Friday, December 14, 2012

The Bank of England tries to answer the Queen's question

During the Queen's tour of the Bank of England yesterday, one of the BoE's top financial policy experts tried to answer the question she asked at the beginning of the financial crisis of why if everything was going so well didn't anyone see the financial crisis coming.

According to a Guardian article, the answer was:
that as the global economy boomed in the pre-crisis years, the City had got "complacent" and many thought regulation wasn't necessary....
financial crises were a bit like earthquakes and flu pandemics in being rare and difficult to predict...
According to a Telegraph article, the answer was:
the City had got “complacent” because it thought risk was being managed better than it was, and the financial system had become too interconnected.
Please note that this response comes from an organization that was responsible for 'taking away the punchbowl just as the party starts going' and didn't fulfill this responsibility.

Complacency, a belief in less regulation, a thought that risk was being better managed and an interconnected financial system do not answer the question of why no one saw the financial crisis coming.

Each of these was a factor that contributed to the financial crisis, but was not a reason for the failure to predict the crisis.

Regular readers know that your humble blogger was among the handful of individuals who predicted the financial crisis.  Speaking solely for myself, the analysis behind the prediction was simple.

Since the Great Depression, the global financial system has been based on the FDR Framework and the combination of the philosophy of disclosure and the principle of caveat emptor (buyer beware).

Under the FDR Framework, financial regulators are responsible for transparency.  They have one task to accomplish:  ensure that market participants have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess the risk and make a fully informed investment decision.

For their part, market participants are given one task to accomplish under the FDR Framework:  recognize that they are responsible for all gains and losses on their investment exposures under the principle of caveat emptor.  Since they cannot expect to be bailed out of their losses, market participants have a very strong incentive to use the information being disclosed.

This framework worked well and prevented a financial crisis for over 70 years until our current financial crisis occurred.

The reason the framework failed is that it was undermined by the regulators with the support of academic economists.

During the 1980s, regulators embraced both the efficient market hypothesis and the idea that markets were better at exerting discipline than regulators.  Unfortunately, they lost track of the fact that they were responsible for the one task that makes both the efficient market hypothesis and market discipline work: ensuring transparency.

That regulators failed to ensure transparency can be readily seen as banks are "black boxes" and structured finance securities are "brown paper bags".

To make matters worse, the regulators also injected opacity into the financial system.  This is best exemplified by the Basel bank capital requirements which were designed to hide the leverage that banks were taking on so the banks could offer a 'competitive' return on capital.

While this was going on, academic economists, knowing that the single necessary condition for the invisible hand to operate properly is that buyers know what they are buying, focused on the symptoms of opacity.  We had fabulous work done on lemons, accounting control fraud and information asymmetry.

Unfortunately, we had no work done on the role of opacity in undermining the stability of the financial system and why financial systems that become dominated by opacity are prone to a systemic financial crisis.

As a result, the academic economists were not publishing articles saying that there is a difference between light touch and no touch regulation.  The difference being that under light touch regulation regulators continue to perform their responsibility of ensuring transparency.

Predicting that a systemic financial crisis would occur was simple when one started to look at the size of the opaque corners of the financial system relative to the transparent parts of the financial system.  It was clear that some event would trigger market participants to focus on the simple fact that they could not independently assess the risk or value any of the opaque swaths of the financial system.

When the event occurred, PNB Paribas said it couldn't value subprime mortgage backed securities on August 9, 2007, the opacity in the financial system guaranteed it would be a systemic financial crisis.

In case you doubt my observation that opacity guaranteed a systemic financial crisis, how many times have you heard the Financial Crisis Inquiry Commission's observation that nobody could tell which banks were solvent and which banks were not?  An observation made when the triggering event was not about the banks, but rather was about valuing structured finance securities.
The Queen, who appeared quite animated during the discussion, said: "People got a bit lax … perhaps it is difficult to foresee [a financial crisis]."... 
"Is there another one coming?" the Duke of Edinburgh joked, before warning them: "Don't do it again."
If the Bank of England and other regulators took the Duke of Edinburgh's warning seriously, they would immediately bring transparency to all the opaque areas of the financial system.

Until this is done, the financial system remains highly likely to experience another systemic financial crisis.

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