Italian bank derivative scandal shows that transparency and discretion in bank supervision cannot co-exist

As reported by the Wall Street Journal, the lesson from the Monte Paschi derivative scandal is that transparency and discretion in bank supervision cannot co-exist and therefore, discretion must be ended.

This is an incredibly important point.

The choice we have is between a stable financial system based on transparency and market discipline or an unstable financial system based on opacity, complex rules and regulatory oversight.

In the stable financial system, investors are responsible for the losses on their investments and hence they have an incentive to use the information disclosed to independently assess the risk of each bank.  Specifically, investors link the amount of their exposure and the return they require on this exposure to each bank's risk.

This results in market discipline as banks with higher risk have to pay more to attract funds.  This also results in ending financial contagion as investors limit their risk to what they can afford to lose.

In an unstable financial system, investors are not responsible for the losses on their bank investments as they have to rely on bank supervision for the assessment and disclosure of risk at each bank.  Bank supervision that is concerned with the safety and soundness of the banking system and therefore exercises discretion in its disclosures about the riskiness of the banks.

This results in banks not being subject to market discipline as the price they are able to access funds at is substantially less than what it would be if investors had transparency and could assess the risk for themselves.

This also results in financial contagion as investors, including other banks, have far greater exposure to each other than they can afford to lose.

Finally, this results in moral hazard and the need to bailout the investors who relied on the bank supervisors' disclosure of the risk of each bank.

Your humble blogger thinks that a stable financial system is preferable.  Achieving this requires having the banks provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

I recognize that this will end the bank supervisors' information monopoly and will limit their ability to exercise discretion.  This is a feature and not a bug in a stable financial system.

There is no reason that bank supervisors should be able to exercise wide discretion.

As I have previously said, bank supervisors don't approve or disapprove of any exposure that a bank takes on.  Bank supervisors don't do this because they do not see it as their job to allocate capital across the economy.

Bank supervisors attempt to focus on one question:  does the bank have enough book capital to absorb the expected losses on its exposures.  Bank supervisors focus on this question because they are attempting to protect the taxpayers by limiting losses that the taxpayers might have to cover because of the deposit guarantee.

The irony here of course is that if banks are required to provide ultra transparency, the bank supervisors could harness the market's analytical power to assess the banks and market discipline to restrain the banks' risk taking.  Both of these would lower the risk to taxpayers of losses on deposit insurance.

Ultimately, the real issue bank supervisors would like discretion on is when to resolve a bank.

Bank supervisors would like this discretion because a bank can be insolvent (the market value of its assets is less than the book value of its liabilities) at one moment in time and can subsequently earn its way back to solvency (the market value of its assets exceeds the book value of its liabilities).

However, this discretion over when to resolve a bank is not needed in a stable financial system.

Requiring banks to provide ultra transparency is not incompatible with letting a bank continue operating and earn its way back to solvency.  In fact, ultra transparency helps in this situation by eliminating the possibility that bank management will 'gamble on redemption'.  An insolvent bank that takes on more risk would see its cost of funding rise substantially.

In a financial system with deposit guarantees and banks providing ultra transparency, the only banks that need to be resolved are the banks that cannot generate pre-banker bonus earnings.  All the rest of the banks should they be temporarily insolvent have the ability to earn their way back to solvency.

The recent trouble at Banca Monte dei Paschi di Siena ... highlights potential vulnerabilities in plans for a new single European bank supervisor. 

The Tuscan lender, which bills itself as the world's oldest bank, used complex derivatives to tweak its balance sheet that have now triggered massive losses contributing to a €3.9 billion ($5.23 billion) black hole to be filled by taxpayers. Many of these derivative schemes are now the subject of judicial probes.

It wasn't the use of derivatives to tweak its balance sheet that was the problem, but rather that it hid the derivatives so that market participants did not know about them.  As a result, the bank's financial statements did not present a true picture of the bank's condition.

The Bank of Italy admitted its supervisors were aware of the schemes, fueling demands for a wider investigation. 

The Bank of Italy is under pressure because it exercised its discretion and it too did not disclose the existence of these derivatives.

So here is a bank supervisor with concerns about safety and soundness of the banking system supporting the mis-representation of the true level of risk at the bank.

In reality, the BOI's freedom for maneuver was limited. One problem was that the derivative deals did not violate accounting rules. 

While international accounting standards require that a seller of credit default swaps mark their position to market, that's not the case for "structured repos"—an innovative transaction that achieves the same effect—for which historical costs can be used. 

Monte dei Paschi took advantage of this loophole to issue structured repos, thereby spreading out accrued losses over a longer period even though the bank remained fully exposed to fluctuating liquidity risks. 

Thanks to this ruse, the bank posted a profit in 2009, enabling it to pay a dividend—which it had secretly promised to creditors that had subscribed to preferred shares used to bolster the capital base. 

Although the BOI was critical of the structured repos, it was hamstrung because no rule was broken.... 

The fact that the derivatives deals did not violate accounting rules does not mean that the Bank of Italy could have have publicly questioned the quality of Monte Paschi's earnings and mentioned the use of these structured repos in achieving these earnings.

But the way in which [the BOI] has handled the affair has led to allegations of subterfuge that have pulled in Mr. Draghi, now president of the European Central Bank. 

Those charges may be wide of the mark, but the political fuss is a timely reminder that bank supervision is a highly charged activity requiring delicate judgments to balance competing interests. 

One of the benefits of requiring banks to provide ultra transparency is that it eliminates the need for bank supervisors to balance competing interests.

With ultra transparency, bank supervisors can concentrate on protecting the taxpayers.

Mr. Draghi will be fully aware just how much more politically sensitive banking regulation will become when conducted cross-border by the ECB as part of the euro zone's proposed banking union. 

Indeed, the discretion required for bank supervision sits uncomfortably with the transparency the ECB deploys in the conduct of monetary policy where clear communication is essential to the management of expectations. 

By requiring banks to provide ultra transparency, we end bank supervision discretion.  As a result, the ECB can continue to provide clear communication about its conduct of monetary policy.