UK regulator says regulators can only reduce frequency of bank crises and taxpayer bailouts

Bloomberg reports that Lord Turner, the chairman of the UK's Financial Services Authority, told Parliament that regulators are only capable of reducing the frequency of bank crises and taxpayer bailouts.

This is confirmation that relying on financial regulators is simply betting with financial stability and the taxpayers' money.

Fortunately, our modern financial system is designed so that it doesn't have to rely on the financial regulators.  As everyone knows, our financial system is based on the philosophy of disclosure combined with the principle of caveat emptor (buyer beware).

It is this combination that effectively prevented a financial crisis for over 7 decades until the financial regulators let the bankers create vast opaque areas of the financial system.  It was these opaque areas like banks and structured finance securities where the crisis occurred.

The solution to end the reliance on financial regulators for ending banking crises is to strip them of their monopoly on all the useful, relevant information on banks.  This is accomplished by requiring 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 each bank and then adjust both the amount and price of their exposure to each bank based on this risk assessment.

It is this ability to adjust their exposure based on their independent assessment of risk that allows market participants to exert discipline on the banks to restrain risk taking.

This ability to adjust their exposure also permanently ends taxpayer bailouts as it ends the risk of financial contagion.  Each market participant knows that they will not be bailed out and sets their exposure to what they can afford to lose given the risk of each bank.

Lord Turner has confirmed that complex rules/regulations and supervision are an inferior substitute for transparency and market discipline.  Therefore, Parliament should focus its attention on restoring transparency and market discipline.

“The honest truth is that if you believe you have forever completely destroyed the possibility of a taxpayer input, we’re probably fooling ourselves,” Turner said at a hearing of the U.K. Parliament’s Commission on Banking Standards in London late yesterday. 

“But if we are successful, we are reducing the periodicity of a taxpayer input from once every 50 years to once every 200 years.”

Transparency and market discipline have already shown themselves to be more effective.  The transparent areas of the financial system did not experience a financial crisis even as the opaque areas like banks and structured finance blew up.

Turner, seen as a potential candidate to succeed Mervyn King as Governor of the Bank of England, said it has been a “learning process” over the last four years and his thinking has changed as the true extent of the financial crisis emerged. 

He said there is a need for a “belt and braces” approach to regulation and the key issue is ensuring banks have an adequate level of capital to protect themselves. 

“The core of resolvability is primary loss-absorbing capacity and bail-in-able debt,” Turner said. “And provided you have enough of that, then if proprietary trading activities produce losses, we can make sure those do not fall on the taxpayer or on a systemic shock to the industry, but are absorbed by the appropriate bail-in-able senior unsecured debt. That’s very important.”

Actually, the "belt and braces" approach to regulation should be to have the analytical ability of the market support the regulatory process.

This is easily achieved when banks are required to provide ultra transparency.

Then, the regulators can ask market participants, including banking competitors, what they see as the biggest risks at each bank.  This can supplement the regulators' internal analysis of the risk at each bank and be used to bring regulatory pressure along with market discipline to restrain risk taking.

Turner said that there is a need for both “structural proposals” to strengthen banks, such as those put forward by the ICB on the ring-fencing of consumer units, and “robust proposals” on capital and liquidity in the aftermath of the crisis. 

“We have to recognize that it was deeper and more fundamental and with more adverse consequences than was apparent in 2009,” he said. “As this crisis and post-crisis has gone on, like many people I’ve been increasingly aware of what a deep set of problems there are in our banking industry.”

The crisis exposed a deep set of problems in the banking industry that are the result of the lack of disclosure by banks that leaves them resembling "black boxes".

For example, one problem was market participants relying on the regulators to both properly assess the risk of each bank and communicate this risk.

Regulators will never properly communicate how risky a bank is because of concerns with the safety and soundness of the banking system.  They fear that if they say a bank is risky it will trigger a run on the bank.

Turner also said it’s too simple to blame investment banking alone for a decline in the “culture” of banking. 

“The culture of classic commercial banking was probably contaminated by three different things -- one of which was an investment banking culture that everything is there to be traded and make money from in the short term,” he said. Still, there were other issues -- the selling of financial products to the public without “appropriate constraints” and a too-heavy focus on return on equity,’’ he said.

“In many sectors of the economy there is nothing wrong” with a focus on ROE, “but I think applied to banking that is potentially dangerous,” Turner said. “That’s because in banking the easiest way to boost return on equity is simply to boost leverage, either in direct open ways or in a set of hidden ways.”

Actually, the culture was a product of opacity.  Opacity provided a veil to hide misbehavior behind.  Lord Turner acknowledges this fact.