An agenda for the Federal Reserve’s review of its monetary policy framework


An agenda for the Federal Reserve’s review of its monetary policy framework



Why Secrecy is Bad for Banking

For several months, the U.S. Treasury Department and the International Monetary Fund have been calling on Asian central banks to fess up about the condition of the banks and finance companies they supervise and to force the borrowers from those institutions to keep their books according to the generally accepted accounting principles required by the U.S. Securities and Exchange Commission.

Meanwhile, at the request of the Federal Reserve and other U.S. banking regulators, 14 members of the House Banking Committee have introduced a Bank Examination Report Protection Act, which would make it all but impossible to find out what U.S. regulators know about the banks they supervise. And Fed Chairman Alan Greenspan has crusaded against a proposed addition to the generally accepted accounting principles, supported by the SEC, that would compel U.S. banks to recognize in their published reports the “fair value” of their holdings of derivatives.

Asian governments and central banks created the current mess by concealing the perilous state of their banks. For seven years, Japan has encouraged banks to carry as good assets old mortgages on real estate now worth perhaps a quarter of face value. Korean multinationals, known as chaebol, have been permitted to conceal their subsidiaries’ losses by shifting loans from one set of books to another. In Thailand, banks were allowed to carry loans at par until the borrowers hadn’t paid interest on them for more than a year.

These Asian governments and central banks were midwives to a fearsome cadre of what the economist Edward Kane calls “zombie” banks. Such walking dead devour their own good assets every night, and thanks to the magic of compound interest they become exponentially more insolvent, like U.S. savings-and-loans in the 1980s. But governments and central banks vouched for the zombie banks, which were able to keep borrowing dollars from banks in other countries.

The dollar-denominated loans are devastating the Asian markets. Debtors have to sell the local currency to acquire dollars so they can pay their debts. As the local currency declines in value, debtors (and local banks) must find ever-increasing quantities of it to service their debts. This can become a death spiral for the local economy. If good information about what was going on in these countries had been available, many of these loans would not have been made. Honest Asian businesses would not be ravaged by declining exchange rates and rising interest rates, and the world would not have to fear further collapse in Asia.

There is a systemic fault here, because the mixture of bank loans and portfolio investments on which the Asian countries have relied to fund their economic development is inherently unstable. Banks accumulate information and keep it for their own exclusive use. They are not and never have been risk takers; they made their living historically by their possession of information not available to others, which they could afford to gather because they spread the cost of gathering it over a number of loans. Secrecy makes sense for banks, especially in an environment where an ever-increasing fraction of their earnings comes from trading, and the habits of secrecy hang on.

Markets, by contrast, cannot survive without transparency. Markets are an inherently less expensive way to price and raise capital, in part because they use generally available information. Banks themselves, once funded from public deposits, now rely on markets to provide most of their lendable resources. Companies get access to capital markets when they grow large enough that information about them is widespread. In an age of information technology, small companies become publicly traded much sooner than they once did, and large companies find banks superfluous. As Dennis Weatherstone observed while he was chairman of J.P. Morgan, we live in a time when “capital markets dominate credit markets.”

But banks retain and secrete information that markets need, not least information about the banks themselves, their sources of profits, lending policies, asset quality and location, and hedging activities. To the extent that bankers confuse or mislead the market, both the market and the banks will be susceptible to severe disruption when an unexpected truth comes to light. The danger is greatest in loans from one bank to another, especially across cultural and linguistic boundaries. Banks themselves consider these interbank loans to be very safe, because ordinarily no government will permit its banks to go belly-up in public. Regulators consider the interbank loans very safe, because they believe the banks making such huge unsecured loans will police each other, refusing to lend to doubtful institutions. The Bank for International Settlements in Basel, Switzerland, the central bankers’ central bank, gives interbank lending among the banks of the developed world (including Korea) a “risk weighting” only 20% of that assessed against a loan to any nonbank enterprise. But interbank loans are not only unsafe (which means that banks will pull these lines fast from any borrower that seems to be getting in trouble); they are also a transmission belt for anxiety and for loss of faith in the financial system.

Banking regulators hate to abdicate their power as sole evaluator of banks’ assets because it is the real source of their authority — and gives them, they believe, opportunities to use denial as a weapon against panic. As the Japanese Ministry of Finance can attest, however, government assertions that everything is really all right carry little weight today. Market discipline already exists. The market will value the bank — as an investment, as a place to keep deposits, as a borrower — according to the information on the street, which may or may not be more accurate than what the banking regulators put out.

Transparency builds confidence; secrecy creates fear. Ultimately, the way to maintain safety and soundness in banks is to reduce what they used to call “window dressing” and give the investing, depositing and borrowing public much more of the inside information management uses to run the bank. William Isaac, retiring as chairman of the Federal Deposit Insurance Corp. in 1984, urged Congress to legislate publication of the front, factual section of bank examiners’ reports. Eleven years later, the Shadow Regulatory Committee of academics who study the Fed urged publication of the entire reports. New Zealand has already established such a regulatory regime, and something like it was clearly in the mind of Britain’s Chancellor of the Exchequer Gordon Brown a few months ago when he took banking supervision away from the Bank of England and turned it over to the new disclosure-oriented Securities and Investments Board.

Eventually, disclosure and market discipline will replace banking regulators in the U.S., too, but right now the wrong lessons are being learned. Old-timers in Japan, Korea and the U.S. believe that if only the secrets could have been kept, the banks and their supervisors would have found some way to avoid the mess. Thus the new bill to protect all examination reports from all interrogators, and the Fed’s opposition to more revealing accounting standards.

In 1983, prodded by the SEC and the late Sen. John Heinz (R., Pa.), banking regulators reluctantly ordered the big international banks to reveal country by country their major foreign loan exposures. The equivalent today would be a requirement that banks post in some public place — the Internet would do fine — a detailed list of their daily interbank exposures.

There are limits to what such a rule could accomplish. Derivatives traders could easily invent a legal instrument that would permit banks to lend to other banks without appearing to do so. But such instruments would have to be priced on a daily basis, and would not carry the presumption of safety the governments now give the interbank market.

The genius of capitalism is that markets, not regulations or politics, force the admission and correction of mistakes. For a global economy to work properly, investors and their advisers must be able to beam their searchlights far deeper into the recesses of the financial institutions than their regulators now allow. No doubt the interbank market would shrink in the glare — perhaps all the way down to its historic function of facilitating trade and payments. But some loss of financial articulation and efficiency would be a small price to pay to reduce systemic invitation to the chaos we see today.