Saturday, January 12, 2013

Virtue, Vice and Banks

In his Bloomberg editorial, the next Archbishop of Canterbury, Justin Welby, examines the need for recreating the banking system with structures that lean towards virtue rather than vice.

Regular readers know that the foundation for this structure is transparency as sunlight is the best disinfectant for vice and its related bad behaviors.

For banks, transparency takes the form of requiring disclosure on an ongoing basis of their current global asset, liability and off-balance sheet exposure details.

This degree of disclosure is necessary so bankers cannot engage in bad behavior behind a veil of opacity.

Under pressure, everyone is prone to make bad decisions and that story remains in my mind as I sit on the U.K.’s Parliamentary Commission on Banking Standards, listening to people talk about banks, bankers and their failures. 
It is blindingly obvious that the banking system we had a few years ago has more or less collapsed. ... Yet it is clear that responsibility needs to be taken and structures created that lean toward virtue rather than vice.

Our commission was set up in July to review the culture and standards of banking in the U.K. Its creation was a government response to the numerous scandals that had erupted, whether around the London interbank offered rate, money laundering or simply the continuing high remuneration of many people in the banking sector.
Please note that ultra transparency fully addresses the issue with Libor and eliminates the possibility of future manipulation.

First, with ultra transparency, banks with deposits to lend can assess the risk and solvency of banks looking to borrow.  This unfreezes and keeps unfrozen the interbank lending market.

Second, Libor and similar benchmark interest rates can be calculated using some or all of the actual transactions in the interbank lending market.  This eliminates manipulation.
The development of the financial-services industry needs to be thought through as part of a significant restructuring of the values within that sector of the economy. The false assumptions that led us into our current predicament must be rejected.
This rejection of false assumptions was also done at the time of the Great Depression as a result of the Pecora Commission.

The result was the creation of the FDR Framework as the basis of the global financial system.  The FDR Framework combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).
Let’s start with some of these false assumptions. 
First, it is clear that rational market theory and its relatives have been undermined by the events of the past five years. Adam Smith’s general cynicism about the tendency of any group of business people, when meeting together, to create a cartel and ensure maximum profitability, has been shown to be justified, both in its own terms and as a general reflection (which he understood well) of the susceptibility of human-made systems to human failings.
Please re-read the highlighted text as Bishop Welby has nicely summarized your humble blogger's point about why the FDR Framework is based on the philosophy of disclosure.

If the buyer does not have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess this information, they cannot make a fully informed decision.  If they cannot make a fully informed decision, buyers are likely to be taken advantage of.

The FDR Framework recognizes that bankers engage in bad behavior when their actions are shrouded by a veil of opacity.  As a result, the FDR Framework sets out to be sure there are no opaque corners in the financial system.

The last five years have shown that rational expectations and its relatives are based on the simple fact that transparency is the necessary condition for the invisible hand and the financial markets to operate properly.

The last five years have shown that the global financial system collapsed everywhere there was opacity.
A second myth to fall has been the idea that financial services could, by themselves, carry the economy
A remarkable 2009 article by Martin Wolf in the Financial Times pointed out that the U.K. had been behaving like a “monocrop” economy. By that he meant that it was heavily dependent upon one sector alone: When the financial-services industry went well, all went well, and when it went badly, everything went badly. The ups and downs would be more severe. 
I believe the jury is now out as to whether, since the reopening of the Eurobond markets by S.G. Warburg & Co. in the early 1960s, financial services have been a net benefit to the U.K. economy as a whole.  
I suggest that much the same might be said about the U.S. market. 
Banking and financial services have created a significant number of jobs, but the amount of money spent in rescuing them since 2008 eliminated a vast proportion of -- if not more than -- the gains in employment and tax revenue that the sector generated over the previous decades....
The Bank of England's Andrew Haldane suggests that the cost of the financial crisis is multiples of the tax revenue generated by the financial sector over the previous decades.
The third major area of inquiry lies in the failure of financial services to enable society to flourish -- what in Catholic social teaching is known as the “common good.” Much of the financial-services industry became essentially self- regarding, and one result was that small and medium-size businesses as well as poor areas were neglected, often unable to obtain credit....
Your humble blogger has argued that it is time for the banks to do something for the "common good".  They need to step up and recognize all the losses on the excess debt in the financial system.

The result of recognizing these losses will be to remove from the real economy the burden of servicing this excess debt by diverting capital that is needed for reinvestment and growth.

The result of recognizing these losses will be to remove the burden from the sovereigns to socialize these losses and divert tax revenue that is needed for social programs and fiscal stimulus.
So what are the answers?
Restore transparency to all the opaque corners of the financial system.

Everything else that is being proposed is simply substituting the combination of complex rules and regulatory oversight for the combination of transparency and market discipline.

The financial crisis has shown that the combination of complex rules and regulatory oversight fails.
Second, I am deeply suspicious of the intensely complex regulatory structures that are emerging out of the crisis. They are well-intentioned, but impossible to operate. 
My own experience of heading a large organization in risky areas (in my case, a hospital) showed me that the more complex one makes the regulation, the less likely it is to be adhered to. 
The head of a major bank whom I interviewed recently told me they had 3,500 compliance staff and 900 lawyers. Good luck with that! 
One of the leading virtues of ultra transparency is that it is simple.  At the same time, it is extraordinarily effective and powerful.
The reason I started out with the story of my own rescue from an ethical slip is that to me it demonstrates that it isn’t regulations, but virtue and leadership embedded within corporate cultures, that stops people from stumbling when under pressure. 
As I said earlier, the sunlight of ultra transparency is the best disinfectant.
There are no simple answers to the current crisis in banking, but there are simple principles. They come down to saying that financial services must serve society, and not rule it. They must be integrated into the economy, not semidetached. They must recognize human fallibility, not assume the effectiveness of human imagination.
Bishop Welby is right that there are no simple answers.  

Transparency is actually incredibly complex.  It was not until your humble blogger defined ultra transparency that there existed a definition for banks of all the useful, relevant information in an appropriate, timely manner that market participants needed to be able to independently assess and make a fully informed investment decision.

Without ultra transparency, banks are in the words of the Bank of England's Andrew Haldane 'black boxes.'

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