Monday, January 28, 2013

Abandon, don't electrify ring-fence

In his Financial Times op-ed, Andrew Tyrie, the chairman of the Parliament's Commission on Banking Standards, argues for 'electrifying the ring-fence' between investment and retail banking because banks will relentlessly lobby until the ring-fence has been effectively torn down.

I agree with Mr. Tyrie's observation about the behavior of bankers and what the final result of adopting a ring-fence will be.

What your humble blogger disagrees with Mr. Tyrie on is substituting the combination of complex rules and regulatory oversight (which is what an electrified ring-fence would be) for the combination of transparency and market discipline.

If banks were required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, this would go further to eliminating casino banking and the danger it presents to utility banking than a ring-fence would.

With ultra transparency, market participants have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess the risk of each bank and make a fully informed decision.  The result of this independent assessment will be market discipline on the banks to reduce their risk taking.

Ultra transparency also has the added advantage that risk reduction is enforced by the market and not by regulators and policymakers who are subject to being lobbied over time.  So ultra transparency directly addresses Mr. Tyrie's concerns about long-term enforceability of reforms.

The Parliamentary Commission on Banking Standards, which I chair, supports the creation of this ringfence. However, in our report scrutinising the draft legislation, the commission also concluded that without significant changes it may well not achieve its objectives. 
The ringfence must be “electrified” if it is to stand a better chance of success – in other words, if the banks test the ringfence too much, they will get a shock. 
Any reform where there is significant doubt about its long term viability is a reform that shouldn't be pursued.
We therefore recommended a reserve power for full separation, an approach Sir John himself endorsed in evidence to the commission this month. 
The regulators, too, have told the commission they want electrification. And they have come forward with proposals to give it practical effect. 
The banks, on the other hand, do not want electrification. They seem to be the only ones. 
The lobbying campaign against this proposal predictably started the moment our report was published – just as it did when the ICB first suggested introducing a ringfence. 
The strength of the industry’s lobbying, even at this early stage, makes the case eloquently for electrification. Even while chastened by public anger over their role in the financial crisis and subsequent revelations such as Libor rigging , they are lobbying....
Please note that the banks have been lobbying against any proposed reform since the beginning of the financial crisis.

Your humble blogger has documented this lobbying in the area of structured finance reform.  The bottom line is the banks have effectively blocked reform.

Even when the EU passed legislation mandating that banks know what they own and that the issuers provide the data to make this possible, the banks managed to lobby the banking regulators and have these regulators agree that opaque, toxic subprime mortgage backed securities qualify for know what you own.

The other way that banks succeed in their lobbying is by keeping certain reforms off the table.  Banks have successfully blocked bringing transparency to all the opaque corners of the financial system by "supporting" through their lobbying the combination of complex rules and regulatory oversight as a replacement for transparency and market discipline.
All history tells us that banks will be at the ringfence like foxes to a chicken coop unless they are incentivised not to do so. On past evidence, they will test it nonstop and try to persuade politicians to alter it in their favour. 
Electrification is therefore essential to ensure that the banks comply not just with the rules of the ringfence but also with the spirit. 
We must legislate now for more benign economic circumstances, when banks are under less intense scrutiny. At that time, politicians will be particularly susceptible to lobbying and the integrity of the ringfence will be most at risk.
 Our proposals help protect the ringfence from such pressures in the long term. Banks see it as a starting point for negotiations; we view it as a starting point for a more stable and sustainable banking system.... 
Mr. Tyrie is wrestling with the issue of how to enforce any complex regulation in light of what we know about the banks' ability to relentlessly lobby.

This issue goes directly to the heart of why the combination of complex rules and regulatory oversight fail catastrophically and make the financial system far more unstable.  Ultimately the banks will get around the regulation.

This is why your humble blogger has been pounding the table on the issue of requiring the banks to provide ultra transparency.  It is a simple regulation that the market can enforce.
Of course, structural reform is by no means the only way to improve banking standards and the commission will now be largely focusing on the second phase of its work. This will involve examining whether changes in areas such as corporate governance, competition, the regulatory and tax framework, and the civil and criminal law could enhance standards and improve behaviour in the banking industry.
Regular readers know that sunshine is the best disinfectant of bad banker behavior and ultra transparency is the gold standard for sunshine.

Regular readers also know that ultra transparency is the key to restoring trust in the banks.  After all, providing ultra transparency use to be the sign of a bank that could stand on its own two feet because it had nothing to hide.

Your humble blogger hopes that Mr. Tyrie and his commission will consider it.

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