Tuesday, February 5, 2013

Transparency > bank capital/liquidity rules > role split

Reuters reports that the general manager of the Bank for International Settlements, Jamie Caruana, observed that bank capital and liquidity rules are more important for achieving financial stability that separating retail and investment banking.

I agree with this observation and would make one minor addition.

The addition is that transparency is more important than bank capital and liquidity rules for achieving financial stability.  Specifically for banks, this would be ultra transparency under which banks are required to disclose their current global asset, liability and off-balance sheet exposure details.

Lesson 1A from the financial crisis is that the areas of the financial system that are opaque fail.  This is true whether the area has complex rules and regulatory oversight (banking) or not (structured finance).

Lesson 1B from the financial crisis is that the areas of the financial system that have transparency continue to function (stock markets).

Separating banks' riskier trading activity from their retail business would make the banking system more complex and is less important that building bigger capital buffers to prevent future crises, a top central banking official was quoted saying. 
"From my point of view, higher capital and liquidity requirements are more important for stabilising banks than the separation of proprietary trading and deposit-taking business," Jaime Caruana, general manager of the Bank for International Settlements, was quoted saying in Handelsblatt newspaper. 
However, it was up to finance ministers if they want to make changes to the universal banking model, whereby retail and investment banking are under the same roof, he told the paper. 
France and Germany are planning a reform of the banking system that will leave big lenders largely intact, despite a welter of rules aimed at making sure taxpayers are not forced to bail them out in the next crisis....
Please note that the welter of rules is focused on containing the next financial crisis with the hope that taxpayers will not have to bail the banks out.

Your humble blogger has repeatedly made the point that the focus should not be on containment, but should be on prevention.  That is why transparency is more important than bank capital/liquidity rules or separating investment and retail banking.

With ultra transparency, market participants can assess the risk of each bank and exert discipline on each bank so that it has adequate capital and liquidity and a lower risk profile.
The BIS has led efforts by international banking supervisors to force banks to bolster their loss-absorbing capital to help prevent the spread of financial crises.
Without ultra transparency, more capital does not help prevent the spread of financial crises.

What we are talking about is financial contagion.  The idea that if one bank fails it will take other banks with it.

And why would other banks also fail?

Because they have too much exposure to the bank that fails (call this interconnectedness)?

And why would the other banks have too much exposure?

Because opacity makes it impossible for the banks to independently assess the risk and solvency of any other bank and adjust the amount of their exposure to reflect this risk.

Leading up to the financial crisis, bankers listened to assurances from the bank regulators that the other banks were low risk and solvent.  This was shown to be untrue on August 9, 2007 when BNP Paribas announced it could not value structured finance securities.  At that moment, banks discovered they had more exposure to insolvent banks than they could afford to lose.

Ending contagion is simple.  Provide ultra transparency.

Banks will use this information to independently assess each other's risk and reduce their exposures to what they can afford to lose.  In doing so, they will assert market discipline on each other to lower their risk profiles and increase their capital and liquidity.

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