Unfinished Business: Making Banks Transparent

One of the main lessons of the financial crisis was that big banks -- along with a parallel "shadow banking system" -- had become too opaque, and that it was impossible to know the full scope of their risky behavior. Lehman Brothers, for example, hid billions of dollar in liabilities in the years before it collapsed -- allegedly with the help of the accounting giant Ernst & Young.

Five years after the crisis, the challenge of transparency endures, as Frank Partnoy and Jesse Eisinger detail in a terrific article in The Atlantic.

The piece is entitled "What's Inside America's Banks?" And the answer of the authors is: Who the heck knows? It remains nearly impossible to figure out the risks undertaken by the biggest and most influential financial institutions in the world. Exhibit A is the recent episode at J.P. Morgan where that bank lost billions of dollars taking massive risks that neither investors nor regulators understood that it was taking. Partnoy and Eisinger dig deeply into the incomprehensible financial statements of Wells Fargo to show that J.P. Morgan's opacity is no exception.

You'd hope, given the lessons of the financial crisis, new regulation would have imposed real transparency on the banks. But that hasn't happened. Partnoy and Eisinger write:

Accounting rules have proliferated as banks, and the assets and liabilities they contain, have become more complex. Yet the rules have not kept pace with changes in the financial system. Clever bankers, aided by their lawyers and accountants, can find ways around the intentions of the regulations while remaining within the letter of the law. What’s more, because these rules have grown ever more detailed and lawyerly—while still failing to cover every possible circumstance—they have had the perverse effect of allowing banks to avoid giving investors the information needed to gauge the value and risk of a bank’s portfolio. (That information is obscured by minutiae and legalese.) This is true for the complicated questions about financial innovation and trading, but it also is true for the basic questions, such as those involving loans. . . .

The problem extends well beyond the opacity of banks’ loan portfolios—it involves almost every aspect of modern bank activity, much of which involves complex investment and trading, not merely lending. Kevin Warsh, an ex–Morgan Stanley banker and a former Federal Reserve Board member appointed by George W. Bush, says woeful disclosure is a major problem. Look at the financial statements a big bank files with the SEC, he says: “Investors can’t truly understand the nature and quality of the assets and liabilities. They can’t readily assess the reliability of the capital to offset real losses. They can’t assess the underlying sources of the firms’ profits. The disclosure obfuscates more than it informs, and the government is not just permitting it but seems to be encouraging it.

Accounting rules are supposed to help investors understand the companies whose shares they buy. Yet current disclosure requirements don’t illuminate banks’ financial statements; instead, they let the banks turn out the lights. And in that darkness, all sorts of unsavory practices can breed.

Partnoy and Eisinger don't think that solving this problem should be all that hard. Rules need to be simpler, they say, and punishments for breaking them need to be a lot tougher. 

The starting point for any solution to the recurring problems with banks is to rebuild the twin pillars of regulation that Congress built in 1933 and 1934, in the aftermath of the 1929 crash. First, there must be a straightforward standard of disclosure for Wells Fargo and its banking brethren to follow: describe risks in commonsense terms that an investor can understand. Second, there must be a real risk of punishment for bank executives who mislead investors, or otherwise perpetrate fraud and abuse.

These two pillars don’t require heavy-handed regulation. The straightforward disclosure regime that prevailed for decades starting in the 1930s didn’t require extensive legal rules. Nor did vigorous prosecution of financial crime. . . .

Is this just a fantasy? The changes we’ve outlined would certainly be difficult politically. (What isn’t, today?) But in the face of sufficient pressure, bankers might willingly agree to a grand bargain: simpler rules and streamlined regulation if they subject themselves to real enforcement.

Amen to all of that.

This piece reinforces what we have been saying at Demos for long time now: Which is that the job of better policing Wall Street is not finished. Not by a long shot. Dodd-Frank was a first crack, and the complexity of that law is problematic. More work needs to be done. 

Add that task to President Obama's To Do list for his second term.