idea that increasingly complex rules are the right way to control an increasingly complex system....

Transparency has been shown to work in the past.

In addition, the requirement for ultra transparency translates easily from country to country.

A balance must be struck, but it’s increasingly clear that regulators have erred too far in the direction of complexity.

Complexity that introduces opacity into the financial system when what is needed is simpler rules that reintroduce transparency into the financial system.