Wednesday, September 11, 2013

Post financial crisis policies promise chronic stagnation

In his Financial Times column, Satyajit Das observes about the policies adopted to deal with the financial crisis:
These policies will engineer a chronic stagnation, requiring continuous intervention to prevent rapid deterioration.
Mr. Das uses arguments that should be very familiar to readers to support this conclusion.

The arguments should be familiar because your humble blogger has been using them under the description of the Japanese Model for handling a bank solvency led financial crisis since the beginning of the current crisis.
The collapse of Lehman Brothers and the ensuing financial seizure was symptomatic of high debt levels, global imbalances, excessive financialisation and unfinanced social entitlements, which underpinned an economic model reliant on credit-driven consumption.
What made all of these conditions possible was opacity in the financial markets.

As a result of opacity, market participants were not able to independently assess risk.  Specifically, market participants could not independently assess the risk of banks, both commercial and investment, and structured finance securities.

Without an ability to independently assess risk, market participants relied on organizations, regulators and rating firms, that represented they had transparency and the ability to independently assess risk.

Unfortunately, even if these organizations were capable of accurately assessing risk, there were institutional reasons why they would not accurately communicate their assessment to the market.

Regulators do not accurately communicate risk because of fear of damaging the safety and soundness of their financial system.  Rating firms do not accurately communicate risk because they compete to be paid by the issuers for their ratings.

Regardless, the reliance on faulty risk assessments led to too much debt in the global financial system.
Surprisingly, little has changed. Unsurprisingly, activity has not equated to achievement. Since 2007, total public and private debt in major economies has increased not decreased, with higher public borrowing offsetting debt reductions by businesses and households. 
Debt levels have also risen in emerging countries from before the crisis....
The financial sector exists to support the real economy. Financial instruments, such as shares, bonds and their derivatives, are claims on real businesses. But over time, trading in the claims themselves has become more rewarding, leading to a disproportionate increase in the level of financial rather than real business activity. 
Regular readers will recall that modern banks are designed to protect the real economy from excess debt in the financial system.

Banks can protect the real economy because they have an ability to absorb upfront the losses on this excess debt and continue to operate.

Banks can continue to operate with low or negative book capital levels because of the combination of deposit insurance and access to central bank funding.  When banks have low or negative book capital, deposit insurance effectively makes the taxpayers the banks' silent equity partner.  As a result, so long as a bank can generate earnings, it can continue operating while it rebuilds its book capital level.
The financial sector needs to be pared back to its utility function: making payments, matching savers and borrowers, and providing simple risk management tools.
Your humble blogger has repeatedly said that paring back the financial sector requires bringing transparency to all the opaque corners of the financial system.

JP Morgan has shown that I am right about this benefit of transparency.  JP Morgan showed this in its handling of the London "Whale" trade.  As soon as the market found out what JP Morgan's position was, it closed the position.

If banks were required to disclose their current global asset, liability and off-balance sheet exposure details, there are a significant number of "positions" that they would quickly exit.  This includes proprietary trades as well as regulatory and tax arbitrages.
Instead of fundamental reform, policy makers are introducing complex capital, liquidity and trading controls of dubious efficacy that invite regulatory arbitrage.
Fundamental reform would have been bringing transparency to all the opaque corners of the financial system.

Instead, we have what your humble blogger refers to as the substitution of technocratic financial regulation involving complex rules and regulatory oversight for transparency and market discipline.

As Christopher Whalen said of this substitution of technocratic financial regulation for transparency and market discipline,
The moral of the story of Lehman Brothers is that no amount of regulation can prevent acts of wanton stupidity, fraud, and greed in a free society. Expecting regulators to proactively prevent a financial crisis is at best wishful thinking.
Returning to Mr. Das.
Too-big-to-fail banks have become larger. Initiatives such as the central counterparty for derivatives have introduced complex interconnections and new systemic risks. ...
The real solution always required reducing debt, reversing imbalances, decreasing financialisation and modifying behaviours....
Transparency is the real solution.

By requiring banks to disclose their exposure details, markets would have been able to exert discipline on the banks so that they recognized their losses on the excess debt in the financial system.

With transparency, financialization would have been decreased as market participants would then be in a position where they could independently assess the risk of the various products Wall Street and the City sell.  Many fewer of these products would be sold as market participants would see that the potential rewards from ownership did not compensate for the risk being taken.

Finally, transparency brings about behavior modification.  Sunlight is the best disinfectant of bad behavior by bankers.

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