Saturday, November 3, 2012

When will financial regulators admit their mistake of protecting opacity

The Guardian reported on a speech given by FSA Chief Lord Turner, a candidate to be the next governor of the Bank of England, in which he showed zero appreciation for the role opacity played in the financial crisis of 2007-08.

Regular readers are not surprised that Lord Turner would not want to talk about opacity.

Under the FDR Framework, regulators are given the responsibility for not allowing opacity into the financial system and ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner to independently assess the risk of an investment and make a fully informed investment decision.

Clearly, the regulators did not fulfill their responsibility.  There are large areas of the financial system that are opaque including banks and structured finance securities.

When the financial crisis hit in 2007-08, it was the opaque areas that collapsed.

Turner said a lesson from the crisis was that commercial banks and the shadow banking system which can create credit and money to finance asset price booms were "inherently dangerous institutions".
They are only dangerous if they are opaque.  That is the lesson from the financial crisis of 2007-08.
He added that "optimal regulation of banks and shadow banking must reflect a recognition that the private financial system, left to itself, will tend to create excessive debt contracts, and excessive leverage".
It was opacity that allowed the private financial system to create excessive debt contracts and excessive leverage.  As the Bank of England's Andrew Haldane says, banks are 'black boxes'.  Your humble blogger refers to structured finance securities as 'brown paper bags'.

With opacity, market participants cannot independently assess risk and exert market discipline.

Leading up to the financial crisis of 2007-08, market participants trusted the global financial regulators when they said that financial innovation has reduced risk in the banking system.

Market participants also trusted the Rating Agencies when they represented the riskiness of structured finance securities.  Underlying the Rating Agencies "influence" is the idea that the firms have access to data that is not publicly available.  It was not until after sub-prime mortgage backed bonds started to implode that the Rating Agencies testified to the US Congress that they did not have access to data that was any different than market participants.
Turner said: "The financial crisis of 2007-08 revealed how deeply flawed were the assumptions of the pre-crisis conventional wisdom. Free market finance left to itself will create huge instability – too much leverage in the real economy and within the financial system, too volatile a new credit supply, too much complexity and dangerous interconnectedness. Increased financial intensity is not limitlessly beneficial."
Bankers left to themselves will bring opacity that they alone can profit from into the financial system.  It was the failure of regulators that the regulators allowed this to happen.

For example, the reason we have too much interconnectedness is that market participants did not have the information they needed to be able to independently assess the risk of the banks.  Instead they relied on financial regulators who incorrectly assessed the risk of the banks.

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