Tuesday, March 12, 2013

Can the Fed pop the next bubble before it is too late?

In a very interesting Fiscal Times column, Mark Thoma tries to answer the question of can the Fed burst the next bubble before it's too late.

Before reflexively saying "no", it is worth pointing out that this question highlights a more fundamental problem with our financial system.

The fundamental problem is that it is currently dependent on the Fed to burst the next bubble before it's too late.

No stable system has a single point of failure.  By definition, a single point of failure will fail.  The only question is when (always at the worst possible time).

Why is the financial system dependent on the Fed?

Because currently only the Fed has access to all the useful, relevant information in an appropriate, timely manner about the global financial institutions, aka the TBTF banks.

Every other market participant is dependent on the Fed to both accurately assess this information and to communicate the results of its assessment.

One of the lessons of the financial crisis is that the Fed and other bank regulators will not accurately communicate the results of their assessment of the risk and solvency of the banks.  The reason for this is institutional.  Specifically, the bank regulators are all concerned with the safety and soundness of the financial system.

As a result, bank regulators will never tell the true condition of a bank experiencing distress as it might trigger issues with the safety and soundness of the financial system.

The problem with our current system is that investors, including other banks, over-invest in the banks based on the assurances by the Fed that the banks are low risk (these assurance come in the form of positive stress test results or comments about how financial innovation has lowered the banks' risk).

This over-investment creates issues like financial contagion; the notion that one bank's failure will trigger other bank failures.

How can the financial system be weaned off of its dependency on the Fed and its ability to burst the next bubble before it is too late?

By requiring the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  With this information, investors can independently assess the risk and solvency of each bank and adjust the amount of their investment in each bank to what they can afford to lose.

Ultra transparency directly addresses and eliminates the over-investment problem.  Investors know that with ultra transparency comes the responsibility for all losses on their investments in the banks.  This gives them an incentive to use the data and limit the size of their exposure to each bank.

Then, even if the Fed does not burst the next bubble before it is too late, the financial system is still stable as each market participant is in a position to absorb the bubble related losses.

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