Patrick Honohan makes the case for new model of bank supervision combining ultra transparency and market discipline

In his speech at the second UCC Garrett FitzGerald Spring School, Irish central bank Governor Patrick Honohan talks about an EU banking union, but in doing so makes a very strong case for a new model of bank supervision based on requiring banks to provide ultra transparency and subjecting the banks to market discipline.

The combination of requiring the banks to provide ultra transparency and subjecting them to market discipline achieves all of the benefits and none of the pitfalls Professor Honohan mentions from a banking union.

First, I hope that it will go some distance to removing politics from the enforcement of bank supervision.

Markets are decidedly non-political and unlike the regulators are not susceptible to lobbying by the banks.  The markets are non-political because the investor is concerned with whether they make or lose money on their investments.

Second, I hope that it brings emotional detachment to the process of supervision. 

While markets are driven by fear and greed, monitoring the banks for changes in their risk profile is done in an unemotional manner.

Third, I hope that it manages to lever the diversity of supervisory experience and aptitude across Europe to provide multiple cross-checks on bank soundness, while not limiting into straitjacket bank behaviour. 

Requiring the banks to provide ultra transparency not only levers the diversity of supervisory experience and aptitude of the regulators, but it also levers the diversity of the market.

For example, brought into the supervisory mix is each bank's competitors.  Each competitor understands how to assess the risk a bank takes and will adjust the amount and price of its exposure based on its assessment of the bank's risk profile.

Fourth, I hope it is effective in breaking the link between sovereign and banks, not only to protect the sovereign but to allow banks to operate effectively and have access to European funding markets on a basis that is not subject to a sovereign risk-add on, but depends only on the bank’s own creditworthiness and standing.

Requiring the banks to provide ultra transparency breaks the link between sovereign and bank as it relates to unsecured debt and equity investments.

When every bank is required to disclose on an ongoing basis its current global asset, liability and off-balance sheet exposure details, market participants have the information they need to independently assess the risk of each bank.

With access to the information necessary to assess each bank's risk, market participants become responsible for any losses incurred on their investments in the unsecured debt and equity of the banks.  This responsibility for loss gives the market participants an incentive to use the disclosed information.

The combination of requiring the banks to provide ultra transparency and subjecting them to market discipline has none of the pitfalls that Professor Honohan thinks can occur with the EU banking union.

First, I hope that it doesn’t get bogged-down in overly complex layering of decision-making structures. 

Second, I hope that the huge task of transferring knowledge to the centre and building new communications channels between national supervisors and the central team does not result in process overwhelming product in an interim period with the result that some problems remain undetected, hidden by the dust kicked-up by the creation of the new structure. 

Third, I hope that the decision-making bodies are truly communautaire and not simply an amalgamation of national interests.  

Fourth, I hope that moving decisions to the centre and away from national authorities in what can be a very sensitive area will not result in divisive clashes between broad European and national interests.