Monday, January 25, 2010

Regulation and Information--Part B

In my previous post, “Regulation and Information—Part A” I argued that banking and finance has become nothing more than information, and in this Age of Information, money and finance have just become the movement of 0s and 1s. As a consequence, finance has gotten away from people and physical assets and paper money and other forms of wealth, like gold, and just become bits of information that can be “diced and sliced” every which way and that can be bought and sold worldwide.

This post, as promised, has to do with my ideas about the possibilities for the regulation of banking and financial institutions. I will post a Part C tomorrow.

First, I need to explain a little bit about where I am coming from. I call myself an “Information Libertarian”. I believe that history shows that information spreads and cannot be contained. Its spread can be slowed down for a while, by governments or religious bodies for example, but eventually the spread of information wins out. As an Information Libertarian, I believe that it is my responsibility to help speed along the spread of information and, where this spread is being contested or resisted, help to unlock the doors that is keeping information bottled up.

To me, information must see the light of day so that it can be tested, used, and lead to the discovery of more information. In this way false information, information not allowed to change, and other constraints on the problem solving and decision making capabilities of humans can be seen for what they are and transcended.

Rules and regulations in the past have tended to rely too much on what I would call “the achievement of outcomes” and not enough on the “process of how things are being done.”

Reliance on “outcomes” focuses upon the wrong things and is very expensive for those being regulated as well as for those that are doing the regulating. The reason: if there is sufficient incentive for the regulated to do the thing being regulated, it will get done in one way or another, in spite of the regulation. This was the essence of the quote by John Bogle, the founder and former chief executive officer of the Vanguard Group, in my post of January 19 (see Bogle stated that “There are few regulations that smart, motivated, targets cannot evade.” This was a part of what I was attempting to say in Part A of my discussion of regulation and information: the means of evading regulations has become sophisticated and easier in this Age of Information.

Also the cost of regulating in such an environment has increased substantially. The talent and skill required, along with the necessary patience and persistence of the regulator has gone up exponentially. In my experience, the regulator is ALWAYS behind the industry in knowing and understanding what is going on. How far behind they are varies from situation to situation and is a constant concern. But, you can rest assured that the regulators are behind the regulated.

As I have written in previous posts, the big banks have once more jumped ahead of the regulators in the past year as these banking giants have gained strength. Nothing has helped them more than the subsidy the Federal Reserve has given them by maintaining short term interest rates at such low levels: the Fed has given them “the gift that keeps on giving.” Not only have these banks regained health, they have moved way ahead of the regulators who have been dealing with all the problem small- and medium-sized banks and the squabbles takikng place in Washington, D. C. over how the banks and other financial institutions should be regulated.

This is the problem of focusing on “outcomes.”

I have argued over and over in earlier posts that banks and other financial institutions need to be subject to greater openness and transparency. This is consistent with my views on the need for information to spread and is consistent with my views on what kind of regulation can achieve some degree of success. It is also consistent with the idea that laws and regulations should focus on “process” and not “outcomes.”

Making banks and other financial institutions open up their books and causing their operations to be more transparent is the only way that I can see, in this Age of Information, to effectively have some impact on the behavior of these organizations. Having to report accurately and often to not only the regulators but also to shareholders as well as the public in general is the only way to be able to have some impact on them over time. The idea is that if they can’t hide what they are doing they will be a little more careful about what actions they take.

I cannot buy the argument that financial institutions need to keep their information on customers or what they are doing proprietary for if they don’t their spreads will go away. We saw what a disaster this was in terms of Long Term Capital Management. To me, the running of a financial institution is like coaching a football team: everyone knows the plays; the winning team is usually the one that executes the best or is the luckiest. Everyone knew what Long Term Capital Management was doing and others mimicked them. When things went the wrong way everyone tried to exit at the same time. Sounds like the subprime mortgage market doesn’t it?

I have also been a constant proponent of “mark-to-market” accounting. Let me describe to you how I see this tool. Banks, and other financial institutions, take risks. In order to achieve a few more basis points return over competitors, executives have either taken on assets that are a little riskier than they did before, or, mismatch the maturities of assets and liabilities a little more than they did. Shouldn’t we the regulators, the investors, the depositors, the analysts know this?

They, the bankers, have taken the interest rate risk and the credit risk and should be held accountable. To me it is childish for the bankers to “cry foul” when the market goes against them saying that it is unfair to force them to recognize the mismatched position they have taken. They are the ones that took the risk, they should be held accountable for doing so. They get the credit when things go well. Shouldn’t they be called on the carpet when things go the other way? If you know you might get caught, should you go ahead and do something?

In this case, maybe the bankers need to present two sets of books. One set to show what the value of the assets are if they (the assets) are held to maturity. Another set of books to reflect actual market values. The crucial thing is that the current real position of the bank needs to be “owned” by those running the bank.

The point is that if a management doesn’t want the public and the regulators to know that they have taken excessive risks, then they shouldn’t take the excessive risks.

In the Age of Information, the probability that people will find out what you are doing, particularly if you have some prominence, is higher than before and is increasing every day. We have just seen what can happen when some prominent person lives a life all out of character with who people thought he was. And, the fall has been pretty substantial.

Again, if this person didn’t want us to find out about his extra-curricular activities, he shouldn’t have pursued them. Simple as that!

The objective in requiring openness and transparency in reporting financial data is to say to people “before the fact”: if you take on too much risk or run your business in a careless manner, we will call you out on it. The “we” stands for investors, depositors, or regulators. The financial position of a bank or a financial institution should be “out-in-the-open” in great detail and the analysis of investors and regulators should be shared. If the bankers know they may be exposed then maybe the banks will attack their problems sooner rather than later.

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