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 http://seekingalpha.com/article/183203-bracing-for-new-banking-regulations). 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.
Showing posts with label John Bogle. Show all posts
Showing posts with label John Bogle. Show all posts
Monday, January 25, 2010
Tuesday, January 19, 2010
The Move Toward More Regulation
The air is heating up when it comes to the subject of banking regulation. The only advice I can offer those considering changes in the regulatory environment is “be careful.”
The main reason for this caution?
John Bogle, the founder and former chief executive of the Vanguard Group, wrote it very succinctly in the Wall Street Journal this morning: “There are few regulations that smart, motivated, targets cannot evade.” (See “Restoring Faith in Financial Markets: http://online.wsj.com/article/SB20001424052748703436504574640523013840290.html#mod=todays_us_opinion.)
Another reason for this caution comes from Mervyn King, governor of the Bank of England: “The belief that appropriate regulation can ensure that speculative activities do not result in failures is a delusion.” Andrew Ross Sorkin provided this quote in the New York Times this morning. (See “Big, in Banks, is in the Eye of the Beholder”: http://www.nytimes.com/2010/01/19/business/19sorkin.html?ref=business.)
According to these two individuals, banks cannot be prevented from engaging in the types of activities that they really want to be engaged in and there is little that supervision can do to keep them from failing due to speculative activities.
In other words, bankers cannot be protected from themselves.
Why is this?
There are two very good reasons. First, in this Information Age, almost anything can be done with cash flows and risk, and regulators will always be behind the curve in trying to catch up with what is going on in the financial sector. After the financial crisis of 2008, this type of behavior has began again in the bigger banking organizations and I would argue that the regulators are already at least three- to six-months behind what these institutions are now doing.
Second, the financial community is truly global now and the flow of money (information) is very fluid. If something cannot be done somewhere it can always move elsewhere. Discussions about what the BRICs are doing (see the week long series of articles on Brazil, Russia, India, and China in the Financial Times this week) present one picture of how the world is continuing to shrink, financially. Another picture of the flow of funds throughout the world is captured in a recent research paper by MIT’s Ricardo Caballero which is quoted in the recent article in Time magazine: “Did Foreigners Cause America’s Financial Crisis?” by Stephen Gandel. (See http://www.time.com/time/business/article/0,8599,1954240,00.html.)
I would like to make one other point: many people continue to assume that behind active governmental policy and regulation are government officials and bureaucrats that are either more perceptive and talented than their private sector counterparts, or, are less self-serving than their private sector counterparts, or, are better placed to observe how the world works than are their private sector counterparts.
In my estimation, government officials and bureaucrats are not more capable or talented than their private sector counterparts and they are certainly not less self-interested. Furthermore, in my experience in government, they are not better placed or better informed about what is going on in the world. This latter point is one that the economist Friedrich Hayek made over and over again.
There is no research that I have seen that indicates that those that work for government perform any better than those that work in the private sector. If anything, the argument goes the other way: government cannot hire or attract people of the same quality that work in the private sector. Furthermore, there is no evidence to prove, in my mind, that people that work in government service are any less greedy for advancement or personal gain than are people that work in the private sector.
Finally, in their attempt to protect the society from “bad outcomes” the government has tended to err on the side of creating an environment for greater and greater private sector risk-taking. This has come in several forms. The obvious case currently is the “Greenspan put” or the bank bailouts that have created moral hazard and greater and greater amounts of risk taking. (See the article by Peter Boone and Simon Johnson in today’s Financial Times, “A Bank Levy will not stop the Doomsday Cycle”: http://www.ft.com/cms/s/0/e118fcc2-0461-11df-8603-00144feabdc0.html.)
Another case relates to the underlying emphasis on trying to maintain low levels of unemployment. This has created an environment that encourages risk taking in terms of increased financial leverage, maturity mismatching, and financial innovation. I have referred to the whole period from 1960 to the present as one in which the government underwrote an environment of credit inflation.
Furthermore, this continual effort to stimulate the economy has tended to put people back to work in jobs that were outdated or in industries that needed change. In order to protect the worker, the easiest and best approach was to put workers back into their old jobs. We see the consequence of this policy in the problems experienced in the auto industry, the steel industry, and many other areas that formerly represented the industrial base of America.
Last, special interest programs, such as housing, although designed with good intent, have ended up with several government agencies serving as the residual lender and insurer of mortgages. Over the past several years we have focused on Fannie Mae and Freddie Mac, but it is now obvious that we cannot ignore the FHA. (See the article by Nick Timiraos in today’s Wall Street Journal, “Souring Mortgages, Weak Market Put Loan Agency on a Tightrope”: http://online.wsj.com/article/SB20001424052748704586504574654710172000646.html#mod=todays_us_page_one.) This effort has resulted in the federal government becoming biggest player in the housing market, by a long shot!
To me, regulation of the banking sector should focus on two things. The first relates to capital requirements. They should be raised.
Second, there needs to be greater transparency and openness in transactions, deals, and balance sheets.
Almost every other kind of regulation that can be put on the books, in the words of John Bogle, can be evaded. We cannot protect the bankers from themselves. But, we can attempt to protect investors and other wealth holders by giving them more information about those institutions they want to invest in. But, like the bankers, ultimately we cannot protect these investors and other wealth holders from themselves.
The main reason for this caution?
John Bogle, the founder and former chief executive of the Vanguard Group, wrote it very succinctly in the Wall Street Journal this morning: “There are few regulations that smart, motivated, targets cannot evade.” (See “Restoring Faith in Financial Markets: http://online.wsj.com/article/SB20001424052748703436504574640523013840290.html#mod=todays_us_opinion.)
Another reason for this caution comes from Mervyn King, governor of the Bank of England: “The belief that appropriate regulation can ensure that speculative activities do not result in failures is a delusion.” Andrew Ross Sorkin provided this quote in the New York Times this morning. (See “Big, in Banks, is in the Eye of the Beholder”: http://www.nytimes.com/2010/01/19/business/19sorkin.html?ref=business.)
According to these two individuals, banks cannot be prevented from engaging in the types of activities that they really want to be engaged in and there is little that supervision can do to keep them from failing due to speculative activities.
In other words, bankers cannot be protected from themselves.
Why is this?
There are two very good reasons. First, in this Information Age, almost anything can be done with cash flows and risk, and regulators will always be behind the curve in trying to catch up with what is going on in the financial sector. After the financial crisis of 2008, this type of behavior has began again in the bigger banking organizations and I would argue that the regulators are already at least three- to six-months behind what these institutions are now doing.
Second, the financial community is truly global now and the flow of money (information) is very fluid. If something cannot be done somewhere it can always move elsewhere. Discussions about what the BRICs are doing (see the week long series of articles on Brazil, Russia, India, and China in the Financial Times this week) present one picture of how the world is continuing to shrink, financially. Another picture of the flow of funds throughout the world is captured in a recent research paper by MIT’s Ricardo Caballero which is quoted in the recent article in Time magazine: “Did Foreigners Cause America’s Financial Crisis?” by Stephen Gandel. (See http://www.time.com/time/business/article/0,8599,1954240,00.html.)
I would like to make one other point: many people continue to assume that behind active governmental policy and regulation are government officials and bureaucrats that are either more perceptive and talented than their private sector counterparts, or, are less self-serving than their private sector counterparts, or, are better placed to observe how the world works than are their private sector counterparts.
In my estimation, government officials and bureaucrats are not more capable or talented than their private sector counterparts and they are certainly not less self-interested. Furthermore, in my experience in government, they are not better placed or better informed about what is going on in the world. This latter point is one that the economist Friedrich Hayek made over and over again.
There is no research that I have seen that indicates that those that work for government perform any better than those that work in the private sector. If anything, the argument goes the other way: government cannot hire or attract people of the same quality that work in the private sector. Furthermore, there is no evidence to prove, in my mind, that people that work in government service are any less greedy for advancement or personal gain than are people that work in the private sector.
Finally, in their attempt to protect the society from “bad outcomes” the government has tended to err on the side of creating an environment for greater and greater private sector risk-taking. This has come in several forms. The obvious case currently is the “Greenspan put” or the bank bailouts that have created moral hazard and greater and greater amounts of risk taking. (See the article by Peter Boone and Simon Johnson in today’s Financial Times, “A Bank Levy will not stop the Doomsday Cycle”: http://www.ft.com/cms/s/0/e118fcc2-0461-11df-8603-00144feabdc0.html.)
Another case relates to the underlying emphasis on trying to maintain low levels of unemployment. This has created an environment that encourages risk taking in terms of increased financial leverage, maturity mismatching, and financial innovation. I have referred to the whole period from 1960 to the present as one in which the government underwrote an environment of credit inflation.
Furthermore, this continual effort to stimulate the economy has tended to put people back to work in jobs that were outdated or in industries that needed change. In order to protect the worker, the easiest and best approach was to put workers back into their old jobs. We see the consequence of this policy in the problems experienced in the auto industry, the steel industry, and many other areas that formerly represented the industrial base of America.
Last, special interest programs, such as housing, although designed with good intent, have ended up with several government agencies serving as the residual lender and insurer of mortgages. Over the past several years we have focused on Fannie Mae and Freddie Mac, but it is now obvious that we cannot ignore the FHA. (See the article by Nick Timiraos in today’s Wall Street Journal, “Souring Mortgages, Weak Market Put Loan Agency on a Tightrope”: http://online.wsj.com/article/SB20001424052748704586504574654710172000646.html#mod=todays_us_page_one.) This effort has resulted in the federal government becoming biggest player in the housing market, by a long shot!
To me, regulation of the banking sector should focus on two things. The first relates to capital requirements. They should be raised.
Second, there needs to be greater transparency and openness in transactions, deals, and balance sheets.
Almost every other kind of regulation that can be put on the books, in the words of John Bogle, can be evaded. We cannot protect the bankers from themselves. But, we can attempt to protect investors and other wealth holders by giving them more information about those institutions they want to invest in. But, like the bankers, ultimately we cannot protect these investors and other wealth holders from themselves.
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