Being open about supervisory aims January 4, 2013 at 7:20 am

Before Christmas, I had a fascinating exchange of comments with long-time and insightful reader Quality Mullet. It began with my observation

It seems to me that the great debate we are not having is what we want the system to look like. If supervisors said `here is what we want, broadly’, then everyone could critique rules on that basis. As it is, supervisors have (often disparate) ideas of what they are trying to achieve which are not publicly articulated. The rules are a result of compromises between supervisors and so are intended to push towards the desired objectives, but often they don’t because of unintended compromises, conflicts between objectives, or because they are either too strong or too weak. The whole paradigm of `do what we are thinking of based on these rules’ is flawed – here’s what we are thinking of, help us get there would be better, but it would require both honesty about objectives and the ability to articulate what they are.

Put tersely, I was suggesting that rather than write rules to achieve a desired end state, supervisors should first articulate what their desired end state is, and then write the rules. That way, we could all judge the rules by their efficiency at achieving the goal, rather than trying to figure out what the goal was (and not being sure we had got it right).

In a sense, then, I am suggesting that the whole dialogue is at the wrong level. We discuss rules, when these are mean simulacra of their desired effects on the financial system. We are talking about the wrong thing when we argue about, say, the new Basel ABS rules improve financial stability or not. We should first say, for instance, that we want banks to hold fewer ABS (with all that that implies). Once that is clear, we can debate how to do that effectively.

QM commented in reply

… what’s not much talked about is how the regulatory framework and system structure you want is actually a very very important social contract. In the UK it is presumed the social contract has to be tilted away from public support but the debate is lop-sided, ignoring what it means on a day to day basis to end users. Vickers to his credit set out some of the tradeoff of losing a contingent liability but gaining a costlier … service. No one has taken his analysis much further in the public policy / social contract space.

This for me is absolutely correct. There is a social contract, and regulatory goals articulate it. By saying, for instance, that we do not want capital markets trading to ever be able to take a retail bank down, we are expressing part of the contract under which society has decided to let banks operate. We should make this contract explicit in order first for it to be agreed and second to better judge what the rules should say.

This then leads to my last observation: because the contract is implicit, it is fuzzy. Supervisors have not been forced to articulate their vision of it, nor has that vision been critiqued. By keeping dialogue at the level of the rules rather than the aims, we allow an unhelpful ambiguity to persist. If we don’t know what the official sector’s aims are, how can we judge their success or failure?

11 Responses to “Being open about supervisory aims”

  1. I think some supervisors, Andy Haldane for instance, have been quite explicit and clear about the social goals of bank regulation and the need to build rules around them. This BIS considerably less so.

  2. Fair point GY – and kudos to Haldane for that.

  3. Yes. Precisely. The Brits are better than the US. The Fed in particular is now responsible for all of the major institutions and continues to only articulate a negative vision (we don’t want a repeat) but not a positive vision of how they want the financial sector to perform. Do we want market-based intermediation or bank balance-sheet based intermediation? Do we want market-based discipline, supervisory discretion, or rules-based? Etc.

  4. It’s all very well the regulators articulating their vision, but shouldn’t it be the place of the politicians to do that in the first place? I appreciate that the ability of most politicians to understand these markets is limited, but they are the primary law-makers and it is their duty to set the overall framework in which the regulators operate.

  5. Personally I do think the politicians should be part of setting down the contract on behalf of society. That is kind of happening in the UK – the first report of the Banking Standards Commission gets to some of the issues on how the UK sector should be structured. But it is only part of the issue. Agree that Haldane has worked hard on this.He favours a simpler reg framework, the corollary of which is perhaps a more intelligible and understandable social contract.

  6. But to the extent that the choice of the “goal” is rather arbitrary, wouldn’t the framing of ground rules (“this is how any efficient financial system would operate”) be a more effective way of identifying the most optimal outcome, rather than defining how the system WILL operate?

  7. Thank you, commentators, I agree with all of the above.

  8. This is a great post, thank you for sharing this. In my previous life in bank supervision I always questioned what appeared to me as a lack of transparency to the outside world (or even the banks in which we oversaw) in the supervisory process. This cultural veil of supervisory secrecy likely emanates from how inherently sensitive banks are to market confidence and sentiment. Perhaps this approach was more appropriate historically when banks were less able (read smaller and less complex) to bring down entire financial systems and bankrupt governments in the process.

    In my current life as a bank analyst I have a similar frustration with the inadequacy of risk disclosures in the sector. I cannot help but get the sense that, rightly or wrongly, the poor quality of bank disclosures are again a reflection of this notion that market participants are to be limited in their knowledge of the inner workings of the sector for the greater good of the sector (ie, the confidence game, again).

    That said, the events over the past few years have shown, I think, that we cannot rely on regulators, bank management teams or the market to get it right and balance each other out. Indeed, it was all three pillars that collapsed in the crisis and all three should be the focus of reforms. This also begs the question that you are asking here and has been ignored largely to date, which is should the public have more say? Of course, convincing arguments could be made either way but perhaps a step in the right direction is getting over this foolish notion that information should be hugged tight.

  9. Thanks Mick. I completely agree with you that we cannot rely on the dialogue between supervisors and the banks to get the balance right. In the US, the public do have a bit more say, at least in form, and the results are sometimes impressive. See Occupy the SEC’s letter on Volcker. Whether they have much influence is another matter, but at least open government initiatives have made a little progress there. Mention transparency in Basel and they would, I suspect, laugh at you…

  10. haha, yes, or at least go awkwardly silent! thanks for the references, will take a look.

  11. A social contract is a mighty fine idea. But just like agency costs have a tendency to undermine the contract between shareholders and management, regulators have their own rent extraction from this social contract. And to the benefit of society it ain’t!