Anat Admati: "The Bankers' New Clothes", right fairy tale, wrong conclusion

In an American Banker column, Professor Anat Admati makes a very important observation about the gutting of financial regulation.  It tends to be good for bankers and bad for society.

The column is an excerpt from a book she co-authored with Martin Hellwig, "The Bankers' New Clothes: What's Wrong With Banking and What to Do About It."

Regular readers know that your humble blogger differs with Professor Admati on both the diagnosis of what is wrong with banking and what to do about it.

I see the problem with banking being opacity.

Opacity that let's bankers engage in bad behavior knowing that they are Too Big to Jail.

Opacity that makes the financial system unstable because market participants are dependent on financial regulators both correctly assessing and communicating the risk of each bank (something the regulators cannot do because of concerns about the safety and soundness of the financial system).

Opacity that prevents the market from exerting discipline on the banks and restraining their risk taking.

Opacity that creates moral hazards like bailouts because investors relied on the Fed's stress tests when making an investment decision.

Opacity that makes the banks such "black boxes" that banks with deposits to lend cannot assess the risk and solvency of the banks looking to borrow.

Opacity that has been made even worse by the response of policymakers and financial regulators.  They have decide we need more of what failed to prevent the financial crisis in the first place.  Namely, the combination complex rules and regulatory oversight.

Professor Admati has championed the notion that banks were holding too little capital going into the financial crisis and by simply upping capital standards all will be well.

This is knowably untrue.

The OECD has written extensively how due to the suspension of mark-to-market accounting and creation of 'zombie' loans under regulatory forbearance bank financial reporting and bank book capital is meaningless.

Opacity hides the true condition of the banks.  Who knows just how distorted each bank's financial statement is from reflecting its true financial condition?  After all, Dexia reported very high capital levels shortly before it needed to be nationalized.

Until there is ultra transparency and banks have to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, bank financial reporting and book capital will remain meaningless.

Ultra transparency is the necessary condition for Professor Admati's capital standards to be relevant.

Do we have to resign ourselves to having a fragile and dangerous banking system, one that harms the economy and requires government support when the risks turn out badly?

No.

As we have seen, there is not much prospect of dealing with failures of large and interconnected banks, particularly those that are active internationally, without imposing large costs on the economy.

Actually, there is a simple solution for dealing with these banks without imposing large costs on the economy.  Require the banks to provide ultra transparency.

Like all market participants, banks know that when they have access to all the useful, relevant information in an appropriate, timely manner they become responsible for all losses on their exposures.

In practical terms what this means is that the banks will independently assess each of the other banks that they have dealings with and they will adjust their exposure to what they can afford to lose should the other bank fail.

With ultra transparency, the cost of failure of a bank is absorbed by investors (including other banks) and not the real economy or society.

Ultra transparency is very important as it also ends the mechanism of financial contagion.  Each bank manages its exposures so that it can survive the failure of the other banks.

The economy is also harmed when many banks are distressed at the same time and do not make sufficient loans because of their overhanging debts.

There is a common misconception that a distressed bank stops making loans.  This is untrue.  I must be too old, but I distinctly remember that in the US Savings & Loan crisis, the management of these institutions gambled on redemption by making large real estate development loans.

As a practical matter, bank lending and the funding of these loans has been separate for at least 40 years.  The reason that they are separate is that holding a loan on a bank balance sheet is not the only option for the bank.  It can sell the loan to a bank syndicate, a hedge fund, an insurance company or a pension fund for example.

It is therefore important to focus on preventing banks and other financial institutions from running into distress or insolvency....

Please re-read the highlight text as Professor Admati has nicely summarized a point that your humble blogger has been making since the beginning of the financial crisis.  We need to take actions that prevent a financial institution from running into distress or insolvency in the first place.

This is why banks must be required to provide ultra transparency.

Investors know that with access to the information they need to independently assess the risk of each bank comes the responsibility for absorbing the losses on their investment exposures.  As a result, investors have an incentive to exert discipline on management so that management does not let the bank become distressed or insolvent.

For this purpose, we need better regulation and supervision.

True, but better regulation does not necessarily mean more regulation and better supervision does not necessarily mean more regulatory oversight.

If the banks' own incentives with respect to the risks they take and the extent of their reliance on borrowing were aligned with those of society, banking regulation would be less important. 

As it turns out, however, the incentives of banks with respect to the risks they take and to their borrowing are perversely conflicted with those of society.

This is only true because of the opacity of the banks.

If banks were required to provide ultra transparency, there would be much more alignment with the incentives of society.  This alignment would occur because investors would no longer be in a position where gains are privatized and losses are socialized.

With ultra transparency, investors know they will get hit for losses should a bank fail.  As a result, investors have an incentive to restrain the risk taking of the banks.  Restraining the risk taking results in banks focusing on supplying the credit the real economy needs and not on taking proprietary bets.

In the last few years, many proposals have been made to address the risks that the banking system imposes on society. Very few, however, have been implemented. 

Most proposals have been rejected, diluted, or delayed, some of them endlessly it appears, because the banks have convinced policymakers, regulators, and sometimes the courts that the regulations might be too expensive.... 

Please re-read the highlight text again as Professor Admati makes a very important point.

Regular readers might recall that before the financial crisis the SEC ran a cost/benefit analysis on bringing observable event based reporting to structured finance securities and concluded that the cost of transparency could not be justified.

Today, a cost/benefit analysis easily justifies bringing observable event based reporting to structured finance securities and ensuring that they are transparent.

Better Markets would argue that our financial system is based on the philosophy of disclosure and therefore transparency should never be subjected to a cost/benefit analysis.

From the bankers' perspective, any regulation that constrains their activities or might reduce their profits is expensive. 

What is expensive for the banks, however, need not be expensive for the economy. 

The costs to the banks are important, but other costs must be considered as well, particularly the costs to everyone else resulting from financial crises or bank bailouts....

When bankers complain that banking regulation is expensive, they typically do not take into account the costs of their harming the rest of the financial system and the overall economy with the risks that they take. 

Public policy, however, must consider all the costs and not simply those to the bankers. 

The point of public intervention is precisely to induce banks, or dye producers, to take account of costs they impose on others. 

For society, such intervention can be very beneficial. 

Appropriate banking regulation is available that would reduce the potential for harm to the financial system without imposing any costs on banks other than the loss of subsidies from taxpayers....

Actually, ultra transparency would cost the banks much more than the loss of their subsidies from taxpayers.

It would end their ability to profit from engaging in illegal activities like manipulating benchmark interest rates like Libor.

It would significantly reduce the profitability of their proprietary trading as market participants could trade against them to minimize their gains while maximizing their downside.

It would reduce their ability to profit from the mismatch between what regulators lead investors to think is the risk profile of the bank and what is actually the true risk profile of the bank.

It would reduce their ability to profit from engaging in regulatory or tax arbitrage.

The fact that this is beneficial and not costly for society is all too often obscured by flawed and misleading claims, what we refer to as the bankers' new clothes.

The bankers' new clothes are simply opacity.

Like the fairy tale Emperor, banks should not be hiding anything.