Andrew Haldane: the Counter-Reformation in Banking has just begun

Leave it to the Bank of England's Andrew Haldane to end the debate about all the success of the "efforts" to reform the banking system since the start of the financial crisis.

In a speech at the Festival of Economics, Mr. Haldane dismissed these efforts as the problem of Too Big to Fail, Too Interconnected to Fail and Too Big to Jail still exist.

As Mr. Haldane observed,

“Too big to fail” banks create three disastrous problems, any one of which should have been sufficient decades ago to convince our politicians to get rid of them. 

They make a mockery of the phrase “free markets.”  

TBTF bank failures risk causing global financial crises. 

TBTF banks create so much economic power that it inherently translates into dominant political power and cripples our democracy by creating crony capitalism and the corresponding problem of “too big to jail.”

So the question is, how do we tackle these problems as the existing efforts to write new laws, like the Dodd-Frank Act, have effectively closed this avenue for reforming the financial system?

Regular readers know that the answer is by enforcing the existing securities laws, particularly the 1930s Securities Act.

Under the 1930s Securities Act, publicly traded firms must disclose all the useful, relevant information in an appropriate, timely manner so that market participants can independently assess this information and make a fully informed decision.

At the time the 1930s Securities Act was written, the standard for disclosure of all the useful, relevant information for banks was to disclose all of their current asset, liability and off-balance sheet exposure details.

This disclosure of exposure details was seen as the sign of a bank that could stand on its own two feet as it invited market participants to independently confirm this fact for themselves.

Judging by Mr. Haldane's observation that banks are "black boxes", clearly banks are no longer providing the disclosure that was the standard in the 1930s.

The starting point for the counter-reformation in banking is to formally reinstate the standard of ultra transparency for banks.

As regular readers know, requiring banks to disclose this information addresses all three of the areas that Mr. Haldane is concerned with.

It brings "free markets" back to banking as with this disclosure market participants can now independently assess the risk of each bank.  As a result, market participants can link the cost of funds paid by the bank to the level of risk at the bank.

It ends the risks of the failure of one global financial institution causing a financial crisis.  With ultra transparency, each market participant knows that they are responsible for any losses on their exposures to the banks.  As a result, market participants will limit their exposures to each bank to what they can afford to lose given the risk of the bank.

By limiting their exposures, market participants end the risk of financial contagion and the possibility of a financial crisis.

It ends the ability of the banks to control their regulators and the political system.  By disclosing their exposure details, banks are subject to market discipline.  Discipline that is not swayed by donations or lobbying.

An example of the market discipline banks become subject to is JP Morgan's London Whale trade.  Jamie Dimon and his management team did everything they could to keep the trade confidential.  They knew that as soon as the market knew of the trade, market participants would trade against JP Morgan in such a manner as to maximize any losses and minimize any profits.

Simply requiring the banks to disclose their exposure details will result in the banks shrinking and become far less politically powerful.

Not only will the banks end their proprietary trading, but they will also end the practice of using thousands of subsidiaries for tax and regulatory arbitrage.  These subsidiaries add complexity to assessing the banks.  Complexity that market participants will see as risk and for which market participants will require a higher rate of return.

Finally, ultra transparency has one more benefit that recommends it as the starting point for the counter-reformation in banking.  Ultra transparency ends the markets dependence on the financial regulators to do accurately assess and communicate the risk of each bank.

Not only does ultra transparency let the market participants independently determine this risk for themselves, but it also lets market participants to exert pressure on the regulators to do their job.

For example, it ends the irresistible urge by regulators to bail-out banks using taxpayer money.  Well before the banks need to be bailed-out, market participants will be putting pressure on the regulators and bankers to address the bank's losses.

In addition, everyone knows that when a bank's interest income is less than the combination of its interest and operating expenses, it will be closed and unsecured debt and equity holders will absorb the losses.