Wednesday, July 31, 2013

Paul Volcker explains how to fix big banks and financial system

In David Brodwin's must read US News column, he looks at Paul Volcker's explanation of how to fix big banks and the financial system.

Mr. Volcker observed:

The erosion of confidence and trust in the financial world, in the financial authorities that oversee it, and in government generally is palpable. That can't be healthy for markets or for the regulatory community....
Regular readers know that transparency is the foundation for confidence and trust in the financial world.

The global financial system is based on the FDR Framework which combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).  Confidence and trust is one the end results of implementing this framework.

This end result occurs because market participants have confidence and trust in their decisions when they have access to all the useful, relevant information in an appropriate, timely manner to independently assess the risk of and value an investment so they can make a fully informed decision.

Confidence and trust are shattered when there is opacity in large corners of the financial system and financial authorities insist on substituting their judgement for each market participant's independent analysis.
Volcker sees two main threats to our banking system: first, our ongoing failure to regulate it adequately in the wake of the subprime mortgage crisis, and second, the development of unrealistic and dangerous expectations for the role of the Fed. 
Volcker begins by affirming that modern financial markets have lost the ability to self-regulate, and that "market discipline alone" fails to "restrain episodes of unsustainable exuberance before the point of crisis." 
Your humble blogger disagrees with Mr. Volcker that modern financial markets have lost the ability to either self-regulate or exert market discipline.

For either of these to occur, there must be transparency because without transparency it is impossible to assess risk.

How can markets exert discipline and restrain bank risk taking when they do not have access to a bank's current global asset, liability and off-balance sheet exposure details?

How can markets exert discipline and restrain bank risk taking when the regulators, who have an information monopoly on the current exposure details, say banks are low risk?

No one should expect markets to exert discipline and restrain bank risk taking when bank disclosure regulations allowed them to be "black boxes" and regulators out of concern for the safety and soundness of the financial system misrepresent the riskiness of the banks.

It is not surprising that confidence and trust in the financial system and financial authorities are eroding.  Market participants have reason to believe they are being lied to.

If the banks are in the great financial condition that the financial authorities claim, then the authorities should insist that the banks provide transparency so market participants can independently confirm this fact.

By not requiring the banks to provide transparency 6 years after the financial crisis began, the financial authorities are effectively waving a large red warning flag.
Yet, the so called Dodd-Frank Act does not solve the problem, he says. It provides both too much regulation and too little.... 
Despite the extensive regulation in Dodd-Frank, the bill is badly compromised by loopholes that prevent it from being fully and effectively implemented. Volcker writes: 
"The present overlaps and loopholes in Dodd-Frank and other regulations provide a wonderful obstacle course that plays into the hands of lobbyists resisting change. The end result is to undercut the market need for clarity and the broader interest of citizens and taxpayers."...
The Dodd-Frank Act uses complex regulations and regulatory oversight as a substitute for transparency and market discipline.

Unfortunately, we are in our current financial crisis because complex regulations and regulatory oversight does not prevent a financial crisis like transparency and market discipline does.

Your humble blogger likes to cite in support of this statement the simple fact that the financial crisis occurred in all the opaque corners of the financial system (think banks and structured finance securities).  In these opaque corners the financial system froze (think unsecured interbank lending).

By contrast, the transparent parts of the financial system continued to operate (think stock and corporate markets excluding banks).  For every seller, there was a willing buyer.  The price might not have been what the seller really wanted, but there was a private buyer.

Your humble blogger has frequently said that most of the Dodd-Frank Act should be repealed (with the exception of the Volcker Rule and the Consumer Financial Protection Bureau).  It should be replaced with a requirement that the SEC implement the Securities Acts of the 1930s and require banks to disclose their current exposure details.

As JP Morgan showed with the London Whale trade, when a bank's exposure details are known, it quickly exits any risky position.

It is remarkable what transparency and the resulting clarity it brings can do.
We can't simply return to the rules of the past, says Volcker. 
The world has changed too much. Financial markets and institutions are larger, more complex, more interconnected and "more fragile." Hedge funds and other non-banks play a much larger role in the system and regulated commercial banks play a proportionally smaller role. 
The old regulatory structures will not give us the stability we need in the system and its major institutional components.
Actually, we can return to the rules of the past when the rules concern ensuring transparency in the financial markets.

Please recall that under the FDR Framework's principle of caveat emptor market participants are responsible for all losses on their exposures.  It is this responsibility that ends financial contagion and fears of interconnectedness.

Quite simply, since they are responsible for losses on their exposures, market participants have an incentive to limit their exposures to what they can afford to lose.  This goes for investors and for banks too.

When all market participants are responsible for their losses, there is financial stability.  A bank can fail without any worries about financial contagion because market participants have limited their exposure to what they can afford to lose.

However, this doesn't work when banks are opaque black boxes that financial authorities say have a low risk profile.  In this case, market participants over invest as they did in the run-up to our current financial crisis.

Fixing the big banks and the financial system is simple: bring back transparency.

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