In his recently published commentary “Covert Affairs,” Bob Eisenbeis, vice chairman and chief monetary economist for Cumberland Advisors, discussed the Bank of England’s tradition of transparency spanning more than a century and the process by which that transparency has quietly morphed into opacity. The commentary includes links vital to an understanding of central bank operations and where they are going. Here is the link to his commentary.
The second link relevant to the question of central bank transparency is a Federal Reserve (Fed) news release in which it has picked two paths of inquiry. The November 20, 2014, release, found here, speaks for itself:
The Federal Reserve Board on Thursday announced two separate reviews that are underway at the Federal Reserve System to ensure that the examinations of large banking organizations are consistent, sound, and supported by all relevant information.
At the request of the Board, its Inspector General is examining two aspects of the Federal Reserve System's examination program for large banking organizations:
- Whether there are adequate methods for decision-makers at the relevant Reserve Banks and at the Board to obtain all necessary information to make supervisory assessments and determinations;
- And whether channels exist for decision-makers to be aware of divergent views among an examination team regarding material issues.
Additionally, the Board is conducting its own review of the supervision of the largest, most systemically important financial institutions in the United States. This review will focus on:
- Whether the decision-makers at the Board receive the information needed to ensure consistent and sound supervisory decisions regarding the supervision of the largest, most complex banking organizations;
- And whether adequate methods are in place for those decision-makers to be aware of material matters that required reconciliation of divergent views related to supervision of those firms.
Third, Gretchen Morgenson’s New York Times column published on November 22, 2014, “The Week That Shook the Fed,” likewise addresses the tensions between transparency and secrecy.
We have mentioned three items targeting transparency and opacity in central bank activities. Where are we going with these new and not so new revelations?
Over the years, we have released several commentaries noting that the removal of formal surveillance units in the primary dealers was one of the worst decisions made by the Fed. The proposal for removal of those units came from the Federal Reserve Bank of New York. At the time, Edward Gerald Corrigan was its president. The removal followed the demise of the primary dealer units associated with Drexel Burnham Lambert and Salomon Brothers. In those issues involving Drexel and Salomon, there were no systemic risks imposed on the financial system. At the time, the surveillance units that were formally placed within those two organizations knew exactly the positions of the organizations. Those units were set apart from the rest of their activities. Surveillance units had clear authority and a defined role. That is what prevented systemic risk from arising in a financial crisis out of the deterioration of Drexel or Salomon.
When Corrigan convinced Alan Greenspan that the Fed’s primary dealers were well-regulated elsewhere and that the surveillance units were unnecessary, the Fed changed its rules. The Federal Reserve Bank of New York then removed the surveillance rules, and formal surveillance ended.
Since that time, and after years of sealed records, it is now revealed how the surveillance units were withdrawn. We have experienced the aftermath of not having them there. Proof of their vital role lies in the most recent financial crisis, when events ranging from the Lehman Brothers’ meltdown to the Bear Stearns’ merger, Countrywide Financial Corp’s merger, and MF Global’s demise all point to the structural results of failure to have a formal surveillance unit in a financial institution that has systemic risk characteristics.
Revelations forthcoming, testimony involving William Dudley, President of the Federal Reserve Bank of New York, and investigations regarding cozy relationships with the Federal Reserve Bank of New York’s informal supervisors or observers and Goldman Sachs reveal the destructive nature of secrecy. (For details see Michael Lewis’s take on “The Secret Goldman Sachs Tapes” at Bloomberg View and Ian Katz and Jeff Kearns’s report, “The Fed Under Goldman's Thumb: Segarra's Picture Gets Senate Hearing.”)
Let’s get to the meat of two issues. Do these revelations change risk premia in market pricing of financial assets? And is this just a policy issue without a price?
Responses to Bob Eisenbeis’s commentary and conversations with me, colleagues, and agents in the financial markets reveal universal criticism of central banks’ secrecy policies, whether the central bank involved is the US Fed or the Bank of England, with its now-revealed covert policy. No one we have spoken with, not one person, has risen to defend opacity instead of supporting transparency.
We’ve spoken to former Fed and Bank of England officials, supporters, advisors, and academics. Highly skilled counselors to central banking authorities worldwide criticize this developing story of secrecy. Among the writings that we have seen within our firm and the dialogues that we have had on various committees and in organizational settings around the world, there has so far not been a single positive response to the idea that the work of central banks should be cloaked in secrecy.
The central banking authorities who are deciding to pursue private cozy relationships, covert policies, and secret actions are acting outside of the sphere of their mandates and are doing so without the support of their thoughtful peers. They are close to becoming full-fledged renegades or rogue actors.
Let’s get to risk premia and markets. Lots of factors enter into market pricing of financial instruments. We know this. Therefore, it is extremely difficult to isolate a pricing factor and attribute it directly to a single cause.
We can, however, do it in certain cases: when a single stock price deteriorates as news about the inner workings of an organization breaks, cause and effect are clear. We see the impact of news more broadly in the deterioration in stock prices, whether in the UK or the US. We saw that in 2007 and 2008 with its awful, deleterious erosion of financial wealth. We saw it again in the prices of securities that were forced to merge under extreme duress. When there are key actors under scrutiny, it is clear that a single stock, stock price, or group of stocks can be impacted by risk premia changes. Those changes are generally attributable to either opacity or to policy errors.
There are broader categories of instruments, however. If significant numbers of single stock prices are impacted negatively, the entire basket of stocks or the entire sector is also impacted. We can track those changes by comparing relative sector pricing, one against the other. During the financial crisis, we saw individual idiosyncratic stocks and their falling prices negatively impact collective baskets of stocks. In turn, those baskets dragged down the broad category of financial assets and finally the entire financial sector, where the good and the bad all melted down in price.
The same occurred with the debt instruments attached to those organizations. People worried about getting paid. They bid up the price of credit insurance. That helped trigger falling prices and higher yields for the debt of organizations that wanted to finance themselves. Just like the stock market, the bond market began to pay the price through widening risk premia. At the worst point of the financial crisis, the entire system was frozen.
In the wake of the failure of Lehman and AIG there was a period of three to four months in which nothing functioned in the financial sector. No one trusted anyone, and the central banks undertook massive liquidity injections in order to survive. By the way, those central banks acted with characteristic cozy secrecy. They could not bring themselves to accept that full transparency and prompt, truthful revelation is the shortest way to healing a system and the most direct way to limit losses.
Those of us who trade in financial markets, manage securities, and make discretionary judgments on behalf of clients understand this principle. Small losses taken immediately are much cheaper than delayed responses and hence large losses. Be transparent and fast. If there is an error, catch it, fix it, and disclose it. Act quickly and do not suffer from “analysis paralysis.” That is the lesson of experienced financial market agents who have to deal on the other side of the transactions and are being thwarted by the secret activity of central banks and their regulatory bodies.
We learned from the financial crisis that an extreme breakdown of the financing mechanism of market agents and their institutions leads to a complete cessation of activity. And the slide from transparency to opacity strikes beyond the financial sector and into the real economy. The failure of Wall Street reaches Main Street. Companies then lose their ability to clear their financial transactions and obtain credit for their operations. This downward spiral triggers the kind of severe recession we saw in 2008 and 2009. The more credit-sensitive the sector (like Housing), the bigger the disaster when the failure occurs.
Each one of these progressive steps originates in the circumstances that preceded it in the narrower sector. When one examines the sequence from A to Z, contagion starts with the failure within the regulatory and supervisory institutions. It starts in the central banks. Whenever they act with secrecy at any level in any decision, they trigger a sequence that can lead to rising risk premia. The relationship between central bank secrecy and opacity and the outcome of rising risk premia is integral. It reaches across time and operates so broadly that its diffuse impacts are difficult to measure, though we can trace cascading consequences that ultimately wreak havoc.
How can we take precise measure of the role Fed rule changes played in the failure of Countrywide Financial Corp., its forced merger with Bank of America, the subsequent failures of Bear Stearns and Lehman Brothers, and the meltdown occasioned by the housing crisis? Would things have been different if the Fed’s decisions surrounding Countrywide Financial Corp. had allowed it to fail with full transparency? If surveillance units had not been extracted from primary dealers but had instead been ensuring accountability in Countrywide Financial Corp. from the beginning, with strictly determined rules, would Countrywide’s behavior have led it to its own demise and all that followed from it?
Can we ultimately trace the financial crisis to the removal of the surveillance units 15 years before the failure of Lehman Brothers and AIG precipitated a meltdown? Is there a way to determine this sequence and thoughtfully expose it so that corrective action will occur within our financial system?
We do not know how these issues will be addressed as we move into 2015, but we do have the ability to surmise and perhaps forecast some events. Here is what we think occurs next year in the US.
Republican majorities in the Senate and the House are likely to develop and pass the “Audit the Fed” legislation. It may have enough votes attached to it to override a veto by President Obama. Alternatively Obama might not use a veto or his small amount of political capital that remains to veto this type of legislation.
Both the Senate and the House will hold inquisitive hearings into the US central bank’s activities and the relationships that occur among the bank, primary dealers, and other market agents who do business with the central bank. We have already seen the beginning of those probes, and the preliminary revelations are disturbing. Our expectation is that there will be more probes, more revelations, and further cause for concern.
Will there be criminal prosecutions from private central bank information misuse? Can there be a construction in which the criminality of an insider trade in the securities market is extended to other market agents who take advantage of inside central bank knowledge for personal gain? This is a classic conflict in government and must be examined in the context of central banking.
More importantly, will there be an examination of the entire system and its changes so that the beginning point of the discussion about auditing the Fed rightly becomes Drexel Burnham Lambert’s failure while the formal surveillance unit was on-site? Will the discussions start by examining the system that was responsbile for supervising market agents and their dealings with our central bank, at a time when failures of idiosyncratic institutions were insulated by these detectives who were formally scrutinizing on-site?
We would like to see the investigation and the move to “Audit the Fed” start with Drexel Burnham Lambert and Salomon Brothers. We would then like it to examine the changes in rules that took place when Corrigan was president of the Federal Reserve Bank of New York and Greenspan and his board accepted the changes he proposed. Watch the entire progression of two decades and then complete an audit that examines the policy changes that altered transparency, introduced more opacity, and added the poison of covert activity and secrecy.
Some form of “Audit the Fed” is coming. If it is a politically noisy investigation rather than a thoughtful one, it will follow other politically noisy failures. In our view, our politicians will come out for the worse and our central bank none the better.
If serious observers of central bank activity, former central bankers and their advisors, and academic counselors are able, invited, and willing to discuss in detail this 20-year period of time, then we can reach some improvement in this most important supervisory function of our financially oriented US economy. Can we be an example for others worldwide, including the UK, whose own central bank has now veered in the wrong direction, from transparency to covert action?
2015 is going to be an interesting year.
David R. Kotok, Chairman and Chief Investment Officer