Thursday, September 16, 2010

Financial regulation, Basel and free markets

One of the essential ingredients of efficient, productive free markets is information. Ineffective suppliers of any service can not long survive if their value offering is public and comparable. This is a simple reason that retail and food industries work so well; prices and availability are eminently comparable, signaling and inducing market position and ultimately profitability.

In fact, markets can not work if information does not flow freely. Real time auctions of cattle, hogs and other commodities, taking place in various cities across the country every day, are popular not just because it is efficient, but because every market signal is inherently public. It is difficult to scam the system with 40 buyers publically purchasing thousands of head of cattle that are physically available for inspection over the course of one day. Anyone interested in the current travails of Wall Street are strongly urged to attend the closest cattle auction.

There is a further aspect of market information that is not so often discussed. Markets work best if the rules are very simple. The more nuance in the market, the less clear is the information in it. As an analogy, we find that life is more effective if our morality stays simple while our psychology and relations grow rich and complex. In other words, keep the game rules simple for winning and losing. The complexity will come in strategy.

Stocks and bonds are also sold on auction. But unlike cattle auctions, not many people are in position to physically visit the companies involved, much less make an accurate prediction of their viability. (Not even the professionals are good at that, given that stock price indexes outperform virtually all mutual funds. In fact, if you are a lay person and you are in a mutual fund instead of an index fund, chances are higher than 98% that you are a victim of marketing and paying dearly for it).

Financial statements of companies form a proxy for intimate and physical knowledge and inspection. They form the fundamental basis of market information. We view the FASB as the guardian of prudent and accurate reporting which forms the underlying precept of stock markets and therefore the modern economy.

The problem is that for quite a while now, financial statements have been rendered meaningless.

First, some drudgery. Regulation of the statements themselves has become so byzantine that it becomes almost impossible to read them unless one obtains a Masters degree in Finance and Accounting. This is not the simple market we expect. This is obfuscation. This is an essential component of what proponents of free markets mean when they say that regulation tends to make markets worse, not better. Simple is always better. And it is not only better, it is essential. Effective accounting and reporting is not brain surgery. The concepts are simple and logically easy to understand.

Wall Street

To illustrate, I will go out on a very short limb and suggest that if we describe a financial statement and the actual state of a company it represents to 10 lay persons, 8 of them could agree on whether the statements accurately reflect the company in any given situation, or whether they have materially obfuscated their position. These lay persons require no understanding of thousands of pages of regulation to come to a common judgment. Neither should auditors or judges. It is obfuscation by lawyers and special interests to change the nature of the game and gain advantage.

Let us return to cattle auctions to illustrate. The producer needs no regulation to realize that undisclosed sickness will result in severe penalty when selling his steers. The market needs neither regulation nor Congress' intervention to determine if the sale was legitimate. We stipulate that neither do lay persons or judges in the judgment of financial instruments. The warren of legal and policing bureaucracy is by now not only inefficient, but an unnecessary cost to the market that only obfuscates its real nature (Neither is the question of upper management acting as proxy for shareholders. Much on that later).

One might ask then, given the importance of simplicity and information in markets, and given the utmost importance of the fiduciary duty of the FASB to perform this duty, why then do we have such a warren of rules and regulation and obfuscation of their development? Indeed.

But there has been another alarming development which is technically a sub-context of the first point, but whose size warrants its own discussion. That elephant in the room is derivatives.

Here is some context to the derivative market. Total US GDP is approximately $15 trillion. World GDP is approximately $60 trillion. The derivative market is approximately $600 trillion. Very little of it is on the Balance Sheets of the banks and corporations playing in that market.

The rejoinder of course is that it is insurance, and therefore does not belong on the Balance Sheet. Besides the gobsmacking question of why we need so much 'insurance,' the more practical question is why there is no need to articulate insurance risk exposure on financial statements. Since risk is never alleviated, but only disbursed, the exposure of that $600 trillion needs to show up somewhere.

The simple fact is that it was the derivatives market that collapsed Enron, a number of equity funds, the Wall street banks, and given bank leverage collapsed the economy. Let us cut through all the professional speak by economists, bankers, politicians and pundits:

The collapse of the housing market alone could not have caused the current recession without a fundamental misrepresentation of the financial statements of the organizations involved.

There. It is that simple. There is no way to refute that statement. There is no need to do multiple regressions to discover the cause of the financial crisis. The housing market alone does not comprise a large enough percentage of the economy to cause a recession. It is impossible.

For the problem to reach gargantuan proportion enough to threaten the economy, the entities involved, in this case the banks, must hide the inherent instability of their Balance Sheets well past jurisprudence.

The recession itself is a testament that derivatives and securities in all their forms, including a measure of their risk, must be on financial statements. That the Federal Reserve could not measure its own risk is merely icing on the cake.

The defense of over-the-counter instruments is that they are unique and inherently immeasurable. This defense is poppycock. Free markets demand that if one can not measure something, it can not be permitted. It is like arguing that since the steer often gets better and the farm is insured, there is no need to speak of its troubling infection. It is an inherent requirement of markets that material information is public. If it can not be articulated, what is it? Gambling? You tell me. Cattle auctions would cease if information regarding the health of the animal was not disclosed.

One might ask where the FASB has been in all of this discussion. After all, they arguably have the clearest fiduciary duty in protecting the markets. The answer is that their position is all too clear. They have nuanced, obfuscated and generally abdicated their most important fiduciary duty to free markets.

A simple reading of that link to the FASB is all that is needed. One does not have to understand that they have postponed and watered down the Derivatives legislation after the largest financial collapse in a generation to see where they are headed. In fact, many readers will find the web page unreadable. As an investor and citizen, what more do you need to know? These people are so absorbed in the minutia they can no longer see the trees.

We can not help but return to the idea of renewal cycles and the inevitable utility of cleaning house once in awhile. This is the ongoing lesson of bureaucracy; that it never finds a reason for self-inspection, renewal or simplification. Even socialists must agree that at least free markets produce their own exacting method of cleaning house and renewal of organizations that have lost their way. Creative destruction is a feature, not a bug.

But what of our institutions? There is something drastically and inherently at issue here. And governments are once again part of the problem, not the solution:

To celebrate the second anniversary of the fall of Lehman, the mountain of Basel has laboured mightily and brought forth a mouse.

For it is the government induced Basel that has caused arguably the most problems in banking:

Despite every major US bank being declared by regulators as “well capitalized” prior to the financial crisis, we still found ourselves watching the government plow hundreds of billions of capital into said banks. How can this be? The answer is quite simple: we were lied to.

And it is also true that:

Back when banks were actually subject to market forces and were not explicitly subjected to government capital standards, they held significantly more capital. In 1900 the average US bank capital ratio was close to 25%, now it’s closer to 5%. The trend is unmistakable: the more government has regulated bank capital, the less capital banks have ended up holding.

As Mancur Olson illustrated 40 years ago in his towering book, The Rise and Decline of Nations, institutions inevitably become captured by their special interests. If the social sciences have done anything of value, it is their painstaking review of the statism and overhead and ultimate rigidity and harm of bureaucracy. Even Progressives and socialists can not evade the evidence.

Without getting into a discussion of merits of fractional reserve banking, it does not take a genius to realize that something is deeply wrong with the current structure of the institutions meant to guard our society and culture. The issues that need to be addressed to restore our nation are much deeper than most people imagine.

The answer of course, is not more regulation. It is simple, clear regulation that allows winners and losers, and which promotes and holds fiduciary duty accountable. It is the only way to ensure periodic renewal and refocus on primary objectives, as opposed to getting caught up in minutiae and special interest lobbying. Our institutions must be expected to do at least that much. And if our politicians and professionals are not up to the task, then they need to get out.

One sensible solution after the financial crisis would be to begin by firing everyone at the FASB. They could join the current staff of the SEC on the beach where they belong. These organizations defend markets. In their current formation, they couldn't defend my son's playground.

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