How to stop the next financial crisis

In his column in the Atlantic, Glenn Hubbard examines what your humble blogger refers to as technocratic financial regulation and finds that it is insufficient to prevent the next financial crisis.  He then calls for bringing in the big gun.

In Mr. Hubbard's case, the big gun is the Fed.  In your humble blogger's case, the big gun is the market.

Which is more likely to prevent the next financial crisis?

The Fed which failed to prevent the current financial crisis and is pursuing a policy of re-inflating the real estate and stock market bubbles or the market which because of opacity was unable to exert discipline in the run-up to our current financial crisis?

I agree with Mr. Hubbard's assessment of why technocratic financial regulation will not prevent the next financial crisis.  I also agree with his calling for an end to small fixes and bringing in the big gun.

What is needed is transparency into all the opaque corners of the financial system, including banks and structured finance, so market participants can once again exert restraint on risk taking and bad behavior.

As regular readers know, our financial system is based on the FDR Framework.  It combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all useful, relevant information is accessible in an appropriate, timely manner.  Market participants are responsible for all losses on their exposures so they have an incentive to use the information disclosed.

Market participants use this information to independently assess the risk and value each of their exposures.  Based on the assessment of risk, market participants then limit their exposure to what they can afford to lose (the basis for market discipline).

Our current financial crisis showed that the FDR Framework works.  Markets, like the equity markets, where there was and still is transparency continued functioning.  It was the markets, like the interbank lending market, where there is opacity that froze and effectively still remain frozen.

Our current crisis is the direct result of the government's failure in its responsibility to ensure transparency.  As a result, we ended up with opaque, toxic sub-prime mortgaged-backed securities and banks that are 'black boxes'.

It time to rollout the big gun and let the market, using the information disclosed as a result of transparency, end our current financial crisis and prevent the next financial crisis.

This worked for 7+ decades before government forgot that it was suppose to error on the side of too much transparency and allowed Wall Street to create opacity in large areas of the financial system.

One key reason for skepticism that policy has put us on a course toward financial stability is that we have treated the loose ends of the financial crisis as technical problems to be solved …

• If proprietary trading by financial institutions is risky – though such risk-taking paled alongside old-fashioned bad lending before the crisis – ban it. 

• If taxpayers and investors lost money in the crisis, force institutions to hold much larger amounts of capital to mitigate future losses. 

• If securitization led to losses, force mortgage originators to hold more “skin in the game.” 

… and so on. 

Each technical problem has been solved using complex rules and regulatory oversight rather than transparency and market discipline.

Unfinished business in battle to fix banks...transparency

The Financial Times ran an interesting article in which it identified what it felt were the five principle reasons for bank failures ("low capital, weak funding structures, poor lending, poor trading investments and misguided mergers and acquisitions").

It concluded that 5 years after Lehman Brothers' collapse significant progress has been made using complex rules and regulatory oversight to address four of the reasons for bank failures and the fifth reason, poor lending, could not be addressed.

Left unsaid was the simple fact that transparency would successfully address all five of these reasons for bank failures.

Also left unsaid is the simple fact that it would not have taken five years to implement transparency and have each bank disclose on an ongoing basis its current global asset, liability and off-balance sheet exposure details.

In an attempt to gauge the merit of the glut of global reforms, the Financial Times has looked back at the 34 main banks and brokers that failed in the crisis, judging the principal reasons for failure from a menu of five – low capital; weak funding structures; poor lending; poor trading investments; and misguided mergers and acquisitions.

Each of these reasons is really a symptom of opacity.

For example, when banks don't have to disclose their current exposure details, they aren't subjected to market discipline to restrain their risk taking.  As a result, they reduce their capital levels in lock-step to what they can convince their regulators is adequate to handle any losses they might incur.

History shows that when banks disclose their current exposure details they have a higher level of book capital.  This higher level of book capital reflects both market discipline and the recognition that transparency requires a bank show it can stand on its own two feet.

Many failed for multiple reasons, though Royal Bank of Scotland is the only institution to which all five triggers applied. 

Any analysis of the precise causes of the global financial crisis, even after five years of reflection, is necessarily subjective. 

Please note, your humble blogger assessed and told everyone about the cause of the global financial crisis, opacity, before the crisis hit.

But if there were five main causes of failure, regulators can claim at least partial victory on four of them. 

Please re-read how the regulators can claim at least partial victory on addressing for of the five main causes of failure.

This is entirely unacceptable and is a damning indictment of complex rules and regulatory oversight.

By simply using the securities laws that have existed since 1930s, all five main causes of failure could have been addressed through requiring banks to provide transparency and disclose their current exposure details.

Capital levels in the system are more than three times higher than they were before the crisis as banks pre-empt the requirements of new Basel III global standards. 

Financing is more stable, with far less reliance on risky short-term market funding and new incoming rules demanding banks hold minimum levels of cash and safe assets. 

Big acquisitions are a thing of the past, too, with regulators making it clear such dealmaking is unwelcome. 

And the kind of complex structured investments that spread the contagion of US subprime mortgage losses around the world are close to extinct, the victim of regulators’ higher capital charges and banks’ lower risk appetites....

The one category of the FT’s five triggers of failure that is immune to regulation is bad lending – a perennial curse of banking since the Middle Ages and one that in the heat of the crisis, when the focus was on complex collateralised debt obligations, was often neglected. 

“The crisis was overspun as a markets problem,” says Robert Law, a former banks analyst and adviser to the UK’s recent parliamentary commission on banking standards. “There were major problems in traditional lending, too.” 

According to the FT’s analysis, this was the single biggest factor in the crisis. Of the 34 big banks that failed, three-quarters succumbed in large part because of the poor quality of basic lending – in particular to residential and commercial mortgage customers. 

There is little that the authorities can do directly in a market economy to curb foolish lending practices by private sector banks.

Authorities cannot do much directly about lending as they don't want to be in the position of allocating capital throughout the economy.

As a result, bank examiners don't approve or disapprove of any exposure taken or loan made by a bank.  Rather, bank examiners ask if the bank has enough capital to absorb any losses that are likely to result from the exposure or loan.

Hence, we have the following:

But reformers argue that a laser focus on capital, which can absorb losses, is the essential way to protect the system from further harm.

Unless regulators are willing to let banks take losses, something they have not done since the beginning of the financial crisis, capital is not the way to protect the system from further harm from foolish lending.

Rather, transparency is the way to protect the system from harm by foolish lending by private sector banks.  Transparency protects the system in two ways.

First, transparency allows market discipline which restrains banks making foolish loans in the first place.  It does this because market participants can see what loans the banks are making and can assess whether or not these loans are properly priced.

Second, transparency allows market participants to reduce their exposure to banks that make foolish loans.  By reducing their exposure to what they can afford to lose should a bank that makes foolish loans go under, market participants eliminate any possibility of contagion from the bank's failure.

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 – Barclays, Deutsche 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.