In his last speech as a Fed Governor, Daniel Tarullo offered his opinion on the regulatory reform efforts he lead.  The speech provides a nice summary of why all the Dodd-Frank Act driven financial regulation works in theory, but not in practice.  He cites as examples of this gap the Volcker Rule, bank capital regulations and stress tests.

Readers of Transparency Games aren’t surprised the regulators have struggled with all three of these examples.  Each is an area where the financial regulators are trying to substitute complex rules and regulatory enforcement for transparency and market discipline.

Mr. Tarullo observed about the Volcker Rule and its related regulation:

During the debates on what became the Dodd-Frank Act, former Chairman Paul Volcker offered a fairly straightforward proposal: no insured depository institution or affiliate thereof should be permitted to engage in proprietary trading. It seemed then, and seems now, like an idea that could contribute to the safety and soundness of large financial firms. However, several years of experience have convinced me that there is merit in the contention of many firms that, as it has been drafted and implemented, the Volcker rule is too complicated. Achieving compliance under the current approach would consume too many supervisory, as well as bank, resources relative to the implementation and oversight of other prudential standards. And although the evidence is still more anecdotal than systematic, it may be having a deleterious effect on market making, particularly for some less liquid issues.

Shorter, the Volcker Rule is a really good idea, but it isn’t practical given the current limitations of regulations and regulatory enforcement.

For good measure, Mr. Tarullo adds:

Had there been an obviously better approach, we would have taken it five years ago.

There was an obviously better approach and I offered it up five years ago.  The Volcker Rule could be reduced to two paragraphs. Paragraph One says no insured depository institution or affiliate thereof should be permitted to engage in proprietary trading.  Paragraph Two says insured depository institutions and their affiliates will disclose their end of business day exposure details so compliance with Paragraph One can be confirmed.

The market can be expected to confirm compliance and restrain proprietary trading.  The market has shown it will do so because, as illustrated by JP Morgan’s London Whale experience, there is money to be made reducing the profitability of these proprietary bets once they are known.

Mr. Tarullo then moved to bank capital and its regulation:

The history of financial regulation over the last several decades is in many respects defined by an increasing emphasis on capital requirements and, specifically, higher minimum ratios based on a more rigorous definition of what constitutes loss-absorbing capital. This tendency can be explained by the fact that capital is a particularly supple prudential tool. As activity and affiliation restrictions on banks have been loosened, and as the integration of traditional lending with capital markets has created new financial products at a rapid pace, capital requirements can provide a buffer against losses from any activities.

Bank capital regulations also suffer from the gap between theory and practice.  In theory, as he says, bank capital can provide a buffer against losses.  In practice, as shown by the financial crisis, regulators will do everything in their power to avoid having banks recognize losses and reduce their capital levels.

He goes on to summarize many of the reasons bank capital regulations are meaningless and why any reliance on them is foolish.

No single measure of capital is sufficient to ensure an adequate buffer however. Simple leverage ratios are a good check on banks becoming too debt dependent, but they encourage more risk-taking, insofar as they impose the same capital charge for every asset, no matter how risky. Standardized risk-based capital ratios implement the intuitively appealing notion that a bank’s capital should depend on the riskiness of its assets. But the grouping of individual loans and securities into necessarily broad categories of risk weights (e.g., residential mortgages) can be arbitraged. And a firm holding lots of assets that look very low-risk in normal times can be vulnerable if its total leverage is high during stress periods. Models-based capital requirements can better distinguish among risks to some degree, and they can be made more forward-looking than static leverage or risk-based ratios. But, to the extent that banks’ internal models are used, it is difficult to monitor whether banks are intentionally or unintentionally running models that understate their risks. And, of course, they are subject to the usual limitations of models that are based only on past experience and correlations.

Before going on, let me just point out that requiring banks to disclose their exposure details eliminates the various problems he finds with the different measures of bank capital.  For example, market discipline restrains the risk taking encouraged under simple leverage ratios.  As bank management increases risk, investors demand a higher yield to hold the bank’s debt and are willing to pay less for its stock.

So what does he propose to rescue us from reliance on bank capital regulations?  Stress tests.

But the stress testing system begun during the crisis, and continually refined since, has been the key innovation in capital regulation and supervision and makes those other measures more effective. The success of the 2009 stress test in restoring confidence in the financial system during the crisis encouraged Congress to make stress testing a required and regular feature of large-firm prudential regulation.

It was not the stress test itself that helped to restore confidence in the financial system.  Rather it was the pledging of the full faith and credit of the United States to provide all the capital necessary to keep the stress-tested banks solvent that did.

As the term suggests, stress tests evaluate the capacity of banks to absorb losses that may be associated with major economic adversity and remain not only technically solvent, but also viable financial intermediaries.

The concept of a stress test is a great idea.  It is such a good idea there is absolutely no reason that the ability to conduct a stress test should be limited to financial regulators.   If banks disclosed their exposure details, then all market participants could conduct stress tests or have stress tests conducted for them by trusted third parties.  If banks provided transparency, stress tests would be part of the due diligence investors do before and while they invest in a bank.

The concept of the Fed announcing the results of its stress tests is a terrible idea.  In the absence of transparency, the Fed creates a moral obligation to bailout investors in any bank that it said passed the Fed’s stress test.  After all, investors could argue they relied on the Fed saying the bank wouldn’t become insolvent.  If the banks provided the level of disclosure necessary to get a label from the Transparency Label Initiative, there wouldn’t be any need for the Fed to announce the results of its own stress tests.  With this level of disclosure, market participants could do their own stress tests of the banks.