Monday, December 31, 2012

Banking industry's year of shame ends

A Guardian column by Heather Stewart and Jill Treanor highlights all the shameful activities that banks engaged in that came to light during 2012.

Included on the list is manipulating a benchmark interest rate, Libor, money laundering and mis-selling financial products like insurance and interest rate swaps.

By themselves, each of these activities is bad.  Together, these activities highlight the need for a radical cultural change not only at the banks, but at their regulators too.

The last time there was a need for such a radical cultural change was during the Great Depression.  What emerged to change the culture was the FDR Framework and a focus on ensuring that market participants had access to all the useful, relevant information in an appropriate, timely manner so they could independently assess and make a fully informed investment decision.

The reason for this focus is that it brings about a radical cultural change as sunlight is the best disinfectant.

What allowed the bank culture to slide back to where numerous parts of the banks were engaged in shameful activities was the re-emergence of opacity in the financial system.  Opacity re-emerged because regulators both failed to ensure transparency and encouraged its re-emergence.

For example, bank regulators jealously guard their monopoly on all the useful, relevant information in an appropriate, timely manner for each bank.  Regulators have access to each bank's exposures 24/7/365.

This is the data that market participants, including competitor banks, need if they are going to assess the risk and solvency of each bank and properly price their exposures to each bank.

In the 1930's, banks routinely disclosed this data as it was the sign of a bank that could stand on its own two feet.  By the 1980s, banks no longer made this disclosure.

The SEC failed in its responsibility to ensure that bank exposure data was made available to all market participants.  It did so with the blessing of the bank regulators.

By protecting their information monopoly, bank regulators enhanced their importance to a properly functioning financial system.  With the monopoly, bank regulators were relied on for analysis of the risk of each bank, communicating the risk of each bank to other market participants and disciplining the banks.

The financial crisis that began in 2007 revealed the wide path of destruction created by regulator driven opacity.  It is this opacity that let banks engage in manipulating Libor for example.

It is this regulatory driven opacity that also prevents the financial system from recovering.  Without transparency into each bank's current global asset, liability and off-balance sheet exposure details, market participants cannot assess the risk of each bank and whether it is solvent or not.

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