Monday, September 2, 2013

Don't outsource bank risk management to global financial regulators

In an interesting ABA Banking Journal article, Dan Borge explains why he feels we should not outsource bank risk management to the global financial regulators.

Your humble blogger would offer a different reason for not outsourcing risk management to the bank regulators based on my experience working at the Federal Reserve and at a Too Big to Fail bank.

As demonstrated by our current global financial crisis, the global financial regulators are not very good at risk management and when they fail they have an irresistible urge to have the taxpayers pay for their failure.

By outsourcing bank risk management to the regulators, we interfere with how the financial markets are suppose to work.

For financial markets to work properly and risk to be restrained, banks must provide transparency into their current global exposure details.

With this information, market participants can independently assess the risk of and value each bank and adjust their exposures based on this assessment.  Then, bank management responds to market discipline as revealed through higher cost debt or lower equity share price that results from the adjustment in market participants' exposures and lower its risks.

Instead, we have a situation where financial markets don't work because risk management has been outsourced to regulators.

Leading up to the financial crisis and still to this day, banks have been allowed to remain opaque "black boxes".  As a result, they are not subject to market discipline.

Instead, banks are subject to regulatory discipline which they respond to by applying political pressure to get the regulators to back off or by gaming the financial regulations.

Regulators have besieged bankers with new and complex risk regulations in the aftermath of the financial crisis: Basel III; stress tests; risk-based compensation ... the list goes on. 
Whether all this regulation is making the financial system safer and healthier is debatable. 
But what is not debatable is that the regulators are taking a much more active role in asserting and enforcing their own notions of what constitutes excessive risk in banking.

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