Don't trust politicians to supervise banks

In his Financial Times post, Lorenzo Bini Smaghi makes the case for requiring banks to provide ultra transparency by arguing for combining monetary policy and bank supervision in one independent organization.

Mr. Smaghi ignores the fact that the Fed combined monetary policy and bank supervision in one independent organization and it failed in the lead up to the financial crisis (the US was ground zero for bank insolvency) and it is still failing in the aftermath of the financial crisis.

One of the fatal flaws in combining monetary policy and bank supervision in one organization is if it allows a bank solvency crisis to occur, it uses monetary policy to try to hide the fact.

Since the beginning of the financial crisis, your humble blogger has written from personal experience from having worked at the Fed a number of posts explaining why the conduct of monetary policy is mutually incompatible with the conduct of bank supervision.

These posts can be summarized as follows:  in the same way that there are macro-economists who focus on the big picture and there are micro-economists who focus on the detail, monetary policy is all about focus on the big picture while bank supervision is all about focus on the detail.

Fed chairman Ben Bernanke confirmed this when he said how much he hated listening to the bank supervisors presentations.  He knows they are important, however, he found them painfully dull to listen to.

The simple reason why anyone thinks that monetary policy and bank supervision need to be linked is that central banks are the lenders of last resort.  In theory, they are suppose to lend at high interest rates to solvent banks.

This requires that the central banks are able to assess the solvency of the banks.

Before the development of 21st century information technology, it was the bank supervisors who had access to all the data needed to assess bank solvency.  Hence, there was a reason to combine monetary policy and bank supervision in one organization.

However, this reason no longer exists as we live in the information age.

If banks are required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure detail, a central bank that only exercises monetary policy could access this data for purposes of performing its lender of last resort function.

When the Bank of England was made independent in 1997 it had to surrender its power to supervise the banking system. 

Parliament used two main arguments to justify this. The first was that there is a conflict of interest between monetary policy and the conduct of banking supervision. The second was that banking supervision cannot be as independent as monetary policy, and therefore needs to be much more accountable to the political authorities. 

Both arguments proved wrong, not only in theory but also in practice. And not only in England. 

Rather than a conflict of interest between monetary policy and bank supervision, the opposite has turned out to be true in recent years. 

The lack of information on the solvency of the banking system made it much more difficult for central banks, such as the BoE, to interpret market developments and to provide liquidity to sound institutions only. 

National supervisors had the tendency to paint a rosy picture of their financial system, which enabled banks to easily qualify as counterparties for central bank operations.

Based on Mr. Smaghi's observations, the solution is not to merge monetary policy and bank supervision in one organization, but rather to require ultra transparency.

With ultra transparency, the central banks can access the data they need so they only provide liquidity to sound institutions.

With ultra transparency, there is market discipline on the national supervisors so that they don't paint a rosy picture of their financial system.

It is also unlikely that independent central banks that are accountable for their monetary policy objective, in terms of price stability, would seek to use monetary instruments for other reasons. Trying to address banks’ solvency problems by extending central bank liquidity support is not very effective over time.... 

Japan has been trying to address bank solvency problems by extending central bank liquidity support for 2+ decades.  This same policy has been adopted by the Bank of England, the European Central Bank and the Federal Reserve.

The conflict of interest argument might have been an issue in the old days of politically dependent and non-transparent central banks. It is less relevant today. The opposite may actually be true. 

Without bank supervision powers the central bank may nevertheless be induced to use monetary policy to resolve problems created by ineffective bank supervision out of fear that those problems might impact on financial stability and, as a consequence, on price stability.....

The BoE, the BoJ, the ECB and the Fed are using monetary policy to resolve problems created by ineffective bank supervision out of fear that those problems might impact on financial stability and on price stability.

The only difference between these central banks is that the Fed was the party responsible for ineffective bank supervision.

Bank supervisory authorities that are not sufficiently independent, and are too closely associated with the political authorities, are generally under pressure to delay the identification of insolvent banks, for the fear that taxpayers would get upset. The problem thus tends to be postponed, and the cost to the taxpayer rises. 

The experience of the recent crisis has shown that taxpayers have paid most in countries where supervision was less independent and where the political authorities are most closely associated with the banking system....

By definition, regulators are under pressure from political authorities to not recognize anything bad happening in the financial system.

The Nyberg Report on the Irish Financial Crisis described this pressure and how it is hard to say to a politician who is dependent on increasing tax revenues that action needs to be taken when nothing appears to be wrong.

The way to circumvent political pressure is by requiring ultra transparency.  With ultra transparency, market participants can assess the risks for themselves and adjust their exposures to levels that they can afford to lose given this independent assessment of risk.

The crisis has shown that the system is indeed broken. 

Had there been a single supervisor from the very start of the euro, independent like the ECB, the truth about some of the most problematic banks would probably have come out earlier. The excess leveraging accumulated in some countries would not have been tolerated for so long. The stress tests conducted since the start of the crisis would have been applied seriously, in a homogeneous way across countries. The cleaning up of banks’ balance sheet would have started earlier.

The truth about the problematic banks would come out if banks are required to provide ultra transparency.  In addition, with ultra transparency, market participants could conduct their own stress tests.  Finally, with ultra transparency, there would be significant pressure on the banks to clean up their balance sheets and recognize their losses.

None of this requires that there is a single european bank regulator.

A single supervisor would probably have confronted several governments at an early stage of the crisis with clear-cut decisions aimed at ensuring an adequate capitalisation of their banking systems, as happened in the US. Maybe that’s what some actually did not want. But that’s what the eurozone needs in order to solve the crisis and avoid new ones in the future.

The US government has never confronted its insolvent too big to fail banks.

It is only the market itself that is both big enough and willing to confront these banks.  It is the market that can exert discipline so that banks recognize their losses and retain an adequate level of bank book capital to handle future problems.

However, in the absence of ultra transparency, the market cannot do this.

Instead, everyone is reliant on politicians to supervise banks through the combination of complex rules/regulations and regulatory oversight that the current financial crisis has shown did not work in the past and is unlikely to ever work in the future.