Wednesday, July 24, 2013

Old-fashion regulators miss the foundation of finance

In his Bloomberg column, Clive Crook asks is the financial system any safer now than in 2008?

His answer is no because regulators miss what is new in finance because they are trapped in the old model of the financial system.
Insurance prevents bank runs, but encourages risky lending because depositors no longer care whether their bank is prudent or reckless. Once you insure deposits, therefore, you also must regulate banks more strictly (setting rules for bank capital, among other things). 
That’s the old model for systemic safety in finance: deposit insurance plus bank regulation.
Please re-read Mr. Crook's old model for systemic safety in finance because that is not actually the old model.  Mr. Crook leaves out transparency.

Regular readers know that our financial system is based on the FDR Framework which combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).  The FDR Framework model for systemic safety is deposit insurance plus bank regulation plus transparency (an equivalent way to describe the FDR Framework model for systemic safety is deposit insurance plus regulatory discipline plus market discipline).

Because of the presence of transparency and the market discipline transparency enables, the FDR Framework model for systemic safety is vastly different from the model suggested by Mr. Crook.  It also leads to vastly different conclusions about how to interpret the financial crisis and fix the financial system.

Under Mr. Crook's model, there was a different kind of bank run that brought down the financial system.  In support of this different kind of bank run he cites the academic work of Yale Professor Gary Gorton.

As Mr. Crook explains, a new form of finance emerged that the old model of deposit insurance plus bank regulation could not handle.

The archetype of the new form of non-deposit bank funding is “repo.” 
In a repurchase transaction, a bank or other borrower sells a security in return for cash, promising to buy it back later at a higher price. The transfer of cash is akin to a short-term deposit; the price difference is the repo equivalent of paying interest. In addition, the loan is “collateralized,” because the bank or other borrower loses the security if it breaks its promise to repurchase. There’s an extra margin of safety because the collateral is typically worth more than the loan -- this margin, called the “haircut,” serves a purpose similar to capital for a deposit-taking bank. 
So what’s the problem? 
Essentially, when fear gripped the capital market, securities deemed safe when they were pledged as collateral suddenly looked unsafe. The market for collateralized short-term funding therefore seized up. Borrowers couldn’t borrow and had to liquidate assets instead. As forced sellers, many lost money; with too little loss-absorbing capital, some faced insolvency. Fear spread, further driving down the prices of securities, adding to the panic. 
It was a run, but not one that traditional financial regulation could have stopped.
This is a wonderful story and entirely consistent with a model for systemic safety in finance that leaves out transparency.  It also leads to the wrong conclusion: a need for more regulation.

When you use the FDR Framework model for systemic safety in finance that has actually been in place since the 1930s, you realize that the "run on the repo" was in fact a reflection of opacity.  Opacity in the structured finance securities being pledge and opacity in the borrowing bank.

Opacity in the structured finance security being pledge meant that the security could not be valued.  Opacity in the banks meant that it was impossible for any bank (or investor) with funds to lend to tell which of the other banks was solvent and which was insolvent.

This ability to distinguish solvent from insolvent banks is important, because when you engage in a repo with an insolvent bank you expect to end up with the collateral.

So let me see, we have opaque banks trying to raise money against opaque securities.  Is there any surprise that this form of financing collapsed?

When you apply the FDR Framework model for systemic safety in finance that has existed since the 1930s, your conclusion is we need to bring transparency to both structured finance securities and banks.

To date, we have made no progress on transparency.  Instead, we have pursued a bunch of meaningless regulations that would not prevent the same crisis from recurring in the financial system.

No comments: