Friday, March 22, 2013

Transparency is missing ingredient for bank creditors to participate in bail-ins

As reported by Reuters, Germany has decided that the time has come in the ongoing financial crisis that bank creditors and equity holders rather than taxpayers contribute to bailing out the banks.

While your humble blogger agrees that this should in fact happen, there is one small step that needs to be taken first.  That small step is that the banks need to be required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details?

Why is transparency necessary?

The global financial system is based on the FDR Framework which combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that market participants 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 decision.

Under the principle of caveat emptor, investors are responsible for all losses on their exposures.  This gives the investor an incentive to use the information that banks would disclose under ultra transparency  to independently assess the risk of the banks.  Based on this risk assessment, the investor would then adjust their exposure to an amount they could afford to lose given the risk.

Currently, banks are not transparent.  They are in the words of the Bank of England's Andrew Haldane 'black boxes'.  As a result, it is impossible for investors to independently assess the risk of the banks and adjust their exposures to what they can afford to lose.

To make the situation worse, governments have created a moral obligation to protect the investors and spare them from participating in a bail-in.

Governments are doing this by making investment recommendations about the banks.  For example, the bank regulators run annual stress tests and announce that the banks are well capitalized.

It is reasonable for an investor to rely on this representation as to the solvency of the banks.  This is what gives rise to the moral obligation to protect the investor from a solvency related bail-in as it is simply unfair for the government to say a bank is solvent and then turn around and say fooled you and take the investor's money.

The way to end the moral obligation to protect the investors and expose the investors to bail-in risk is to provide ultra transparency.  With ultra transparency, investors have all the useful, relevant information they need so they are no longer reliant on the governments' investment recommendation.  This ends the moral obligation to protect the investor.

Please note that providing ultra transparency and weaning the investors off of the moral obligation cannot happen overnight.  We are looking at a period of 24-36 months to a) make the bank data available, b) let market participants assess this data and c) let market participants adjust their exposures based on their assessments.

To put this transition period into perspective, until there is ultra transparency, there is always going to be morally justifiable push-back to the notion of bank investor bail-ins.

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