Sheila Bair is not a substitute for market supervision

In his NY Times Economix column, Professor Simon Johnson argues that it is important to appoint Sheila Bair to the vacant post of Fed Vice Chairwoman for Supervision because without filling this vacancy the Fed faces a potential crisis of legitimacy for its handling of the Too Big to Fail banks.

While there is much to recommend his column, Professor Johnson misses two critical facts.

First, a major reason for the financial crisis was the failure of regulatory supervision.  There is little that has happened since the beginning of our current financial crisis to indicated that the reasons that regulatory supervision is not a viable substitute for market discipline, including regulatory capture, have been fixed.


Second, the Fed has a long running policy of financial failure containment and its corollary the Geithner Doctrine (from Yves Smith, nothing should be done that hurts the profits or reputation of a big or politically connected bank).

As regular readers know, banks are not subject to market discipline because they are, in the words of the Bank of England's Andrew Haldane, "black boxes".  When market participants do not have the information they need to independently assess the risk of the banks, they cannot exert discipline on the banks by adjusting both the amount and price of their exposure based on each bank's risk.

Leading up to the crisis and even now market participants rely on the regulators' representation about the riskiness of the banks.  This reliance is the result of the simple fact that the regulators have access to all the useful, relevant information on each bank in an appropriate, timely manner and investors don't.

Unfortunately, this reliance is misplaced as the regulators have to both correctly assess this information and accurately communicate the results of this assessment to the market.  By definition, regulators cannot accurately communicate the results because of concerns over the safety and soundness of the financial system (the regulators won't say anything bad about the banks).

This problem is compounded by the moral hazard creating Dodd-Frank Act mandated stress tests.  Each year, the Fed performs a stress tests on the banks and pronounces them solvent under extreme economic conditions.  This announcement effectively makes the taxpayer obligated for bailing out the investors for any solvency related losses.

Why?  Where is there the investor who is going to argue with the Fed given that the Fed has better access to information than the investor?

That the government making investment recommendations creates moral hazard has been well known since the 1930s.  FDR warned about it and specifically said that the government should stay out of the business of making investment recommendations as this create a moral hazard to bailout investors who relied on the government's recommendation.  The Fed's stress tests are nothing less than the government making an investment recommendation.

More troubling is that former Treasury Secretary Tim Geithner pledged the full faith and credit of the US to provide the banks with all the capital they need as a guarantee to investors that they would not suffer any losses from investing based on the stress test findings.

The policy of financial failure containment was in place back when I worked for the Fed and can be seen in the handling of Continental Illinois and the Savings & Loan crisis.

This policy has already destroyed the Fed's legitimacy when it comes to dealing with the Too Big to Fail banks.  Everyone knows the Fed will not do anything to control them and prevent them from taking outsized risks.

Rather, the Fed will come along and try to "mop up" after one of these banks blows up again.

If the Fed were truly interested in having the Too Big to Fail banks subjected to appropriate levels of supervision, the new Vice Chairwoman for Supervision would be leading the charge to require the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With ultra transparency, the banks would be subjected to both market supervision and market discipline.  Supervision that would be far superior in terms of both manpower and resources than anything that our regulators can offer.

The Dodd-Frank Act created the position of the Vice Chairwoman for Supervision at the Fed precisely because Wall Street knows that the Fed will never support ultra transparency.  Supporting ultra transparency means giving up its information monopoly.

It also means that the market could exert discipline on the Fed in its performance of is supervisory duties.  The last thing the Fed and its economists would ever be willing to do would be to put themselves in a position where they could be held accountable for their actions or lack thereof.