Thursday, March 22, 2012

Brookings Institution's Douglas Elliott makes the case for ultra transparency

In explaining why the Volcker Rule will not fix banks, the Brookings Institution's Douglas Elliott makes the case for why banks must be required to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

In a CNN Money Markets column, he wrote
The core problem is the Volcker Rule purports to eliminate excessive investment risk at banks without measuring either the level of risk or the capacity of banks to handle it, which would tell us whether the risk was excessive. 
Instead, the rule focuses on the intent of the investment. 
This subjective and vague approach means the Volcker Rule will do a poor job of identifying or eliminating excessive investment risk, will be costly even when it correctly identifies risk, and will be even more costly when it discourages risk that is incorrectly treated as if it were excessive....
The only way to measure the level of risk or the capacity of a bank to handle the risk is by looking at the bank's exposure details.

This is exactly what a bank's internal risk management team does.

As the opaque sub-prime mortgage backed securities showed, without this exposure detail it is impossible to assess risk.
There are at least four core problems with the Volcker Rule: 
Measuring risk. It is unclear why we should care very much about a bank's intent. 
It's the level of risk relative to the ability to bear that risk that is of prime interest.... 
Which is precisely why banks should be required to provide ultra transparency.
Defining 'prop trading.' The concept of "proprietary investments" is a very subjective and arbitrary one. 
Many supporters of the rule seem to be particularly concerned about investments made by banks that are funded with depositor money and on which the shareholders collect any gain.
However, that defines essentially any investment made by a bank, since depositor funds are basically interchangeable with all the other funds gathered by a bank. And the shareholders always benefit from any gains on investments. 
I therefore surmise that the underlying rationale for the rule must be to try to separate out activities that are integral to banking from those that are not. 
By focusing on investments alone, the Volcker Rule implicitly assumes that lending is good. 
In addition, some investment activities are recognized as integral to banking, while others are not. 
This raises several concerns.... it is often extremely hard to draw the line between acceptable and unacceptable activities. 
For instance, securities dealing requires the holding of securities to meet potential customer demand in a timely manner. 
At what point does the inventory shift from being an appropriate size to being at a level that indicates speculation of a type the Volcker Rule prohibits? 
Perhaps more fundamentally, finance has evolved over the last few decades to the point where corporate borrowers switch easily between borrowing via loans and via securities. 
This means that securities activities are now integral to modern banking, just as lending has always been. Treating loans as good and securities transactions as suspect, which is implicit in the Volcker Rule, leads to bad policy.
Therefore, good policy would be to require ultra transparency as it does not matter in assessing the risk of the bank and its capacity to handle the risk whether the exposure is a loan or a security.
Guessing the intent. Operationalizing the arbitrary and subjective distinctions created by the Volcker Rule forces regulators to peer into the hearts of bankers. 
The proposed rules are inevitably very complex, as regulators make an honest effort to obtain enough information to guess the intent behind investment actions. 
We are in danger of forcing regulators to micromanage the actions banks take in one of their core activities, the ownership and trading of securities. That raises costs and discourages legitimate activities.
Implementing ultra transparency is very simple and it eliminates any complexity that arises in worrying about arbitrary and subjective distinctions in the intent behind investment actions.
High risk investments. By focusing on intent, we are almost certain to miss large swathes of investments that are taken on for an acceptable purpose, but which carry excessive risk. 
Almost all of the AAA-rated mortgage-backed and asset-backed securities on which banks lost money in the financial crisis would have passed the Volcker Rule tests easily.
With ultra transparency, market participants will have the information they need to identify large swathes of investments which carry excessive risks and impose market discipline on the banks to reduce their risks.
We will survive the Volcker Rule, but it is an unnecessary, self-inflicted wound. Congress should repeal it. 
Failing that, Congress should clearly instruct regulators to stop only those activities that very clearly violate the Volcker Rule without halting activities where the intent of the transactions is unclear. 
Regulators should also be encouraged to implement the rule in the least burdensome manner possible.
The least burdensome manner of implementing the Volcker Rule just happens to be by requiring ultra transparency.

By requiring traders to disclose their positions as of the close of business every day, ultra transparency allows the market to assess whether the position is "inventory" or a "proprietary trade".

Naturally, if it looks like a "proprietary trade" market participants might engage in activities like front running or trading against the position that reduce the profitability of the proprietary trade or inflict outright losses on the bank.

Regardless of which activity market participants engage in, the intent of the Volcker Rule was to stop banks from proprietary trading and ultra transparency provides a mechanism by which the market can enforce this stoppage.

No comments: