Which Direction for Banking Reform?

Naked Capitalism’s Yves Smith makes a compelling case for the need for structural reform. She is spot-on about the significance of disintermediation for the banking industry and the need to decouple risk. Her lament—”I see perilous little grappling with the problem that [Bank of England’s Mervyn] King flagged, that of industry structure”—really resonates with me.

I believe the overarching problem of industry structure is being ignored for two reasons.

One reason is the continuing influence of views from the financial academy by well-respected professors like Dr. Rajan who preach the gospel of market value but know very little, in reality, about the microstructure of financial markets, and whose theories would have to change if they acknowledged these inconvenient truths.

The other reason, coming from banks and financial system regulators, is a very rational fear of death. Acknowledging the need for restructuring can only lead to dramatic increases in the cost of banking business when there is no obvious way to improve the bottom line with future growth.

The less obvious solution would be to change the foundation of modern finance in favor of less reliance on price as a proxy of value and greater use of information via statistical simulation and cybernetics—feedback—with oversight by information experts instead of, or alongside, the bankers — in other words, to reduce the opportunity to cook the books.

Ultimately, this solution is kind to banks but a threat to the financial academy and the accounting profession. Nevertheless, banks are rather more accountable for their mistakes than banking professors or accountants, as we have learned from the Financial Tsunami.

And, since what links the markets together is the common language of price that is taught in business schools, the most capital-efficient way to decouple the markets is to return to fundamental analysis using asset-side data instead of the last traded price. The revival of securitization (with a restoration of the independent monitoring and valuation function) would give the banks the capital efficiency they need to stay in business, and the language for discovering value in new businesses. For banks, the only downside to this solution is that informational efficiency puts a crimp in crony business practices. In the short run, this is a small price to pay for a new lease on life.