Thursday, 24 July 2008

Keeping secrets, telling lies

Yesterday, the Wall Street Journal reported that the FSA would like to conceal the disclosure of emergency loans to troubled UK banks. The suggestion comes in the wake of the NRK crash, when there was a widely held belief that public disclosure of BoE emergency loans actually destabilized NRK rather than helping it.

There is a simple test of any new policy initiative; consider a few plausible hypothetical scenarios and see how the initiative would deal with them. For example, suppose there was a hypothetical bank – lets call it the Halicrap – that suddenly finds itself holding a pile of rapidly defaulting mortgage debt. The CEO of the Halicrap calls up the FSA and says that the bank needs some secret emergency financing. Sensing that the bank could be careering towards a bank run, the FSA agrees to give the bank some secret funding.

Suppose also that you are a shareholder of the Halicrap and you decide to buy an additional tranche of shares. Since the Halicrap and the FSA conceal the funding difficulties from you, you buy these additional shares without fully understanding the health of the bank. Since you are also an existing shareholder, you have a right to know the true financial position of the bank. After all, the CEO is, technically speaking, working for you and not the FSA. You have a right to know what the CEO is doing on your behalf.

Consider another hypothetical bank – say the Royal Bank of North Britain – who decides to give a line of credit to the Halicrap. Again, the fact that the Halicrap is secretly receiving money from the state would materially affect whether the Royal bank would extend a credit to the Halicrap. Suppose further that the Halicrap subsequently became bankrupt, it is not hard to see plenty of useful employment for lawyers as the Royal Bank argues, with some justification, that the FSA withheld information that adversely affected the financial position of creditor banks.

A third group of individuals also has a right to know the financial activities of the FSA and the central bank – the taxpayer. These emergency loans are public resources. It seems reasonable that the use of public resources should be open to scrutiny.

Disclosure is the key principle of our financial system. Stock market listed companies must disclose all significant information about the financial health of the company. Otherwise, people can not make informed decision. If investors fear that information is being concealed, they will demand higher returns to compensate for the risk.

Some might say that the end justifies the means. It might be better to tell a little white lie in order to prevent a banking collapse. It would be a much better strategy to strengthen banking regulation rather than concealing emergency help as poorly regulated banks begin to fail. At the margin, a secret emergency credit line facility might actually delay decisive regulatory action.

My dear old grandmother had a neat phrase to describe situations when people conceal information. How did she put it? Yes, I remember, she called it lying. She had a few other words; deceit; dishonesty, and deception.



Well argued, Alice.

Anonymous said...

Alice - this should be in one of the national dailies!!! A knock-down case. Well done you - B. in C.

Anonymous said...

Agreed. The whole reason the market is frozen is because nobody trusts anybody.

There's a basic rule with secrets - you only have them if you don't want people to know the truth. If the truth was good, why hide it?


powerman said...
This comment has been removed by the author.
powerman said...

Great piece. I'm no lawyer, but I can't see how they can avoid exposing the taxpayer to massive legal damages when irate investors queue up for reparations when they get scalped during a rights issue. It seems like they would have every right to say 'this public company did not fully disclose its financial obligations'.

Thai said...

You have made an excellent case from the point of view of the average taxpayor, who's personal money in the banks is probably insured. Kudos

But what aboout his/her company's payroll?

Many company's payroll accounts are far too large to be insured. This money would be wiped away instantly were there a generalized bank run... Or by suggesting maintianing transparancy, are you also suggesting the government guarantee the entire british banking system's deposits fully (like I think they did with NR).

How would the government avoid these conflicting issues?

Again, I am an American, and I don't know how much uninsured deposits are at risk in the UK banking system (I am also assuming that most of the uninsured money in the UK banking system belongs to businesses for general cash/payroll purposes); I'll wager it's a lot.

Tto refer you to another posting by Mish, were there a run in America of just 10% of uninsured deposits, EVERY bank in the US would be out of cash and very likely insolvent thereafter.

It wouldn't matter which industry your readers worked for were such a run like this to happen, everyone would get burned.

I assume your readers like to get paid?

How do you suggest the governement solve issue issue and simultaneous (and appropriately) remain transparant?

There were runs at NR, why would this not happen again?

The problem is we collectively got into this, there is no way that I can see where we collectively do not.

Thai said...

Sorry, the Mish posting

Anonymous said...

Thai. 4 words for you.

End fractional reserve lending.


Thai said...

Nick, I don't necessarily disagree with you

But even if you ended fractional reserve lending, the current problem still remains. Your payroll is still at risk.

Anonymous said...

Not really. The problem is there's no safe place to put cash over the FSCS limit. That's only a problem because banks have loaned out almost all of the cash deposited with them. They can only do that because of fractional reserve lending.

Ergo. End the fraud, then the worry will go away.


Anonymous said...

We have a problem in the UK that the US and France, Germany don't have: we no longer manufacture anything significant.

We live by taking in each other's washing and on a balance of payments deficit financed by loans from abroad.

The banking crisis is really quite minor in comparison.

Someone said that Margaret Thatcher hollowed out British industry: her successors have done nothing to reverse this trend.

Discouraging really.


Anonymous said...

Agree entirely.

Also,though,wouldn't the Treasury have to account for where the money went? Surely the PAC might be asking questions?

Anonymous said...

Love the article. As a believer in the moral hazard of spending public money to bail out private companies, I would like to see a market correction involve the collapse of the worse offending lenders.

When British banks where posting record profits and loving themselves for being so great, I failed to notice them paying into the treasury the sort of amounts they now want to take out.

In the end why should they be saved when they are paying execs stupid bonuses for delivering this mess, only to avoid the pain these idiots have brought, so they can get right back to paying stupid bonuses.

If this situation is allowed to pass without consequences we'll be right back here again.

sobers said...

Fractional reserve lending is like adding a turbo charger to your car engine. You get extra performance for the short to medium term, at the expense of over stressing the engine in the long term, causing damage. It's the same in the ecomomy. If we were to return to a situation where people could not get easy credit, either for mortgages, credit cards or personal loans, then the amount of demand in the econmoy would plummet.

Don't get me wrong, I agree with the principle of only spending what you have, of saving, of true (not GB style) prudence. But to end FRL just like that would cause the UK consumer to go cold turkey. The effects would be similar amounts of unemployed as in the 1980's.

I think a transitional period of 10 years would be needed to wean people off easy money credit.

Anonymous said...


My suggestion has been to raise reserve requirements consistently over several years, having announced in advance the intention to phase out FRL altogether.


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