Wednesday, April 24, 2013

The Telegraph's Jeremy Warner's epiphany about banks and their regulators

The Telegraph's Jeremy Warner had an epiphany about banks and their regulators:  bankers run a pro cyclical business that is made even worse by their regulators.

The trouble with banks is that they are extraordinarily pro-cyclical beasts. 
During the good times they throw caution to the winds and lend with reckless abandon. 
During the bad times they do the opposite; in rebuilding capital to pay for the bad debts of the boom, they become highly risk averse. The priority is to reduce credit, rather than expand it, so that solvency can be re-established. 
This process is reinforced by regulators, who having been asleep on the job during the boom, then go violently into reverse and attempt to bullet proof the banks against all eventualities by insisting on much tougher capital and liquidity requirements. 
Only last month, Britain's Financial Policy Committee identified a further £25bn shortfall in UK banking capital, a deficit likely to be met by further shrinkage in bank balance sheets. 
A vicious cycle of credit destruction thus sets in. 
The madness of this regulatory over reaction is there for all to see the latest Basel III capital adequacy rules, which bizarrely require banks to hold much higher capital against corporate loans than mortgages. 
The inevitable consequence of such thinking is that the housing market is held up at silly valuations and the corporate market delevers even further. The impact on growth is terrible.
The only way to end this negative reinforcing cycle is by making the banks provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balane sheet exposure details.

With this information, market participants can assess and restrain bank risk taking.

As a result, we won't get the extremes on the upside in lending nor will we get the regulators kicking in policies that hurt lending on the downside.


Ralph Musgrave said...

I don't see your "ultra transparency" solving the problem, though of course the more transparency the better. In the run up to the credit crunch, the Bank of England had all the figures about what private banks were doing: total loans extended, etc. But the BoE, along with other regulators completely failed to see anything was wrong. I doubt they'd be any more clued up even when given the additional information that comes from more transparency.

Full reserve banking would cut down on the boom bust cycle since it outlaws money creation by commercial banks.

Richard Field said...

Dear Mr. Musgrave, thanks for your comment.

Whether ultra transparency solves the problem or not is a question of what you think the problem you are trying to solve is.

There are a number of problems that ultra transparency solves including the failure by financial regulators to properly assess "risk" in the financial system.

Ultra transparency makes it each investors problem to independently assess the risk they are taking through their investment exposures and limit this risk to what they can afford to lose.

This way, even if the financial regulators didn't see a credit bubble, when it bursts, the financial system's stability isn't threatened as each participant can absorb the losses tied to their investment exposures.

The act of investors limiting their exposures to what they can afford to lose also reduces the amplitude of the boom/bust credit cycle. However, it does not eliminate it like 100% reserve banking would do.

So if the problem is defined solely as eliminating the boom bust cycle, ultra transparency is not the most effective solution.

You might not be aware of it, but we already have "full reserve banking". It is called a mutual fund.

Ironically, look how much more transparency a mutual fund provides than a bank. Mutual funds disclose their exposure details once per quarter, more frequently once per month and some even daily.

Having said that, please note how financial regulators are trying to bring an end to the money market mutual fund. Apparently, the regulators don't like 100% reserve banking.