Friday, December 21, 2012

Parliamentary Commission worried about future bank lobbying

Reuters reports that the Parliament Commission on Banking Standards has issued its final report which concludes that reform of the banking system needs a shield to protect the reform from future bank lobbying or politicians.

The report recommends providing regulators with the power to break-up investment and commercial banking if the banks or politicians try to create holes in the ring-fence being set up to separate investment and commercial banking.

There are two reasons to believe that this solution for protecting reform will not work.

  • Regulators are concerned with the safety and soundness of the financial system and breaking up the banks could threaten this.
  • As demonstrated by the financial crisis, regulators are captured.
Regular readers know there is a far better solution to protect ring-fencing:  require 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 assess the risk of the banks regardless of where the risk is held.

With this information, market participants can exert discipline and restrain risk taking regardless of how much lobbying the banks do, the degree of regulatory capture or politicians poking holes in complex regulations.

Ultra transparency is the safety net if the rest of the current reform proposals fall short of what is needed.
Britain needs to introduce legislation that could break up banks if standards slip because current reform proposals fall short of what is needed, an influential parliamentary panel said. 
The Parliamentary Commission on Banking Standards also said on Friday the government could set tougher rules for how much leverage banks were allowed, adding that the committee itself would consider whether to propose banning proprietary trading. 
Britain, going further than most countries in pushing through change, is forcing banks to separate, or "ring-fence", their domestic retail arms from riskier investment banking. 
"The proposals, as they stand, fall well short of what is required. Over time, the ring-fence will be tested and challenged by the banks," PCBS chairman Andrew Tyrie said. 
"That is why we recommend electrification. The legislation needs to set out a reserve power for separation; the regulator needs to know he can use it."... 
Osborne appears unlikely to go as far as the PCBS wants. 
A previous Commission, led by John Vickers, said a full break-up of banks was not needed, and Osborne may decide that if the ring-fence plan proved to be flawed, the Treasury could then introduce fresh legislation to strengthen it....
The only way to prevent a repeat is with ultra transparency.

It is only when the market has the information it needs to discipline the banks that effective restraint on risk taking by the banks will come to pass.
The PCBS, asked to assess government plans before their introduction, said legislation should be introduced now because banks had to be discouraged from gaming the new rules for the ring-fence to succeed. 
"All history tells us they will do this unless incentivised not to," Tyrie said, adding politicians could be lobbied to put holes in the ring-fence too. 
"Additional powers are essential to provide adequate incentives for the banks to comply not just with the rules of the ring-fence, but also with their spirit," the Commission said in its 146-page report....

"I would be concerned ... that a future, politically-motivated government or regulator could take draconian action with impunity. It would be putting in place a simple mechanism for banks to be picked on and to be broken up," Investec Securities analyst Ian Gordon said. 
"One could argue that threat is there anyway and could be implemented," he said, adding the PCBS had added to uncertainty about reforms....
The beauty of ultra transparency is that it provides a very strong incentive for the banks to comply with both the both the rules of the ring-fence and their spirit.
In a concession to most banks, the PCBS said banks should be allowed to sell simple derivatives within their ring-fenced operation, which had been a point of contention....
Yet another reason for requiring ultra transparency.  It is important to monitor the risk of the operation inside the ring-fence that the taxpayer is obligated to support in the future.
Tyrie said the market rigging and corruption shown this week at Swiss bank UBS "beggar belief. It is the clearest illustration yet that a great deal more needs to be done to restore standards in banking....
What needs to be done is require ultra transparency.  It is well known that sunlight is the best disinfectant.
It said it was concerned too many reforms will be left to the discretion of the future regulator, and said the power to force bondholders to take losses when a bank hits trouble should be included in primary legislation.
Until such time as banks are required to provide ultra transparency, bondholders will be protected by the taxpayers.

Current disclosure by banks leaves them as "black boxes".  Nobody is going to invest in the bonds of a bank where they cannot assess its risk.

The only reason investors bought bonds before the crisis was the government's saying the banks were low risk.  This statement created a moral hazard which meant that the taxpayer would have to ride to the bondholders' rescue if risk turned out to be greater.

Ending this moral hazard and getting bondholders to take on the risk of loss requires that banks provide ultra transparency.  With this information, investors can assess the risk of the banks and adjust their exposure according to what the investor can afford to lose given the risk.

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