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The Wall Street Journal ran an article on the Bank of England's (BoE) plan to adopt 21st century oversight of financial institutions. This plan places "a greater emphasis on understanding macroeconomic issues and on requiring the banks to disclose more information to the markets." This plan explicitly trades off market discipline for bank examination.

The plan is in sharp contrast to the current Financial Services Authority and Federal Reserve practice of bank oversight. Their practice of bank oversight involves sending out large numbers of examiners to look through the banks' books, demanding lots of detailed information for their internal review and asking the banks to run stress tests on assumptions the regulators provide. A key feature of this practice of bank oversight is that no detailed information is shared with the markets.

If this practice of bank oversight looks like it parallels how the rating agencies operate, it does. The parallel in the US goes all the way to the issuance of a CAMELS rating by the regulator. Just like the rating agency business model, since the markets do not have the information to do its own homework, the markets have to trust that the regulators get their bank oversight right. Unfortunately, recent history shows that regulators do not always get their bank oversight right.

According to the WSJ article:

A top Bank of England official, Andy Haldane, said the new regulator will curtail the FSA's practice of dispatching dozens of examiners to banks to collect loads of granular information... Mr. Haldane noted that ... they rarely yield much useful information for regulators, who can find themselves overwhelmed by the quantity of data.

Mr. Haldane identified the flaw in the rating agency bank oversight model and the reason that regulators need to have banks disclose more information to the markets:

The markets are not overwhelmed by the quantity of data disclosed by financial institutions. There are a number of market participants who are able to and have an incentive to analyze all of the individual asset level data these institutions could provide and turn it into useful information.

This point bears repeating as it is the key to 21st century oversight of banks. The markets are not overwhelmed by the quantity of data disclosed by financial institutions. There are a number of market participants who are able to and have an incentive to analyze all of the individual asset level data these institutions could provide and turn it into useful information. Since the markets can and have an incentive to turn the disclosed data into useful information, the markets are able to bring discipline to the financial system that the regulators with their resources cannot.

For the Bank of England to succeed in replacing examination with market discipline requires using 21st century information technology. Specifically, it means applying observable event based asset-level performance reporting not just to the loans and receivables underlying structured finance securities, but across the entire asset side of bank balance sheets.

What is observable event based asset-level performance reporting? For each individual loan or receivable on the bank balance sheet, it is simply whenever there is a payment, a delinquency, a default, an insolvency filing by the borrower or similar event, it is reported on a borrower privacy protected basis to the market on the day that it occurs.

Observable event based asset-level performance data is the current information markets need to analyze and assess the risk of each individual bank. It is the current information markets need to bring discipline to the financial system. There are no technological hurdles that prevent making this data available. There are no technological hurdles that prevent the market from using this data.

The cost of providing the data is not a hurdle. Particularly when this cost is compared to the trillions of dollars of losses that the global financial system suffered in the credit crisis because the market did not have this data. What has prevented this data from being made available is the lack of a regulator who would champion this approach.

This approach eliminates reliance on only regulators to detect problems at and curb the risks of a single institution. This approach eliminates reliance on only regulators to identify systemic problems. This approach instead allows the regulators to harness the resources of the market, including ironically, the ability of each financial institution to evaluate its peers. This approach allows market participants to perform their own stress tests on each financial institution.

During the Great Depression, the decision was made to bring the disinfectant of sunlight to the financial markets through the adoption of disclosure laws. The belief was that providing investors with access to all the information they needed to make a fully informed investment decision was the best way to restore and maintain confidence in the capital markets. This belief was rewarded with financial markets that functioned without a slew of government guarantee programs, government loss sharing programs to bribe investors to buy a specific class of securities and government coercion through zero interest rate policies to force investors to buy riskier assets.

The fundamental problem with using expensive government programs instead of the inexpensive disinfectant of sunlight is that it is not always sustainable. Markets dependent on government programs collapse if the solvency of the government is called into question. Now, coming out of the Great Recession, the BoE is proposing to extend the disinfectant of sunlight and the market discipline it brings into the opaque source of the credit crisis, the financial institutions.

To truly bring in the sunlight and the restoration of confidence in the capital markets will require financial institutions provide asset level disclosure on an observable event basis.

Disclosure: None

Source: Bank of England Adopting 21st Century Oversight of Financial Institutions