Regulators' information monopoly is an impediment to investors

A Wall Street Journal Heard on the Street column provides yet another example of how the financial regulators' information monopoly causes investors difficulty in evaluating and properly pricing the risk of banks.

Here's a lesson for the government and Ally Financial in particular: With bank investors fretting about the potential costs of soured-mortgage claims, it is best to get the details out in the open. 

That's the opposite of how Ally and Freddie Mac handled a payment last year of $325 million by the firm to the mortgage company to settle mortgage-repurchase claims. Neither Ally, General Motors' former financing arm now majority-owned by the government, nor government-owned Freddie disclosed the amount of the settlement when it occurred. The fact that a deal was struck at all was only disclosed by Ally and Freddie in quarterly securities filings. 

The $325 million payment has now come to light only in an exhibit tucked deep within an amended offering document recently filed by Ally as part of a planned sale of shares to the public. And that disclosure only happened after prompting by the Securities and Exchange Commission. 

This episode underscores the challenge for bank investors trying to assess risks posed by demands that banks repurchase soured mortgages. Concerns over legal risk, along with fears of a weakening economic outlook, have weighed on bank shares of late. 

... The problem is the lack of detailed disclosure. Even now, neither company has disclosed the amount of loans covered by the settlement. That makes it hard for investors to know how to interpret the deal and how tough a negotiating stance the government took. 

The government's role is central. It controls Freddie and Fannie, which guaranteed trillions of dollars in loans originated by banks and, with their value sinking, have demanded that banks repurchase billions of dollars of them. And investors have to question how the government is balancing the need to lessen taxpayer losses at Fannie and Freddie against a desire to avoid actions that may destabilize banks, like playing hardball on soured-loan repurchases. 

This has broad implications. Fannie and Freddie's regulator, the Federal Housing Finance Agency, is nearly a year into an inquiry of private-label mortgage securities sold by banks to investors, including Fannie and Freddie. While banks already have settled some claims for repurchases of soured mortgages with Fannie and Freddie, the FHFA could decide banks need to repurchase more. Bank of America, for example, has $222 billion in at-risk, private-label securities that weren't covered by past settlements with Fannie and Freddie. The bank hasn't said how much of these are owned by Fannie or Freddie. 

Understanding the economics and rationale behind settlements such as the Ally deal are, therefore, important for both bank investors and taxpayers. The lack of disclosure cuts both ways. In January, some members of Congress questioned whether mortgage settlements with BofA and between Ally and Fannie actually were back-door bailouts. In other words, the deals may have been too favorable to the banks. The FHFA's response that the deals were in Fannie's and Freddie's best interests hasn't resolved the uncertainty. It said detailed information concerning the agreements is proprietary. 

That may be the case for normal companies. But Fannie and Freddie, which have received $138 billion in taxpayer funds, aren't normal. As Democratic U.S. Rep. Maxine Waters said in a letter to the FHFA, loan-repurchase agreements involving them are "a matter of critical importance to the public interest," and so "transparency is therefore essential." 

It's bad enough the government is influencing the market in so many ways. The least it can do is be clear about its actions.

WSJ doubts bank capital is a panacea

A Wall Street Journal Heard on the Street column expressed doubts about bank capital as a solution.

Higher levels of capital aren't a panacea for banks. 

That is a lesson from this week's release of the Federal Deposit Insurance Corp.'s quarterly banking profile. The FDIC noted that 96% of the nation's banks "met or exceeded the highest regulatory capital requirements." 

In other words, only 303 institutions—the other 4%—failed to meet the highest capital requirements. But the FDIC also reported that the number of institutions on its "Problem List" increased by four during the quarter to 888. Banks placed on the problem list are in greater danger of failing. 

This means that there are 585 problem institutions that ostensibly have more than enough regulatory capital, a measure of loss-absorbing equity adjusted for a variety of factors. How can this be? The FDIC looks at more than just capital levels when deciding whether an institution is at risk. This illustrates why investors should use measures of regulatory capital only as a starting point in assessing bank strength. 

This paragraph highlights everything that is wrong with the financial regulators having a monopoly on all the useful, relevant current information on banks and why the focus on regulatory capital is misguided.

The starting point for an investor determining if a bank is solvent is to look at the current value of its assets and the book value of its liabilities.  A bank is solvent if the current value of its assets exceeds the book value of its liabilities.  It is insolvent if the current value of the assets is less than the book value of its liabilities.

This starting point is also the same starting point that investors use for exerting market discipline on banks.  If the risk of a bank's assets increases, investors adjust both the amount and pricing of their exposure to the bank.  This is market discipline.

However, because of the regulatory monopoly on current asset level data, investors cannot analyze the solvency of a bank or exert market discipline.  Instead, they have to rely on the financial regulators to do this.

Unfortunately, financial regulators do not do this.  For example, look at the 585 problem institutions referenced above.  Instead of closing these institutions, the financial regulators have adopted the policy of gambling on redemption.  This involves hiding the fact that the banks are highly likely to be insolvent and hoping that something will occur that will restore the banks to solvency. 

A paper last week by Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, and Charles Morris, a Fed economist, also pointed out the danger of overreliance on capital levels. The two argued that new, tougher, international standards governing capital rules for banks won't be enough to curtail the risk posed by too-big-to-fail banks. 

Messrs. Hoenig and Morris cited "the complexity of the largest financial companies and the variety of their activities." Their solution? Break up big banks by splitting one group of businesses—lending, asset management and underwriting and advisory work—from activities such as brokerage and market-making activity as well as trading for their own accounts. 

That is a radical Rx. Then again, it would acknowledge that even the best-crafted capital requirements aren't always enough to make sure banking boats won't capsize in a market storm.

Your humble blogger has been advocating a far less radical Rx that has passed the test of time.  The solution is to make each bank's current asset and liability-level data available to all market participants.

With this data, market participants can evaluate the risk of each bank and adjust the pricing and amount of their exposure relative to this risk.  This brings market discipline to bear on banks as investors understand that they are at risk of loss of their investment if a bank were to become insolvent.

With the disclosure of the current asset and liability-level data, it also ends the era of financial regulators gambling on redemption and forcing investors to guess which banks the regulators are gambling on.  For example, are the regulators gambling on the Too Big to Fail banks today?

The Race to the Bottom in Capital Requirements Begins

Contrary to the financial regulators' claims, the race to the bottom in capital requirements has begun.

According to a Telegraph article

Michel Barnier, the Commissioner responsible for the internal market and services, said suggestions that he would not fully impose Basel III were "unjustified and factually wrong". "Europe will implement Basel III: we have said it before and I confirm it to you today, the Commission's proposals to implement Basel III will respect the balance and level of ambition included in Basel 3," said Mr Barnier on Friday. 

... Mr Barnier said he would "not be swayed" from imposing the rules, despite warnings that they could harm Europe's economic recovery.

"A few weeks ago, some people were accusing us of damaging the economic recovery by implementing rules which would be too tough for banks because they would impede their lending to the real economy. 

Today, others seem to accuse us of the opposite with suggestions Europe would not be implementing Basel properly, thus not learning all the lessons from the crisis," he said.

Experience shows that regulators can be swayed.  If we look at disclosure for structured finance securities, we see the regulators embracing the disclosure practices that gave these securities the moniker "opaque" when their goal was to allow investors to know what they own.

You know it is bad when ...

Bloomberg carries an interesting article on even FINRA fining Credit Suisse and Bank of America for failing to disclose all the useful, relevant information in an appropriate, timely manner to investors in RMBS securities they underwrote and sold.

Credit Suisse Group Inc. will pay $4.5 million and Bank of America Corp. (BAC)’s Merrill Lynch unit will pay $3 million to resolve Financial Industry Regulatory Authority claims that they misrepresented delinquency data in issuing residential subprime mortgage securitizations. 

Credit Suisse Securities failed to inform clients of misrepresentations on 21 subprime RMBS it underwrote and sold in 2006, Washington-based Finra said in a statement today. In a separate case, Merrill Lynch negligently misrepresented delinquency rates for 61 subprime RMBS, though it corrected the errors on its website in June 2007, Finra said. 

“Firms must provide accurate information about the products they offer,” Finra enforcement chief Brad Bennett said in the statement. “Credit Suisse and Merrill Lynch failed to monitor and supervise the reporting of historical delinquency rates, depriving investors of information essential to assessing the profitability of mortgage-backed investments.” 

The two companies agreed to resolve the claims without admitting or denying wrongdoing. 

Issuers of subprime RMBS are required to disclose historical performance information for past securitizations that contain mortgage loans similar to those being offered to investors, Finra said. Because there are different standards for calculating delinquencies, issuers are required to disclose the specific method they used, the brokerage regulator said. 

... For six of the securitizations from Credit Suisse and eight from Merrill Lynch, Finra said the errors “were significant enough” to affect investor assessments. 

The agreement between Finra and Zurich-based Credit Suisse said the bank’s outside servicer of the 21 securitizations “had provided inaccurate delinquency data” between January and September of 2006. The data was “variously underreporting and overreporting delinquencies for different securitizations within this period,” according to the letter, which was posted on Finra’s website. 

Bank of America’s agreement with Finra also said that the Merrill Lynch errors both understated and overstated delinquencies in various mortgage pools.

Buy-side Responsible for Losses Under the ECB's ABS Data Warehouse

The Market Group informed your humble blogger that his firm was not on the short list to build the ECB's ABS Data Warehouse.  This was not surprising given that the selection criteria were not:

• Have you built the envisioned ABS data warehouse before (to date, only my firm has); 

• Are you free of the conflicts of interest that the European Union's Competition Committee finds unacceptable in any firms who have or could control a financial information vendor (my firm is notably free of conflicts of interest);

• Do you need funds from investors to build the data warehouse (my firm did not);

• Is the data warehouse you are going to operate going to provide all the useful, relevant information on a current basis for free to all market participants or is it going to charge market participants for access to stale information that guarantees Wall Street retains the equivalent of an insider informational advantage when valuing and trading ABS securities (my firm was going to offer current information for free and eliminate Wall Street's informational advantage)?

Given that these were not the selection criteria, the question the comes to mind is:

What if the ABS Data Warehouse does not restore investor confidence because it is riddled with conflicts of interest from its controlling ownership through its constructor/operator and lacks all the useful, relevant data in an appropriate, timely manner so that an investor could know what they own?

Then the ECB will get to see if it adhered to the advice of Walter Bagehot who said over a century ago that central banks were suppose to lend freely against good collateral.

If the ABS data warehouse fails to restore investor confidence, the ECB will continue to hold almost 500 billion euros of ABS securities of which almost 300 billion euros worth are securities from Greece, Ireland, Portugal and Spain.  The passage of time will show if this collateral is good or not.

Why should the ECB's proposed ABS data warehouse end the buyers' strike?  After all, investors have plenty of investment opportunities other than ABS securities where they do have access for free to all the useful, relevant information in an appropriate, timely manner.

Why invest in securities which have a track record of showing that Wall Street is willing to use its information advantage for its benefit and to the detriment of investors [think shorting sub-prime mortgage backed securities]?

But what if the ECB's ABS data warehouse does end the buyers' strike?  Then, I would have a long and lucrative career as an expert witness.

I would be able to go from case to case where investors lost money on their structured finance investments and testify in their lawsuits against the money managers.  This opportunity would be available because I strongly doubt that any money manager would disclose the following to a perspective investor:

Due to a lack of current information on the underlying collateral performance, investing with me in structured finance securities is asking me to blindly bet on your behalf as there is no way for me to actually know what I am buying or selling.  Without actually knowing what I am buying, I do not know how to tell if the price Wall Street shows represents the bigger fool as a buyer or seller.  Therefore, I cannot make informed investment management decisions.

So long as money managers are investing their clients' money without this disclosure, they are guaranteeing their investors that the investors will not lose money.  How could it be otherwise?

• The money managers know that the disclosure in the ECB's proposed ABS data warehouse is the same level of disclosure that was not adequate for BNP Paribas to value sub-prime mortgage backed securities in August 2007.  

• The money managers know that under Article 122a of the European Capital Requirements Directive they have an obligation to know what they own.  No amount of lobbying by the sell-side or regulatory incompetence changes the legislative intent.  The European Commission and European Parliament knew what level of disclosure was inadequate for BNP Paribas and they did not intend to set this level of disclosure as adequate for knowing what you own.

Common sense tells money managers that if the level of disclosure was not adequate for BNP Paribas to value securities, it is not adequate for knowing what they own.

It is simply not a defense to say "well other money managers were buying these securities".  Money managers have a fiduciary duty.

The suggested investment management disclosure by is necessary because without the current data I proposed the ECB's ABS data warehouse should collect and distribute for free, buying an ABS security is just betting on the value of the contents of a brown paper bag.  For any money manager who believes otherwise, I invite them to take the Brown Paper Bag Challenge!

'Dark Forces' fighting financial reform really oppose FDR Framework

Bloomberg ran an article in which Tim Geithner observed that there were 'dark forces' fighting financial reform.

As you can imagine, the FDR Framework, with its call for disclosing to market participants all the useful, relevant information in an appropriate, timely manner, is a lightning rod for the dark forces' fight.

The dark forces know that if the FDR Framework is fully implemented, the ability to profit from opacity is eliminated.

Unfortunately, the dark forces have an ally in the fight against the FDR Framework.  Their ally is the information monopoly on all the useful, relevant current asset and liability-level data held by the global financial regulators.

The dark forces know that financial regulators are reluctant to give up this information monopoly because it implies significant changes in what the financial regulators can do.

Giving up their monopoly implies that gone are the days when financial regulators can put the financial system at risk for a credit crisis like we just experienced and rush in with taxpayer money to bailout the financial institutions.

Instead, financial regulators would be held responsible for

• making sure to error on the side of 'too much' disclosure when ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner; and

• analyzing this information with the help of market participants so that the price and amount of the government exposure to any financial institution reflects the riskiness of that institution.

As reported by Bloomberg:

Treasury Secretary Timothy F. Geithner said “dark forces” are waging a “war of attrition” against efforts to strengthen regulation of the financial system. 

“You’re seeing some people run a war of attrition against the reform act,” Geithner said at an event today in Washington, without identifying the people. “They’re trying to starve the agencies of funding so they can’t enforce protections for investors.” 

Geithner also said opponents of the Obama administration are trying to block presidential appointments to regulatory agencies “as a way to get leverage over the outcome, and they’re trying to slow down so that they can weaken over time the thrust” of the Dodd-Frank financial overhaul law. “We’re not going to let that happen.” 

... Asked by a moderator at the breakfast held by Politico to identify the “mysterious forces” working against the administration, Geithner said, “dark forces, I would say.”

Where is Europe's John Reed? [updated]

Where is Europe's John Reed?  Where is the head of a major European bank who will shake the European financial regulators out of their cover-up mode and stop the governments where the lenders are based from putting enormous political pressure on the borrowing countries to adopt austerity?

John Reed was the Chairman of Citicorp during the mid-1980s.  Among his many achievements was overseeing the first write-downs of loans to less developed countries.  For this, he was put on the cover of the mainstream media weekly news and business magazines.

Why was this such a big deal?

Because until he publicly acknowledged that the value of the loans to less developed countries on Citicorp's balance sheet was not the 100 cents on the dollar they were carried at, but rather the 60 cents on the dollar that a Bloomberg terminal showed they traded for, financial regulators acted as if this valuation problem did not exist.

Financial regulators justified their cover-up by saying they were concerned that when the capital markets found out how bad the losses on the banks' balance sheets from loans to less developed countries were, it would spark a financial crisis.

As everyone who is familiar with the FDR Framework knows, stability in the financial system comes from market participants having all the useful, relevant information.  


Instability in the financial system comes from regulators using their information monopoly to cover up a problem that the market knows exists, but in the absence of the useful, relevant information the market participants cannot quantify and price the risk.

A fundamental prediction of the FDR Framework, which has proven true for 75+ years, is that financial markets do not implode when market participants have access to all the useful, relevant information.  


The corollary, which has also been proven true with the most recent credit crisis, is that financial markets do implode when market participants do not have access to all of the useful, relevant information.

It is a matter of fact that Citicorp's stock price went up significantly on the day John Reed announced the write-downs and for several days thereafter.  It is also a matter of fact that the rest of the global banking system followed his lead and that they too saw their stock price increase.

In fact, with the issue of the valuation of the loans to the less developed countries addressed, many of the banks were able to tap the capital markets for more equity.

One of the financial firms that followed John Reed's lead was Security Pacific Corp, at the time a Fortune Top 10 US bank holding company.  It had a significant portion of its loan portfolio concentrated in loans to less developed countries.  In fact, had Security Pacific matched the percentage write-down taken by Citicorp, it would have had negative equity.

Did this fact cause a run on the bank at Security Pacific?  No.

Did this fact cause Security Pacific's stock price to drop to zero?  No.

Market participants understood that Security Pacific would need to rebuild its capital and factored that into the price and amount of their exposure to the bank holding company.

What does this have to do with Europe?

The situation in Europe is virtually the same as John Reed faced.

• A quick check of a Bloomberg terminal would show that like the loans to the less developed countries the debt of Greece, Ireland, Portugal and Spain are not trading at par.  

• For their part, financial regulators are engaged in a cover-up.  They are not a) disclosing each financial institutions' asset-level exposure or b) requiring financial institutions to write-down the value of their exposure to market prices.

• Governments where the lending financial institutions are located are working feverishly to promote austerity to try to keep the value of the debt at par.

• Market participants do not have the information they need to assess the risk of and properly price the securities of the financial institutions.

There is no reason to believe that the financial markets will not react in the same way to a European financial institution CEO stepping up and announcing a write-down of their exposure to existing market price levels.

Hence the question, "Where is Europe's John Reed?"

China on path to requiring current asset-level disclosure by banks

The Wall Street Journal carried an article on China's bank regulator taking steps to establish a leverage ratio as part of its efforts to curb credit risk in its banking system.  This is the next step along the path that will ultimately lead to requiring the banks to provide current asset level disclosure.

As discussed in an earlier post in which the Economist Magazine called for a new model of bank supervision, requiring current asset level disclosure is necessary to overcome the shortcomings of what China's bank regulator calls inadequate traditional bank supervision.

In addition, once market participants can see the quality of a bank's current on- and off-balance sheet assets, they can adjust both the price and amount of their exposure to the bank so they are properly compensated for risk.  This market discipline acts as a constraint on the riskiness of the bank's asset portfolio.

China's banking regulator has proposed that banks have a 4% minimum leverage ratio to curb credit risk, and analysts said the nation's banks are likely to take the requirement in stride. 

But some analysts said that tighter regulation and looming risk could point to slower growth in the medium term. 

The China Banking Regulatory Commission said late Friday in a statement that it is seeking public opinion on the proposed regulation, which requires that the leverage ratio for commercial banks, including both on and off-balance sheet assets, shall not be lower than 4%. The leverage ratio is generally calculated as core capital as a proportion of total adjusted assets. 

"It is now widely agreed that we should introduce a simple, transparent and non risk-sensitive leverage ratio tool -- in addition to the current capital adequacy tool -- to effectively control the degree of leverage in the banking system," the CBRC said in a statement. 

It went on to say that the financial crisis showed that traditional supervision is inadequate because some Western commercial banks were over-leveraged despite having high capital adequacy ratios. 

The leverage ratio is an additional tool to complement minimum capital adequacy requirements, and thereby reduce the risk of excessive leverage building up in individual banks and in the financial system as a whole. 

"The new regulation is likely to create pressure for some banks to replenish capital, but most listed commercial banks will basically meet the requirements," said Li Shanshan, a banking analyst at Bocom International in Beijing. 

"Some banks will meet the requirements after they complete capital-raising exercises by the end of this year," she said. 

Four commercial banks--the China Merchants Bank, Everbright Bank, Shenzhen Development Bank and Huaxia Bank--do not meet the requirement now, but are likely to meet the requirement after their refinancing plans are completed later this year, she said. 

The CBRC issued new regulations early this month to bring management of the country's banking system in line with new global banking requirements that are known as the Basel III rules. 

It stated that systemically important financial institutions will have to comply with a minimum capital adequacy ratio of 11.5%, while non-systemically important financial institutions will face a capital adequacy ratio of 10.5%. 

The regulations will start to apply in 2012 and banks will be expected to meet all requirements by 2016, two years ahead of the Basel III schedule, the CBRC said at that time. 

China's banking authority has repeatedly raised the minimum capital adequacy ratio for banks to slow loan growth and rein in credit risks amid a lending binge of around CNY18 trillion over the past two years. 

However, analysts have been warning that massive loans to local government financing vehicles and the property sector may hold risks for China's banking sector in the coming years despite its current bumper earnings. 

Lu Lei, vice president of Guangdong University of Finance, warned in an article in the Century Weekly magazine Monday that China's banking sector is facing a downturn. 

He estimated that Chinese banks may need to raise as much as CNY4 trillion over the next four years to boost capital if their assets double and if the government doesn't change the current requirement on capital adequacy. 

"A downturn is unavoidable if under credit tightening there is a fall in asset quality, the banking system could become a 'black hole' for capital," he said. 

Banks will also be required to have a loan-provision ratio of at least 2.5%, meaning that percentage of the total loan book must be set aside to guard against losses. The provision coverage ratio, or the amount of non-performing loans that are already covered by provision, will be at least 150%. 

The Economist Magazine lays out the problem with existing bank supervision model

The Economist Magazine ran a special report in which it discussed a number of shortcomings of the current system of regulating banks and the need for a new model of bank supervision.

As this blog has previously discussed, the current model of bank supervision gives regulators an impossible task.  The Economist lays out why the task is impossible.

In the old days, in so far as they worried about the risk of banks going bust, regulators usually relied on simple measures of health, concentrating on making sure the right paperwork was in the files, says one senior regulator. “It was a wood-and-trees problem,” says another official. “You would go in and come up with a list of 45 things a bank could do better, but you would not be saying: ‘What are the five important things that could threaten this bank?’” 

In the new world of regulation, supervisors are still doing some of the things they have always done. They are tightening capital standards and looking far deeper into the inner workings of banks, down to the plumbing that connects them to one another. “Regulators have gone from saying ‘tell me all your [payment] systems work’ to saying ‘show me how they work’,” says Simon Bailey, of Logica, a technology firm. “They are shining a pretty bright light on parts of the banking system that are massively complex and, if I’m being polite, slightly dusty.” 

Far more controversially, though, regulators are now also tentatively stepping over a long-standing divide between enforcing basic rules and playing a part in business decisions. In regulator-speak the difference is between “conduct regulation” and “prudential regulation”. Under the old rules supervisors were simply referees trying to ensure that the game was played fairly.... 

At first glance it seems sensible that regulators should pay attention to banks’ health as well as to their conduct. Regulation, after all, is the price that society demands, and banks pay, in return for the implicit promise of a government bail-out if the worst happens. The reason banks are regulated and hairdressers are not is that a badly run barber poses little danger to outsiders. Banks, on the other hand, cause widespread chaos when they collapse. One sick bank going broke can destroy confidence in the entire banking system and start runs that could bring down healthy banks too. Most advanced economies try to prevent that by offering deposit insurance to savers. They also regulate banks to make sure they do not gamble with savers’ protected deposits. 

But it is not easy to stop banks from making bad decisions. In the past regulators have tended to leave it to the market to judge the health of banks, not least because they themselves did not feel up to it. Legions of clever, well-paid investment analysts and investors failed to see the crisis coming. Those who did are remembered mainly because there were so few of them.

Under the FDR Framework, it is not the job of regulators to stop banks from making bad decisions.  By making sure that market participants have access to all the useful, relevant information, when banks make bad decisions, the market quickly disciplines them.

Under the FDR Framework, it is not the job of the regulators to replace the wisdom of the market.  Instead, by making all the useful, relevant information available to the market participants, the regulators can tap competitors and credit and equity market analysts for insights.

A primary reason that almost all analysts did not see the crisis coming was they did not have access to all the useful, relevant information.  

Now central bankers and supervisors are expected to make a better job of it, but most would prefer not to get too involved. “We don’t want to get into the business of making very close business judgments,” says one American official, but “we are making a judgment of our own about whether they have a coherent strategy and coherent risk management.” 

Under the FDR Framework, regulators also have the role to act like investors and protect their investment, deposit insurance.  As an investor, they should not try to run the bank.  Rather, they should adjust the price and amount of exposure based on the riskiness of the bank.  As the risk goes up, so too should the effective cost of deposit insurance to the bank.  This increase in cost can take many forms including higher capital requirements.

One problem is that rules and laws are written with the benefit of hindsight. The good ideas that might well have prevented the last crisis, however, can make regulators dangerously overconfident about being able to predict and prevent the next one. 

Actually, the FDR Framework came out of the last major crisis.  Had it been fully implemented, it would have mitigated the severity of the recent credit crisis.  Where the financial markets failed in the valuation of banks and structured finance securities was where there was opacity that prevented market participants from accessing all the useful, relevant information.

Besides, the regulators’ reluctance to second-guess bank executives was well founded, because it can take them onto dangerous ground. If regulators underwrite certain strategies that seem safe, such as lending to small businesses or helping people buy houses, they may encourage banks to crowd into those lines of business. That can drive down interest rates and lending standards and push up asset prices. If enough banks pile into these markets, downturns in them can affect not just a few banks but the whole system. Paradoxically, the very act of signalling that a market is safe can make it dangerous. It also introduces a form of moral hazard, because banks and their creditors may assume that the government would be duty-bound to bail them out if a closely monitored institution were to fail. 

This moral hazard speaks very clearly on why disclosure of all useful, relevant information is necessary. 

On the other hand over-strict regulation can also be harmful if it stifles financial innovation and squeezes all appetite for risk out of the banking system. In Japan, a banking crisis that started more than two decades ago still lingers on, in part because the country’s bankers have become gun-shy and tend to buy government bonds rather than lend money.

Over the last three decades, the focus of financial innovation has been to create opaque products that are difficult for market participants to analyze, assess the risk of and accurately value.  While adherence to the FDR Framework would stifle these innovations, it would not effect valuable innovations like the invention of the ATM.

And even if supervisors rule wisely, they have to keep it up year in and year out to remain effective. “I worry that supervision is an endless process of having to get better,” says a senior regulator in Britain. “You have to keep hiring lots of clever people and you have to avoid atrophy over time.”

By disclosing all useful, relevant information in an appropriate, timely manner, the regulators can leverage off the market, its clever people and its endless process of analyzing all the available information. 

Most regulators are doing all they can to mitigate these risks. Many are concentrating on changing incentives in the banking system, in the hope that this will change behaviour. Yet they also know that in the new world of intensive regulation the very need for it is an admission of failure.

The failure of the old system where regulators have a monopoly on all useful, relevant information in an appropriate, timely manner.

The Economist Magazine calls for new model of bank supervision

The Economist Magazine ran a special report in which it discussed a number of shortcomings of the current system of regulating banks and the need for a new model of bank supervision.

BANKING CRISES OF the sort that affect a large part of the world, slowing global economic growth, freezing finance and crimping international trade, are mercifully rare.... The costs of any such meltdowns are difficult to estimate... It is not just a question of totting up the direct costs of bailing out the banks or transferring debt from private balance-sheets onto those of the state. There is also the toll of broken lives, lost homes...

Most of the time, though, banks do not blow up. When things go well, they help to produce growth and wealth. They also make people’s lives easier.... 

Regulators and their political masters now have to ensure that the benefits of a vibrant and innovative banking system are ever more widely spread and meltdowns become ever rarer. ...

Yet there are still fundamental flaws in the global financial system. All the measures that regulators are putting in place to try to make banks safer, such as higher capital requirements, stricter regulation and limits on risk-taking, need to be tested against a simple question. If all other safeguards have come to naught, can big financial institutions be allowed to go bust (or be saved without asking taxpayers to stump up)? ....

Regulators are finding it hard to crack this problem... because they are being excessively cautious, seeking certainty before they act. Like a jury in a criminal trial, they are looking for evidence that is beyond reasonable doubt. 

Actually, the FDR Framework has 75+ years of evidence that shows it solves the regulators' problem.

As this blog has documented on several occasions [see here, here, here, here and here for example], it it the regulators' monopoly on all useful, relevant information for financial institutions that is the source of financial instability and the reason that it is impossible to let big financial institutions go bust.

This monopoly forces market participants to be dependent on the regulators.  This monopoly prevents the market participants from performing their risk management function and properly adjusting both the price and amount of their exposure based on the risk of a financial institution.  

If the regulators were to give up their monopoly on all the useful, relevant information, they would be able to let banks go bust again.  The FDR Framework explains why through its combination of disclosure to market participants of all useful, relevant information in an appropriate, timely manner with the principle of caveat emptor [buyer beware]. 

With access to all useful, relevant information, market participants can now evaluate the riskiness of an investment in a financial institution.  With the ability to do their homework, the market participants accept all the gains or losses on any investment knowing the investment was made under the principle of caveat emptor.

It is the ability to control exposure combined with the acceptance of losses that allows financial firms to go bust without causing a financial crisis.  Financial firms can go bust again because market participants only have as much exposed to a financial firm as they feel comfortable losing.