Monday, November 22, 2010

The Future of Finance: The End of Opacity and The Mother of All Databases

The future of finance is the elimination of opacity throughout the financial system by using 21st century information technology.

This statement is the logical conclusion of the Bank of England's plan to substitute market discipline for bank examination.  As discussed in an earlier blog, Bank of England Adopting 21st Century Oversight of Financial Institutions,  the current model of bank examination does not work.

The current bank examination model, as practiced by regulators like the Financial Services Authority and Federal Reserve, involves sending out large numbers of examiners to look through the banks' books, demanding lots of detailed information for their internal review and asking the banks to run stress tests on assumptions the regulators provide.  A key feature of this model is that no detailed information is shared with the markets.

If this model looks like it parallels how the rating agencies operate, it does.   The parallel in the US goes all the way to the issuance of a CAMELS rating by the regulator.  A CAMELS rating is for regulators eyes only and is a reflection of a bank's overall condition in the areas of capital adequacy (C), asset quality (A), management (M), earnings (E), liquidity (L) and sensitivity to market risk (S).

Just like the ratings produced by the rating agencies, since the markets do not have the information to do their own homework, the markets have to trust that the regulators get their ratings right.  Unfortunately, recent history shows that regulators were just like the rating agencies and they did not always get their ratings right.

According to a WSJ article, "a top Bank of England official, Andy Haldane, said the new regulator will curtail the FSA's practice of dispatching dozens of examiners to banks to collect loads of granular information... Mr. Haldane noted that ... they rarely yield much useful information for regulators, who can find themselves overwhelmed by the quantity of data."

Mr. Haldane identified the flaw in the bank examination model and the reason that regulators need to have banks disclose more information to the markets.

The markets are not overwhelmed by the quantity of data disclosed by financial institutions.  There are a number of market participants who are able to and have an incentive to analyze all of the individual asset level data these institutions could provide and turn it into useful information.

Andrew Redleaf, a hedge fund manager, takes the idea of banks disclosing data and market participants using this data further.  

He wrote "the late crisis happened not because banks were reckless or regulators incompetent, though both were surely true. It happened because together banks and regulators forged a system that denied citizens and markets the information they needed to respond rationally to events.

Banking has always been too secretive in this country. Banks are quasi-public institutions, performing both private and public functions, including sustaining the credit system that sustains the dollar itself. In return, the big banks especially are granted extraordinary privileges, such as the right to borrow from the Fed virtually for free at times of crisis. Under the circumstances there is no excuse for bank balance sheets to be anything but utterly transparent to the citizens and investors....

Imagine for a moment that in 2004 the government had required every major financial institution in the U.S., any one with the potential for imperiling credit markets, to publish their investment positions. All of them. In detail. Lists of every security or derivative held in their portfolios, along with all data about the underlying mortgage pools, defaults so far, etc.
With such a rule in place, the mortgage crisis likely would never have happened on the scale it did. Most of the worst mortgages, the loans that crashed the system, were written from 2005 through the early days of 2007. Opening the banks' books would have revealed just how near the edge they were playing. The resulting market pressure on bank securities would have forced them to cut back their mortgage books. This would have been a crisis of a sort; the housing bubble would have popped. But popping the bubble two years earlier would have avoided the worst of the damage.
Even if transparency failed to avoid the mortgage crisis, it almost certainly would have prevented the banking crisis and the crash of 2008. Because we would have known. We would have known how much -- or how little -- trouble Bear was in long before March 2008. We would have known, for better or worse, about Lehman, and Morgan, and Goldman, and Citi. Not instantly. It would take time to digest millions of lines of information kept secret for decades. But surely millions of investors poring over the information, including those heroic rag-pickers, of capitalism the vultures and short-sellers would have given us a quicker and better answer than the grand-high-poo-bahs.
The megabanks would hate it....They would scream bloody murder about being forced to let competitors see what they owned. Nonsense. Investors who hold interesting or unusual positions in their portfolios may have something to lose by disclosure. But too-big-to-fail banks have no business taking "interesting" positions. Banks are not supposed to be extra clever, they are supposed to be extra careful."

On February 23, 2009, in a Wired article, Daniel Roth provided the support for Mr. Haldane's observation and solution in much more detail.  

"Even the regulators can't keep up. A Senate study in 2002 found that the SEC had managed to fully review just 16 percent of the nearly 15,000 annual reports that companies submitted in the previous fiscal year; the recently disgraced Enron hadn't been reviewed in a decade. We shouldn't be surprised. While the SEC is staffed by a relatively small group of poorly compensated financial cops, Wall Street bankers get paid millions to create new and ever more complicated investment products. By the time regulators get a handle on one investment class, a slew of new ones have been created. 'This is a cycle that goes on and on—and will continue to get repeated,' says Peter Wysocki, a professor at the MIT Sloan School of Management. 'You can't just make new regulations about the next innovation in financial misreporting.' 

That's why it's not enough to simply give the SEC—or any of its sister regulators—more authority; we need to rethink our entire philosophy of regulation. Instead of assigning oversight responsibility to a finite group of bureaucrats, we should enable every investor to act as a citizen-regulator. We should tap into the massive parallel processing power of people around the world by giving everyone the tools to track, analyze, and publicize financial machinations. The result would be a wave of decentralized innovation that can keep pace with Wall Street and allow the market to regulate itself—naturally punishing companies and investments that don't measure up—more efficiently than the regulators ever could.

Tracking Wall Street's complex inventions may be difficult for regulators, but it's a snap given the right software....
When data is kept under lock and key, as mysterious as a temple secret, only the priests can read and interpret it. But place it in the public domain and suddenly it takes on new life. People start playing with the information, reaching strange new conclusions or raising questions that no one else would think to ask. It is impossible to predict who will become obsessed with the data or why—but someone will.

'People care about money,' Tim Bray, director of Web technologies at Sun Microsystems says. 'There's money in money and substantial personal upside to someone who can mine the data and uncover the truth.'"

How can the disclosure pushed by regulators like Haldane and investors like Redleaf actually be implemented?

By creating the "mother of all databases."  This is the database that your humble blogger has been pushing since before the credit crisis (herehere and here) and is necessary if European investors are going to be able to comply with the 'know what you own" provision of Article 122a of the European Capital Requirements Directive.  

This is the database that the Office of Financial Research and Data (OFR) is suppose to develop, but because it is a governmental entity never will.  OFR is fundamentally handicapped because:

  1. The current operating philosophy of the regulators is not to share detailed information with the market.  
  2. By law it must, where possible, use information collected by other governmental agencies.  What if the frequency that another governmental agencies collects data, say monthly, is not what is required to, as Lloyd Blankfein advised, monitor every position every day?

What is required is an independent third party to run the mother of all databases.  The independent third party must only be in the business of managing this database.  This assures all market participants that the database is free of all conflicts of interest and they can trust the numbers.

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