Friday, March 1, 2013

Senator Sherrod Brown explains why banks must provide ultra transparency

In a must read speech on Too Big to Fail banks, US Senator Sherrod Brown explains why banks must provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Regular readers know that ultra transparency is the key to dealing with the TBTF banks.
History has taught us that we never see the next threat coming until it is too late.
Actually, some of us saw this threat coming and tried to a) warn policymakers about the threat and b) have transparency restored to all the opaque corners of the financial system so as to moderate the impact on the real economy when the financial crisis occurred.
That’ we passed the Dodd-Frank Act, which contains tools that regulators can use to rein in megabanks’ risk-taking.
The Dodd-Frank Act is based on the flaw notion that the combination of complex rules and regulatory oversight is superior to the combination of transparency and market discipline.

As the financial crisis showed, every area of the financial system that froze relied on the combination of complex rules and regulatory oversight (banks and the unsecured interbank lending market; structured finance).

The areas of the financial system that continued to function throughout the financial crisis without government intervention relied on the combination of transparency and market discipline (stock markets, non-financial corporate bond markets).

The Dodd-Frank Act embodies the policy of financial failure containment and its corollary, the Geithner Doctrine (nothing shall be done that hurts the profitability or reputation of big or politically connected banks).  This policy has been shown not to work and lead to the creation of the Too Big to Fail banks.

The alternative policy is financial failure prevention.  It is the policy on which our financial system is based and is embodied in the FDR Framework.  The FDR Framework combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).

Financial failure prevention works because investors are responsible for losses on their investments and thus have an incentive to monitor their investments and exert discipline on management so that losses are avoided.
Unfortunately, many of those rules have stalled, and most will not take effect for years. 
Dodd-Frank was written by the big bank lobbyists for the benefit of the big banks.  By having multiple complex rules, the big banks guaranteed they could both delay the impact of any regulation and water down this impact through lobbying.
Dodd-Frank focuses on improving regulators’ ability to monitor risk and enhancing the actions that regulators can take if they believe that risk has grown too great. 
In the last five years alone we have seen faulty mortgage-related securities; foreclosure fraud; big losses from risky trading; money laundering; and Libor rate rigging. 
One of the myths behind Dodd-Frank is that the regulators did not have the ability to monitor what the banks were doing.

This is untrue.

Bank regulators have access to everything a bank does 24/7/365.  This access was granted in the 1930s when the US government started guaranteeing deposits.

As a practical matter, prior to the beginning of deposit insurance, all banks provided ultra transparency and therefore all market participants had the ability to monitor what the banks were doing. Disclosing their exposure details was a sign of a bank that could stand on its own two feet.

A second myth behind Dodd-Frank is that regulators will actually stop the banks from engaging in activities like foreclosure fraud, proprietary trading, money laundering, Libor rate rigging or selling fraudulent securities.

History shows that regulators will not do this.

History also shows that the only way to get banks to stop engaging in these types of activities is by requiring transparency.

Even in the halls of Congress, it is well known that sunshine is the best disinfectant.
Until Dodd-Frank’s rules take effect, the rest of us are standing idly by as megabanks take more risks that will eventually lead to near failure.
Even when the Dodd-Frank rules do take effect, the TBTF banks will continue to take excessive amounts of risk.


Because Dodd-Frank protects the opacity of the banks.

Only the regulators can see how risky the banks are and the regulators are not going to disclose the true level of risk to market participants out of fear about the strength and stability of the financial system.

Dodd-Frank is a boon to the TBTF banks as it prevents these or any other banks from being subject to market discipline.  With ultra transparency, the TBTF banks would see the cost of their funding linked to the risk the banks were taking (more risk would be met with a higher cost of funding).

With Dodd-Frank in place, this linkage doesn't happen and as a result, the TBTF's risk taking is subsidized as investors do not require a high enough return to compensate them for the risk being taken by the TBTF.
We shouldn’t tolerate business as usual, monitoring risk until we are once again near the brink of disaster; we should learn from our recent history and correct our mistakes by dealing with the problem head-on....   
How many more scandals will it take before we acknowledge that we can’t rely on regulators to prevent subprime lending, dangerous derivatives, risky proprietary trading, and even fraud and manipulation? 
Wall Street has been allowed to run wild for years. We simply cannot wait any longer for regulators to act. 
These institutions are too big to manage, they are too big to regulate, and they are surely still too big to fail. 
We cannot rely on the financial market to fix itself because the rules of competitive markets and creative destruction do not apply to the Wall Street megabanks.
Please re-read the highlighted text as Senator Brown has nicely summarized why we must bring ultra transparency to the TBTF banks.

It is only with ultra transparency that we can stop Wall Street from being allowed to run wild.  This solution was adopted in the 1930s after the last time Wall Street ran wild.

We know transparency works.

We know that it is opacity that causes instability in the financial system.

Your humble blogger has written numerous posts explaining why ultra transparency ends proprietary trading, ends manipulation of benchmark interest rates like Libor, and ends a reliance on financial regulators to act.

Your humble blogger has written numerous posts explaining why ultra transparency subjects the banks to the one institution that is bigger than they are:  the global financial market.  The global financial market is the only institution capable of exerting discipline on the TBTF banks.

Your humble blogger has written numerous posts explaining why the financial regulators' information monopoly prevents the TBTF from being subjected to the rules of competitive destruction and competition.

If market participants do not have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess this information and make a fully informed investment decision, you cannot expect the banks to be subject to market discipline and the rules of competition.
Megabanks’ shareholders and creditors have no incentive to end “too big to fail” – they get paid out when banks are bailed out.
These shareholders and creditors would have an incentive to end "too big to fail" if the TBTF banks provided ultra transparency.  With ultra transparency, investors would have access to the information they need to make a fully informed investment decision.

With access to all the useful, relevant information in an appropriate, timely manner comes the responsibility for absorbing losses on an investment in the TBTF banks.

Right now, investors are not responsible for absorbing losses on their investment in the TBTF banks as they don't have access to all the useful, relevant information in an appropriate, timely manner.

In addition, investors are protected because financial regulators continue to make representations about the solvency and risk of the TBTF banks.  For example, Dodd-Frank requires the TBTF banks to undergo stress tests and the regulators report the results.

How can you expect an investor to absorb a solvency related loss when the investor does not have the information needed to assess solvency for themselves and the financial regulators are saying the bank is solvent?

This is the ultimate moral hazard.

A moral hazard that FDR was aware of and why he said that governments should never be in the business of offering an opinion on an investment.  Rather, governments were suppose to be responsible for ensuring that all the useful, relevant information was made available to all market participants in an appropriate, timely manner.
Taking the appropriate steps will lead to more mid-sized banks – not a few megabanks – creating competition, increasing lending, and providing incentives for banks to lend the right way....
The appropriate step is to require banks to provide ultra transparency.  The SEC could do this today as it already has the legislative authority.

What is lacking is a Congressional kick in the backside to get the SEC to require banks to provide ultra transparency.
Just about the only people who will not benefit from reining in these megabanks are a few Wall Street executives. 
Congress needs to take action now to prevent future economic collapse and future taxpayer-funded bailouts....  
The simple action is to require banks to provide ultra transparency.
Mr./Madame President, the American public doesn’t want us to wait until another crisis develops. 
They want us to ensure that Wall Street megabanks will never again monopolize our nation’s wealth or gamble away the American dream. 
To those who say that our work is done, I say that we passed seven financial reform laws in the eight years following the Great Depression.
These financial reform laws established the FDR Framework with its philosophy of disclosure and principle of caveat emptor.
We cannot restore Americans’ faith in the financial markets and in representative government until we ensure that taxpayers are not paying for Wall Street’s failures.
And the only way to do that is to return to the FDR Framework and make sure that all banks are subject to ultra transparency.

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