Satyajit Das wrote an interesting column about how rather than dismantling the financial doomsday machine that failed so spectacularly in 2008/2009, policymakers have instead embarked on mission impossible.

Policymakers are trying to make the financial system safer through regulation at the same time bankers are making it riskier by creating products that circumvent these regulations.  Compounding this problem is the simple fact the regulations’ effectiveness has already been compromised by the lobbying efforts of the banks while the regulations were being written.

Mr. Das looks at six problems our current large banking systems create.  All six problems are manageable if there is transparency.

First, the role of banks expands beyond support for the real economy, facilitating payments, capital formation and deployment and risk transfer. Economic activity becomes inordinately dependent on trading financial instruments and channelling rapid capital movements, which are largely zero-sum games or relatively low economic value-added functions.

Transparency and the market discipline it makes possible limits banks taking proprietary bets.  With transparency, the cost of taking proprietary bets increases.  Market participants can see the risk being taken and will want to be compensated for this risk.  At the same time, market participants can also front run the banks.  This dramatically reduces the potential reward from and increases the potential loss on a proprietary bet.

Second, the commercial drive for growth and higher profitability leads to increased risk taking. For example, the need to grow loan volumes may require lowering lending standards or taking other risks. This is what happened in the led up to the 2008 financial crisis, exemplified by the sub-prime loans in the US.

Transparency doesn’t prevent risk taking.  What it does is insures this risk taking is properly priced.  If a bank reduces its lending standards, it will see its cost of funds increase to reflect the higher risk of its new loans.

Third, there are complex linkages between banks and financial entities, both within countries and internationally, reflecting the mobility of capital and cross-border transactions. In 2008, the dangers of these connections were exposed as the globalised financial system’s intricate linkages became a conduit for transmitting contagion. It led to a sharp fall in cross-border capital flows, which remain well below the pre-crisis levels.

Transparency ends contagion.  Every investor knows in exchange for transparency they need to limit their exposures to any investment to what they can afford to lose.  The same holds true for banks.  When banks have to provide transparency and disclose their exposures, investors can see if there are any exposures greater than what the bank can afford to lose.  Market discipline insures banks reduce these exposures to a level where contagion risk ceases.

Fourth, frequently (untested) financial innovations create new risks, both for individual institution and systemically. It also allows rent seeking by banks and financiers, who exploit the asymmetry of information between sellers and buyers of complex products. It also creates control issues as managers, directors and regulators are unable to keep up with new developments. During the 2007/ 2008 crisis, the problems of higher risk mortgages, CDOs and the shadow banking system populated by off-balance sheet vehicles illustrate these risks.

Banks have an incentive to create opaque securities as they have a higher margin than transparent securities do.

The Transparency Label Initiative directly addresses this issue by reminding investors they don’t have the information they need to know what they are potentially buying.

Fifth, the identified problems are amplified by the leverage of financial firms. In the last 20 years, capital ratios and liquidity reserves of banks have fallen sharply. Leverage is increasingly used to drive higher and more volatile returns on equity. During the GFC, the high leverage, both on and off-balance sheet, accentuated the problems.

 

Leverage has always been a red herring argument.  What allows financial firms to take on too much risk is opacity.  If financial firms had to provide transparency, market discipline would restrain their risk taking so it is consistent with what they can afford to lose.

Sixth, the increase in size of the banking system, risk and complexity is implicitly underwritten by the state, a fact which is recognised by rating agencies. It typically takes the form of deposit insurance, liquidity insurance and implied capital support. Given the central role of banks in payments and credit provisions, it is difficult for governments to allow banks to fail.

So long as banks are opaque, it is impossible for governments to allow the biggest banks to fail. Rightly, there will always be fear of contagion across the financial system.

However, if banks are transparent, then it is possible for government to allow the biggest banks to fail.  Transparent banks can fail because their failure doesn’t risk triggering contagion.

Since 2008/2009, have our policymakers embraced transparency to address these problems?  No.  Instead, they have pursued mission impossible and tried to get the benefits of transparency and market discipline using complex regulations and regulatory enforcement.