Systemic Risk Regulation Requires Greater Transparency

Four weeks ago, Goldman Sachs CEO Lloyd Blankfein wrote a most intriguing article for the Financial Times. Entitled, "To avoid crises, we need more transparency," Mr. Blankfein distills the two most important lessons from the financial crisis and in so doing, helps to clarify that mischaracterizing the problem leads policy makers to treat symptoms and not the underlying disease.

Mr. Blankfein's first point is that "the systemic regulator must be able to see all the risks to which an institution is exposed and require that all exposures be clearly recognised." [bold emphasis added] With this definition of transparency, Mr. Blankfein relegates to the world of opacity anything less. In this he echoes the position of Paul Volcker and the Group of Thirty in a most valuable January 2009 report on financial stability.

The devil is in the details, however, and Mr. Blankfein offers a clue as to how a systemic risk regulator must approach the question of risk. He states unequivocally:

"It is not enough even that all exposures be identified. An institution’s assets must also be valued at their fair market value – the price at which willing buyers and sellers transact – not at the (frequently irrelevant) historic value." [bold emphasis added]

On October 24th, I offered a definition of transparency that borrowed heavily from Nobel laureate Joseph Stiglitz when I wrote this definition of transparency as it applied to structured finance securities:

Widely disseminated cash flow data as to collateral underlying securitized assets on a daily basis such that investors may use the data to reliably value and price these securities and negate the advantage of asymmetrical information normally enjoyed by firms trading these securities with access to more reliable and timely data.

Mr. Blankfein offered a more simplified definition of transparency. It is the data necessary to permit regulators to ascertain the complete risk profile of a company being regulated and investors the ability to value and price securities on a daily basis. Anything less is opacity.

The ability of a systemic risk regulator to adequately perform these two levels of oversight will depend entirely on the quality of information on hand. Clearly, the industry standard method of disclosure in this financial crisis has proven to be entirely inadequate for both its regulatory purpose and for the ability to bring willing buyers and sellers together at an agreed upon price.

The two main proposals before Congress seek to have a systemic risk regulator that is either a weak form (Frank) or a strong form (Dodd). While I prefer the strong form of a systemic risk regulator as outlined in a September article, the turf battle debate somewhat misses the mark.

Neither form of systemic risk regulation will prove effective in preventing a future financial crisis if there isn't sufficient information for quality regulation.
Indeed, there is an excellent argument that having many regulators with access to the same quality information may be a superior methodology as it permits many eyeballs to review the data. This is the thesis in Daniel Roth's article on the need for a central database.

Pooling together the disparate information gathered by the many regulators is an inefficient and ultimately less-than-useful methodology for systemic risk regulation.

First, there is no guarantee that pooling the information will give a complete picture of a company's systemic risk profile, especially if the different regulators are utilizing the current industry standards for disclosure. Second, the method increases IT costs dramatically. A better solution is to have a central database collect "all of the information" and make it available to regulators and investors around the world (as it pertains to the ability to value and price securities on a daily basis as Mr. Blankfein indicates).

Obviously, government needs to pay for this database as I've written many times in the past. Only government can by law override the contractual disclosure provisions that dictate how money is distributed in structured finance and what information must be disclosed. Only government can require that the database be administered by an independent third party. Asking the securities industry to do this, an industry with an ingrained belief in the profitability (for them) of opacity, is a bit like asking a casino to disclose the odds of winning on a slot machine.

The belief in the profitability of asymmetrical information is too deeply a part of the Wall Street psyche to be overcome voluntarily. It must be mandated by government and for the information/data to be trusted by investors demands that it be administered by an independent third party. See this article in Total Securitization.

The value of this approach is that investors will be able to trust the information flow from the government created database. As such it will answer the implementation question Mr. Blankfein leaves open at the end of his article:

"The task of a systemic regulator will be superhuman without the transparency and tools to instil market discipline. The trouble with the old system is it is too easy for institutions to deny problems that allow systemic risks to fester and grow. This denial contributed significantly to the distrust that froze the system."

Mr. Blankfein correctly identifies opacity, a lack of transparency, as a central cause of the financial crisis.

FDR defined transparency as all of the material information an investor would need to make an informed decision as to an investment. That became the basis for the securities acts in the 1930s. Those laws served us well for almost three generations. Seventy years later, in the name of greed, we allowed a beast to be created with a foundation, not of transparency, but of opacity and we are still paying for that lack of judgment.

As Mr. Blankfein intimates, it is time to correct that mistake. It is time to implement real transparency.

Comments

[Tadit Anderson:]

Well stated, and transparency applied as a general principle will eliminate the temptation to fraud as perpetrated by perpetrators in positions of control by positions by way of accounting razzle dazzle. To enforce this practice will require the restoration of the regulatory institutions and of the leveraging of the political process. Poof all of the executive perks and short frame analysis of performance. In the transition we could expand the incarceration institutions to include a Club Fed. I have to wonder how much of the calls for transparency is just another misdirection toward something far less than what should be required. The unstated requirement is also the slowing down of the whole process, despite the investment in the strategies of sneak and peek connected to ultra fast computers. The screaming and protest of the well heeled will probably echo around the globe. I need to read Stilglitz's asymmetry paper to see if going "symmetrical" would involve exploding a whole series of economic rationalizations, such as who is entitled to decide what a comparative advantage would be and actually for whom in particular. Likewise hollowing out an economy also is a very bad investment really for all concerned in even the moderate long run. Minsky would I expect approve in particular for the untested "innovations." This might even reduce banking to the utility that its trade representative typically claim that they serve. Bye bye, criminogenic culture. thank you
economics.arawakci...

Nov 11 05:41 AM