Sunday, January 30, 2011

Economist Magazine Champions Creation of the 'Mother of All Databases'

The January 15, 2011 Economist Magazine championed your humble blogger's call for the creation of the 'Mother of All Databases' for the global financial industry.

The 'Mother of All Databases' would end opacity in the global financial system.  It would have current asset-level data for every financial institution, broadly defined, and shadow banking entity, including structured finance securities, on an observable event basis.

What is observable event based reporting?  For each individual loan or receivable on a bank balance sheet, it is simply whenever there is a payment, a delinquency, a default, an insolvency filing by the borrower or similar event, it is reported on a borrower privacy protected basis to the market on the day that it occurs.  For each security, whether in the trading or investment book, it is simply whenever there is a purchase, sale, a payment, a delinquency, a default, an insolvency filing or similar event involving the security, it is reported to the market on the day that it occurs.

As reported in the Economist Magazine article titled "the great unknown - can policymakers fill the gaps in their knowledge about the financial system": [emphasis added]
IN THE depths of the Great Depression, Presidents Hoover and Roosevelt had to set economic policy on the basis of information that decision-makers today would consider pathetic. ...
The world has since invented a vast array of financial and economic statistics and the processing power to crunch them. Yet policymakers are today in a similar position with regard to the financial system. New “macroprudential” bodies have been tasked with maintaining financial stability, such as the European Systemic Risk Board (which has its inaugural meeting next week) and America’s Financial Stability Oversight Council. But the crisis exposed vast gaps in knowledge. From conduits and subprime-related securities to the regulatory-capital-enhancement swaps written by AIG, there was a bewildering list of financial exotica that played a significant role in the meltdown.
As regular readers of this blog know, FDR did not limit access to information to only policymakers.  Instead, he created a financial market system that functioned well for 70+ years based on disclosing information to all market participants.

In this financial market system, FDR laid out a framework (see hereherehere, and here for example) for what the government should and should not do in the financial markets:
  1. Governments should make sure that market participants are provided with useful, relevant information in an appropriate, timely manner.
  2. Governments should not endorse specific investments.
The Economist Magazine article continues with how policymakers would use the information in the 'Mother of All Databases'.

The International Monetary Fund (IMF) and the Financial Stability Board (FSB), a global club of regulators, have picked some priorities. Three things are at the top of the wish-list. First, system-wide measures of borrowing and “maturity mismatch”, where banks use short-term funding to buy long-term assets. As in the past, these were the root causes of the financial crisis. The world’s ten biggest banks more than doubled the size of their balance sheets between 2003 and 2007. As they made loans faster than they gathered customer deposits, banks plugged the gap by short-term borrowing, often from other financial firms. After the collapse of Lehman Brothers in September 2008 many banks faced severe difficulties rolling over this funding.
Maturity mismatch was not a cause of the financial crisis.  It was like trees in a forest, fuel when the fire began.

As has been repeatedly said on this blog, the cause of the financial crisis was opacity.  Opacity in structured finance securities that made it impossible to value these securities.  Opacity in bank balance sheets that made it impossible to determine which banks were solvent and which banks were not.

Opacity is the issue that the 'Mother of all Databases' addresses.
The second priority is data on the links between big banks and other bits of the financial system. It was not just the investment banking giants that had exposures around the world. Many European institutions were up to their necks in securities linked to the American housing market. This suggests that more information is needed on banks’ exposures across borders and the concentration in underlying asset classes.
This is why Jamie Dimon, Gary Cohen and Peter Sands need and want the 'Mother of All Databases' for the global financial industry.  They want to have visibility so they and their organizations can see and get out of the way of big dumb banks and other lightly supervised entities before these banks and entities fail.
The final priority is data on the “shadow banking system” which comprises non-bank financial firms that often slip below regulators’ radar. In the run-up to the crisis, regulated banks became too reliant on shadow banks for funding. Off-balance-sheet vehicles were used to create further layers of intermediation, making things even more opaque.
The goal for the 'Mother of All Databases' is to eliminate opacity throughout the global financial system.  Therefore, "shadow banking system" also needs to provide data.  

For example, structured finance securities need to provide current asset-level information on an observable event basis.  Market participants need this data to analyze, value and make portfolio management decisions (buy, hold or sell) based on the price being shown by Wall Street and bring liquidity back to the structured finance market.
The IMF and FSB will report back in June this year. Some progress has been made. The Bank for International Settlements (BIS), a club of central banks, has used its data on international banking to develop a measure of maturity mismatch. But this is restricted to banks, and covers only their international activities and on-balance-sheet positions; and, as the euro-zone crisis has shown, the BIS data can also be difficult to interpret.
To get a better handle on global banks, the FSB has developed a common reporting template, which will identify exposures to different financial sectors and national asset markets. Persuading banks actually to fill it in may be harder: widespread consultation will be needed and there are confidentiality and legal issues to grapple with.
Collecting the data is not difficult if regulators want to do it, the information technology to support the database has existed for over a decade, nor does it take additional legislation.  What it takes to create the 'Mother of All Databases' is for either the regulators or industry to step up and do it.

To show their appreciation for all that regulators and the taxpayers have done for them since the beginning of the financial crisis, without being asked by regulators, the leading global financial institutions should voluntarily provide their current asset-level data to the 'Mother of All Databases'.

The shadow banking system poses a thorny problem too. The IMF is trying to measure the problems of sectors where data do not exist or are sparse: for instance, for hedge funds, money-market funds and over-the-counter derivatives. This will require twisting the arms of financial firms that currently do not report data. Until then, the most severe gaps may be in the most leveraged parts of the financial system.

To date, regulators, under significant pressure from industry trade groups, have backed off from asking for data from the shadow banking system.  

For example, in May 2009 the European Parliament passed Article 122a as an amendment to the Capital Requirements Directive.  Article 122a requires that credit institutions that invest in structured finance securities must know what they own.  

The European Banking Authority, formerly the Committee of European Banking Supervisors, was given the task of developing the regulatory guidelines for Article 122a.  It issued a request for public comment.

The only response out of 18 responses that was not from a sell-side firm, an industry trade group dominated by the sell-side or a law firm representing the sell-side focused on the need for underlying asset-level data on an observable event basis.  It used the Brown Paper Bag Challenge (see here, here and here) to show that the only way an investor can know what they own for a structured finance security is if they have access to the underlying asset-level data on an observable event basis.  

In its discussion of responses to its public consultation, the European Banking Authority made no mention of this one response.

Naturally, in setting the regulatory guidelines for implementing Article 122a, the European Banking Authority did not address whether asset-level disclosure should be done on an observable event basis.

Both the Bank of England and the European Central Bank have also looked at requiring asset-level disclosure for structured finance securities.  Both of these central banks were concerned with the possibility of losses by the central banks if they accepted structured finance securities onto their balance sheets but were unable to value these securities both prior to their being pledged and while on the central bank balance sheet.

Despite knowing about the Brown Paper Bag Challenge and why these securities could not be value (see here and here), the central banks, with heavy reliance on expert committees dominated by sell-side firms and sell-side dominated industry trade groups, have not made current asset-level disclosure on an observable event basis a requirement for eligibility to be pledged to their balance sheet.
Paul Tucker of the Bank of England worries about the threats to financial stability that are created from outside the regulated sector and wonders whether the “regulatory perimeter” should be widened to encompass such institutions. That would allow regulators to supervise these firms, but would also give policymakers better information.
Even if the regulatory perimeter is not widened, the requirement that these firms provide data should be.  The goal is better information that is shared with all market participants.  For those institutions outside of the formal regulatory perimeter, market discipline will have to work to reduce their threat to the stability of the financial system.

What you don’t know will hurt you
For all the effort expended on data gaps, the constant evolution and footloose nature of the financial system complicates matters hugely. As bank whizz-kids dream up new products, it will be hard for officials to keep up. Indeed, there is a good case that new financial techniques are created precisely because regulators cannot spot or understand them and therefore do not penalise them for being risky. 
Actually, a better case can be made that the whole point of these financial innovations is to create opacity.  As Yves Smith observed on Naked Capitalism:

... opacity, leverage, and moral hazard are not accidental byproducts of otherwise salutary innovations; they are the direct intent of the [financial firms'] innovations. No one was at the major capital markets firms was celebrated for creating markets to connect borrowers and savers transparently and with low risk. After all, efficient markets produce minimal profits. They were instead rewarded for making sure no one, the regulators, the press, the community at large, could see and understand what they were doing.
This is why precisely why regulators need to focus on making sure that useful, relevant information is being disclosed in an appropriate, timely manner.

Returning to the Economist Magazine article:
The insurance contracts that made AIG so entwined with the banking system were designed to help banks boost their capital ratios. The bundling of risky loans into complex securities was attractive for many firms precisely because they had low capital charges. Regulators, therefore, are not just in a race to keep pace with finance, they are in a constant battle to outwit it. The hope is that good market intelligence, for example discussions with clued-up investors, can help officials to become more savvy.
As discussed in the FDR Framework, the task regulators have is to constantly evolve the data disclosure requirements so that opacity does not return to the financial system.
Yet imagine data nirvana: a colossal, constantly updating spreadsheet of the trading and lending exposures, cross-border activity, interconnectedness and funding risks of all regulated and unregulated institutions.
A nice summary of what is in the 'Mother of All Databases'.
Even if a few humans could get their heads around it—a collective nervous breakdown is more likely—they would still have to decide when to act.
In the run-up to the crisis policymakers and supervisors, like most other people, managed to rationalise bad things that were plain for all to see, such as inflated house prices and some banks’ rock-bottom capital levels. As Claudio Borio of the BIS puts it, “The main reason why crises occur is not lack of statistics but the failure to interpret them correctly and to take remedial action.”
The argument misses that under the FDR Framework the data in the database should be available to all market participants and not just policymakers and supervisors.  

For example, the Wall Street Journal ran an article on the Bank of England's (BoE) plan to adopt 21st century oversight of financial institutions.  This plan places "a greater emphasis on understanding macroeconomic issues and on requiring the banks to disclose more information to the markets."  

This plan explicitly trades off market discipline for bank examination and requires the creation of the 'Mother of All Databases'.

According to the 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 current bank oversight 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, including competitors, 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.

This point is very important as it is the key to why the FDR Framework can be successfully updated for the 21st century using existing information technology to create the 'Mother of All Databases'.  

Since the markets can and have an incentive to turn the disclosed data into useful information, the markets are able to bring discipline to the financial system that the regulators with their resources cannot.

There are no technological hurdles that prevent making this data available.  There are no technological hurdles that prevent the market from using this data.  

The cost of providing the data is not a hurdle.  Particularly when this cost is compared to the trillions of dollars of losses that the global financial system suffered in the credit crisis because the market did not have this data.

What has prevented this data from being made available is the lack of a regulator who would champion this approach or the industry recognizing that it is in its best interest to create the 'Mother of All Databases' itself. 

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