Monday, August 5, 2013

Key problem with technocratic financial regulation: it doesn't work

Since the beginning of the financial crisis, global policymakers have indulged in an unprecedented ramp-up of technocratic financial regulation.

Technocratic financial regulation substitutes complex rules and regulatory oversight for transparency and market discipline.

There is just one key problem with this approach:  our current global financial crisis was the result of the failure of technocratic financial regulation and there is no reason to believe that technocratic financial regulation could be successful in preventing a future financial crisis.

The failure of technocratic financial regulation can be seen in the bailout of the banks.

Banks are "black boxes" into which only the banking regulators can look.  When they looked in the run-up to the financial crisis, the regulators told everyone that they had very little risk.

Whether this statement was the result of not being able to assess bank risk or they were concerned with the safety and soundness of the financial system is irrelevant.  What was relevant was the bank regulators failed to restrain bank risk taking.

When the financial crisis began, it was apparent to everyone that nobody, including the bank regulators, could tell which banks were solvent and which were insolvent and the most likely choice was all of the major banks were insolvent.

Policymakers acting upon the recommendation of the bank regulators choose to cover up the failure of complex rules and regulatory oversight to prevent the financial crisis.  The result was adoption of the Japanese Model for handling a bank solvency led financial crisis and protection of bank book capital levels and banker bonuses at all costs.

Given the global failure of technocratic financial regulation, there was and still is absolutely no reason to bet the financial system's stability on the bizarre notion that the outcome will be better next time.

This is particularly true because under the FDR Framework, the global financial system is designed to be anti-fragile.  Where there was transparency and market discipline, the global financial system functioned without need for government intervention even during the most acute phase of the crisis.

As Adam Levitin nicely summarizes technocratic financial regulation, it is:
Add two parts capital and one part co-cos, mix with risk retention requirements and garnish with macroprudential regulation...
In fact, as more and more complex regulations are enacted it becomes less and less clear that banks are becoming less as oppose to more risky.

The Financial Times reports on the conflict between simple bank capital leverage ratios and bank liquidity coverage ratios,

Can regulation make banks less safe? What has happened in the past week certainly seems to suggest so. 
Three large European banks – BarclaysDeutsche Bank and Société Générale – moved to partly dismantle one of their main bulwarks against another liquidity crisis: their massive cash reserves....

The bosses of all three banks sung the same refrain to explain the wind-down of cash and safe assets: It will help them boost their leverage ratio, a gauge of financial soundness that measures a bank’s equity against its overall assets....

Banks’ drive to reduce their liquid holdings reverses a trend that started after the collapse of Lehman Brothers in 2008. Since then, banks have tended to hoard large reserves of easy-to-sell assets. .... 
Regulators have pushed banks to do this as part of the lessons learnt from the global liquidity crunch of 2007-09. The first-ever global liquidity standards – an early element of the Basel III rule book called the liquidity coverage ratio – require banks to stockpile enough liquid assets to sustain their operations for 30 days if faced with another crisis....  
European bank executives might thus simply be using a reduction in their cash pools as a neat lobbying tool, trying to shock regulators into moderating leverage requirements. 
But even if that is the case, their key argument is worth listening to: Leverage ratios do not make a distinction between liquid, non-risky assets such cash on one side and high-risk, illiquid instruments such as complex securitisation products on the other. For leverage purposes, an asset is an asset. ... 
There is certainly a rationale for a leverage ratio threshold that will make banks safer by forcing them to hold more equity in relation to their assets. But it makes no sense to persist with definitions of leverage that clash with the objectives of liquidity rules.

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