Banks still too clever for regulators

In her Guardian column, Jill Treanor looks at how banks manipulate their risk weighted asset calculations and concludes that banks can game the Basel III rules and fool the bank regulators about how risky they really are.

She sees the regulators being misled about the true risk of the banks as a big problem.

Our current financial crisis showed just how big a problem regulators underestimating the risk of banks is.  Based on representations by regulators that financial innovations had made the banks less risky, investors, including other banks, invested too much capital at too low a rate in the banks.

Regular readers know that the only way to end bankers gaming the system and avoiding future misallocation of capital to the banking system is if the banks provide ultra transparency.

With access to each bank's current global asset, liability and off-balance sheet exposure details, market participants can assess the risk and solvency of each bank.  Based on this assessment, market participants can adjust both the amount and price of their exposure.

After the banking crisis it became clear that banks had been too smart for their regulators and it seems this is still the case, if the findings of a survey by Europe's top banking regulator is anything to go by.

Without ultra transparency, there is no reason to believe there will ever be a time when banks are not too smart for their regulators.

Simply put, bankers are better paid than regulators and they have a financial incentive to find or use their lobbying to create the loopholes in any regulation.

The only way for regulators to catch up to the banks is if the regulators harness the analytical and discipline ability of the markets.

This is easily done by requiring the banks to provide ultra transparency.  

With ultra transparency, the regulators can then tap the banks themselves for help in analyzing and exerting discipline on their competitors.  The banks have an incentive to do this because they have to manage their own risk including the risk of their exposures to the other banks.

The European Banking Authority has found discrepancies in the ways banks measure the riskiness of their assets. This could reduce the amount of capital they need to hold.

No surprise with this finding.

One of the advantages of ultra transparency is that it creates a "market" price for bank assets.

The EBA, which oversees regulation of banks across the European Union, concluded there were "material differences" in the way risks are measured across 89 banks in 16 countries. 

Andrea Enria, chairman of the EBA, said some of the differences could be accounted for by more explanation about the methodology being used. "But this is not enough. The remaining dispersion is significant and calls for further investigations and possibly policy solutions," he added. 

Quite. The Financial Services Authority is already on the case: in November the Bank of England's financial policy committee told banks to make a more "honest" assessment of potential losses they face and to report to the regulator by March....

If banks were required to provide ultra transparency they would have an incentive to be as conservative as possible in valuing their assets.  Banks that aren't conservative in valuation would be signaled out as being riskier and would have to pay more for funds.

Unless regulators can be confident about the riskiness of the assets banks hold they cannot have any confidence that banks have enough capital.

It is not enough that the regulators have confidence about the riskiness of the assets banks hold.  Since the beginning of the financial crisis which the bank regulators missed and the subsequent nationalization of banks that passed the regulators' stress tests, market participants no longer trust the regulators' representation about the riskiness of the banks.

Ultra transparency is needed so that market participants can have confidence about the riskiness of the assets banks hold.