Friday, May 17, 2013

IMF study calls into question the whole approach to regulating banks

The Guardian reports that an IMF study has called into question the whole approach to regulating banks by asking if this approach is really addressing the real issue.

The authors of the study point out the simple fact that had all the proposed regulations been enacted prior to the beginning of the financial crisis they would not have prevented the financial crisis from occurring.

This conclusion is worth repeating.  For all the sound and fury, the proposed regulations would not have prevented the financial crisis.

Naturally, the authors call for seeing if there might be an alternative approach.

Regular readers know that there is an alternative to the combination of complex regulations and regulatory oversight.  That alternative is transparency.

Remarkably, transparency happens to be "low cost" and has a track record of success.

Transparency is particularly effective when combined with the principle of caveat emptor (buyer beware).  This combination makes the buyer responsible for all losses on their exposures.  This gives the buyer an incentive to use the disclose data to assess the risk of their exposures and limit the size of their exposures to what they can afford to lose.

By limiting their exposures to what they can afford to lose, buyers build robustness into the financial system.

This is the exact opposite of what we had in the run-up to the financial crisis and the adoption of the bury them in complex regulation approach.

The financial crisis occurred because of the fragility injected into the financial system by its opaque and heavily regulated corners (structured finance securities and banks).   So naturally, the response as pointed out by the IMF is to add even more opacity and, one of its chief sources, complex regulations.

The authors said: "The structural measures to reform banks such as the US Volcker rule, the UK's Vickers ring-fence, and the EU's Liikanen proposal, which would create functional separation of businesses, all reflect a deep sense of unease with the risk culture engendered by the assumption of trading and speculative investments by deposit-taking banks." 
But they added that the proposed reforms would not have prevented the crisis a tLehman Brothers in September 2008, the event that brought the global financial system to the brink of collapse. 
"Looking back, however, restrictions on proprietary trading or investments in private equity alone would not have prevented major bank failures such as Lehman Brothers. Nor would reorganising the bank into separate subsidiaries in each host and home country have facilitated its global, group-wide resolution." 
The study said Britain, the US and the EU were important financial centres and that they could bring benefits to the global economy if the structural reforms led to greater stability.

And the critical structural reform is to bring transparency to all the opaque corners of the financial system.

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