Simon Johnson and the great Basel Betrayal

In his NY Times Economix column, MIT Professor Simon Johnson examined the Basel Committee on Bank Supervision's new bank liquidity requirements.

Needless to say, he was not happy with what he found.

On the other hand, he was quite pleased with the Atlantic article by Frank Portnoy and Jesse Eisinger titled "What's inside America's banks".  [An article that regular readers know was based without attribution on the original content on this blog.]

When "investors think that the banks are hiding trouble in the published balance sheets", Professor Johnson asserts that confidence is not restored by relaxing bank regulation.

When "investors think that that banks are hiding trouble in the published balance sheets", your humble blogger would add that talking about bank capital levels also does not restore confidence as capital is meaningless if the banks are hiding their troubles.

What restores confidence is requiring the banks to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  With this information, market participants can independently assess the solvency and risk of each bank.

Market participants trust and have a high degree of confidence in the results of their own assessment of this information or the results of the assessment of this information by third party experts they hire.  It is this trust and confidence in the results of the assessment that restores trust and confidence.

The only positive role for regulation in restoring trust and confidence is regulation that requires the banks to provide ultra transparency.

This week the Basel Committee on Banking Supervision, as it is known, let us down – once again. Faced with renewed pressure from the international banking lobby, these officials caved in, as they did so many times in the period leading to the crisis of 2007-8. 

As a result, our financial system took a major step toward becoming more dangerous....

Why did this happen? Must Basel always let us down? And is there any alternative?

Yes, there is an alternative.  An alternative that I have brought to Professor Johnson's attention.

The alternative to the combination of complex rules and regulatory oversight, the specialty of the Basel Committee, is the combination of transparency and market discipline.

You will no doubt have noticed that very large banks with a global span have an unusual degree of political influence. 

Please note that one of the reasons complex rules and regulatory oversight fail is they are susceptible to political influence.

One of the reasons that transparency and market discipline works is that the market is not susceptible to influence by the banks.  After all, investors care about getting properly compensated for the risk they take on as they know in the parts of the financial system where there is transparency they will not be bailed out of their losses.

In particular, they have the ability to threaten the economic recovery. Their line is: if you don’t give us what we want, credit will not flow and jobs will not come back.

Policy makers in Washington are often impressed by this line, although less frequently than they used to be. 

Excuse me, but virtually every policy being pursued in Washington reflects the Japanese Model for handling a bank solvency led financial crisis and the fear that if bank book capital levels or banker bonuses are not protected the economic recovery will not occur.

More and more, managers have begun to understand that the people who run large banks have distorted incentives. 

Because they receive downside protection from the public sector – the too-big-to-fail phenomenon – bank executives want to take a great deal of risk. When things go well, they get the upside; when things go badly, that is largely someone else’s problem.

Regular readers know that I hold Professor Johnson in high regard for the work that he has done highlighting this issue of privatizing the gains and socializing the losses.

How does that desire for risk manifest itself? The banks lobby for the ability to fund themselves with more debt and less equity, and they also want to be less safe on other dimensions, including holding fewer liquid assets. 

The Basel Committee this week agreed to water down its liquidity requirements....

A prime example of how the combination of complex rules and regulatory oversight fail as a result of political influence.

If the banks were required to provide ultra transparency, then they would be subject to market discipline as to how much they hold in the way of liquid assets and capital.  Market discipline that would reward banks with a lower cost of funds/higher share price that had more liquidity and capital as these banks would be less risky.

The idea that the Basel process is all about expertise – or smart people working out the right answers – is exploded by Sheila Bair’s book, “Bull by the Horns.” ....

What we saw before 2007 and what we see now is not officials applying some sort of optimization procedure or sensible independent thinking. Rather, this is about an industry that wants to take more risk because that is how it gets larger subsidies. And this industry is expert at playing the regulators off against each other, including across borders. The Europeans are again the patsy.

Unfortunately, some United States officials are so captured or captivated by the ideology of modern banking that they want to play along....

This argument by Professor Johnson makes adopting the combination of transparency and market discipline compelling as it does not have fatal flaws including those that exist in the combination of complex rules and regulatory oversight.

We need a financial sector that works for the real economy – not a continuation of the dangerous, nontransparent government subsidy schemes that have brought the Europeans to their knees.

Professor Johnson nicely summarizes your humble bloggers argument for why banks must be required to provide ultra transparency.