Monday, June 17, 2013

Heidi Moore: Wall Street is winning the long war against regulation

In her Guardian column, Heidi Moore looks at how Wall Street is winning the war against post-financial crisis regulation.

Regular readers know that this is just a minor skirmish in the much larger war Wall Street has been waging against the regulations it was subjected to following the stock market crash of 1929.

In the aftermath of the 1929 crash, but not the 2007/2008 meltdown, Wall Street's behavior was investigated.  What the Pecora Commission uncovered was that everyplace there was opacity in the financial markets, Wall Street engaged in unsavory conduct.

As a result, the FDR Framework became the basis for the global financial system.  The FDR Framework combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).

The FDR Framework makes governments responsible for ensuring that market participants have access to all useful, relevant information in an appropriate, timely manner so they can independently assess this information and make a fully informed decision.

Please note that the governments are made responsible for ensuring "valuation" and not price transparency.  This is intentional as valuation transparency is the starting point for the investment cycle and differentiates investing from gambling.

The FDR Framework also provides an incentive for market participants to engage in the investment cycle and independently assess the disclosed information as it makes market participants responsible for all losses on their investment exposures.

The three steps of the investment cycle are as follows:

  1. Independently assess the disclosed information to determine the risk and valuation of an investment;
  2. Obtain prices from Wall Street at which it would buy or sell the investment;
  3. Compare the independent valuation to Wall Street's prices and make portfolio management decision to buy, hold or sell.  

Market participants gamble when disclosure does not provide them with all the useful, relevant information in an appropriate, timely manner.  Without this information, market participants cannot start the investment cycle and independently determine the risk and valuation of an investment.  Rather, they are simply blindly betting on the contents of a brown paper bag when they buy or sell the investment.

When all there is valuation transparency, knowing they are responsible for losses, investors limit their exposures to any investment to what they can afford to lose.  This builds market discipline into the financial system as investors link what they need to be compensated for making an investment to the risk of the investment.  This also builds stability into the financial system and eliminates concerns about financial contagion.

The only exception where market participants are not responsible for losses is for deposits at banks that are less than or equal to the level guaranteed by the government.

As demonstrated in the 1920s and again in the run-up to our current financial crisis, Wall Street prefers opacity.  Wall Street prefers opacity because it makes it impossible for investors and other market participants to properly assess the risk of and value an investment.

Wall Street particularly likes opacity when it has access to all the useful, relevant information in an appropriate, timely manner and investors and other market participants do not.  Examples of this would be opaque, toxic structured finance securities or the banks themselves.

Wall Street also likes opacity because it can hide behind the veil of opacity and manipulate markets.  Examples of this include all the benchmarks like Libor and foreign exchange.

Obviously, Wall Street's preference for opacity runs into the government's responsibility for ensuring valuation transparency.  This is a war without end.

Unfortunately, as shown by our current financial crisis, it is a war where periodically Wall Street wins a  battle.

If you look, you will see that large portions of our financial system are opaque.  Examples include structured finance and banks.  It is these corners of the financial system that froze at the beginning of the financial crisis and have not unfrozen.

Ending our financial crisis requires bringing valuation transparency to all the opaque corners.  One of the results of bringing valuation transparency to banks will be to subject Wall Street to market discipline (not just regulatory oversight where Wall Street can capture the regulator).

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