Neil Weinberg: Why the debate on TBTF is a distraction

In his American Banker column, Neil Weinberg, its editor in chief, explains why the debate about breaking up the Too Big to Fail, just like the debate about banks needing more capital, is a distraction from what would make our financial system safer and should be the true focus of reform.

In Mr. Weinberg's case, he suggests the true focus of reform should be:

The primary threat is that the system is so interconnected and complex that the failure of a bank big or small, or an institution that exists in the industry's shadow, can imperil everyone else with little or no warning.

Please re-read what Mr. Weinberg says because it nicely summarizes why transparency is the true focus of reform and why it must be brought to all the opaque corners of the financial system.

Regular readers know that our financial system is based on the FDR Framework.  The FDR Framework 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 investment decision.

Under the FDR Framework, the principle of caveat emptor makes market participants responsible for all the losses on their investments.  This responsibility for loss gives market participants an incentive to use the disclosed information to assess the risk of their investments and to limit the size of any individual investment to what they can afford to lose given the risk.

The FDR Framework is designed to support the three step investment process:

1. Independently assess the useful, relevant information so as to understand the risk of and value an investment.
2. Solicit from Wall Street the price that the investment can be bought or sold for.
3. Compare the investor's independently determined value with the price shown by Wall Street and make an investment decision, (buy, hold or sell), based on the difference between the independent valuation and Wall Street's price.

The issue of interconnectedness is not a problem under the FDR Framework as market participants limit their investments to what they can afford to lose.

The issue of interconnectedness becomes a problem when governments do not fulfill their responsibility under the FDR Framework and let large parts of the financial system become opaque (think banks and structured finance securities).

The opaque parts of the financial system are not investable because market participants cannot perform the first step of the investment process.  Market participants cannot perform this first step because they do not have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess the risk and value an investment.

While the opaque parts of the financial system are not investable, market participants can gamble and buy opaque securities (think opaque, toxic subprime mortgage backed securities).

What led to our current level of interconnectedness is market participants gambled based on the recommendation of rating firms and government agencies.

Both the rating firms and government agencies represented they were in a position where they had access to all the useful, relevant information in an appropriate, timely manner and they were providing an accurate assessment of the risk.  Of course, this wasn't true.

Rating firms didn't have any information about structured finance securities that was not available to the investors and they were not in a position to accurately assess the risk and update their ratings in a timely manner.

Government agencies were limited in what they could say about the banks because of concerns about the safety and soundness of the financial system as well as lobbying by the banks.

Unfortunately, the result is more interconnectedness than would be the case if there was transparency and each market participant was held responsible for the losses on their exposures.

The solution for reducing interconnectedness is simple: bring transparency to the opaque corners of the financial system.

For banks, this means having them disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

For structured finance securities, this means observable event based reporting under which all activities like a payment or delinquency involving the underlying collateral are reported to market participants before the beginning of the next business day.

With the restoration of transparency in the financial system comes the restoration of responsibility for losses.  The result is a dramatic increase in the robustness of the financial system and decline in the level of interconnectedness.