WSJ: misguided faith that rules and regulators can prevent next financial crisis

The Wall Street Journal added its support to your humble blogger's argument that the combination of complex rules and regulations will not prevent the next financial crisis.

The misguided faith that rules and regulators can prevent the next financial crisis is hard to shake, but this week brought a glimmer of hope.

Regular readers know that the combination that will prevent the next financial crisis is transparency and market discipline.

The parts of the financial system that failed in our current financial crisis are those that feature complex rules and regulatory oversight (think banks) and/or opacity (think structured finance securities).

The parts of the financial system that continued to function throughout the financial crisis without government intervention feature transparency and market discipline (think stock or non-financial corporate bond markets).

The chairman of the Basel Committee on Banking Supervision signalled that regulators might be starting to understand how their rules contributed to the 2008 financial crisis—and the damage these rules could do in the future.

It is not the rules that do the damage.

It is the regulators' information monopoly that does the damage.

The regulators' information monopoly prevents market participants from accessing all the useful, relevant information in an appropriate, timely manner when it comes to financial institutions.

As a result, market participants cannot see how the rules are distorting the risk of the banks or, more importantly, how the banks are gaming the rules and adding risk.  Both lead to a financial crisis.

The Basel rules are the global standards that encouraged banks to hold mortgage-backed securities before the crisis and have since been re-written to favor investment in sovereign debt (such as Italian or U.S. bonds). 

Perhaps realizing how terrifying that sounds to taxpayers, Chairman Stefan Ingves said on Tuesday that the committee, whose members include U.S. financial regulators, has created a "high-level task force" to study the issues raised by Basel critics. 

Reformers like Andrew Haldane at the Bank of England and Thomas Hoenig at the U.S. Federal Deposit Insurance Corporation have pointed out that the complex Basel rules have been enormously costly yet were of little use before the crisis in determining which banks would run into trouble....

The failure of the Basel capital requirements in the run up to our current financial crisis should have forever ended the faith that the combination of complex rules and regulatory oversight can prevent a financial crisis.

The failure of the combination of complex rules and regulatory oversight in the run up to our current financial crisis should have caused us to look for an alternative.

The alternative that would have been found is the combination of transparency and market discipline.

Why would the combination of transparency and market discipline have been found?

Because our financial system is based on the FDR Framework which combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).  Which is simply the combination of transparency and market discipline.

Instead of relying on a straightforward calculation of how much capital banks hold, Basel has embraced complicated methods for assigning "risk-weights" to the various assets held by banks. 

The opportunity for banks is either to lobby regulators to favor particular assets, or to simply wait until regulators bless certain types of investments for political reasons, and then figure out how to construct the most Basel-friendly balance sheet. 

Either way, guess which firms are best at navigating this byzantine regulatory architecture?...

The combination of transparency and market discipline puts an end to banks gaming the rules.

It ends this gaming as the market is only concerned with the risk that banks are taking and not how the banks manipulate some meaningless rules.  If the banks are required to provide ultra transparency, the market will exert discipline based on the actual exposure details of the bank regardless of how the banks game the complex capital rules.

Mr. Ingves and his colleagues have a long way to go. 

Actually, Mr. Ingves and his colleagues will never get to the point where they acknowledge that the combination of complex rules and regulatory oversight will not prevent the next financial crisis.

They are regulators and this would be acknowledging a significant limitation to their capabilities.