Since banks everywhere are opaque, there is no way for investors to independently assess the risk of their unsecured debt and equity securities. Instead, they rely on the utterances and actions of the bank regulators when making their investment decisions.
This is the equivalent of gambling on the bank regulators.
In this particular game, only the senior management of the bank gets to see the true condition of the bank. Since their employment and hence personal wealth are related to keeping the bank open, senior management is only going to say everything is going well with the bank.
The bank regulators get a partial view of the true condition of the bank. The bank regulators can actually look at the bank’s current exposure details and try to assess how risky the bank is. This assessment is passed up the regulator’s chain of command to the senior decision makers. These individuals don’t just get the assessment, they also hear from the bank’s senior management if senior management thinks the assessment doesn’t show the bank in a flattering light.
And then there are the investors or should I say gamblers. They have no view into the true condition of the bank. Instead, they hear a story from bank management about how well everything is going, but they are left with no way to confirm if the story is true or not.
What the gamblers do have to look at is the statements and actions by the bank regulators.
For example, the gamblers can see when bank regulators push for ending mark-to-market accounting. This tells the gamblers the banks have a significant exposure to assets that are not worth what they are carried on the banks’ books as being worth.
The gamblers can also see when regulators are forcing banks to raise capital so they can use the capital to absorb losses that are already on the banks’ balance sheets. What the gamblers cannot see is if the amount of capital being raised exceeds the losses that are currently hidden on or off the balance sheets. Will the banks have to raise capital a second or third time?
As Walter Bagehot observed,
a well run bank needs no capital; no amount of capital will save a poorly run bank.
The gamblers simply have no idea how much capital the banks need to raise to plug the hole in their balance sheets.
More importantly, the gamblers have no idea when the bank regulators will decide to close the bank. When this happens, the gambler loses 100% of their exposure to the banks.