Donald Kohn's call for optimal transparency

In his speech, Enhancing financial stability:  the role of transparency, Donald Kohn calls for theoretical and applied research in the area of "optimal transparency".  He calls for this research because he and the other members of the Bank of England's Financial Policy Committee see that transparency has a role in enhancing financial stability.

Fortunately, this is the research I have done for several years and on which my prediction of and subsequent predictions about the credit crisis is based.  On the theoretical side, I have written the seminal articles on transparency.  On the applied research side, I hold a patent in the application of transparency using 21st century information technology to structured finance securities.

With that background, in his speech, Mr. Kohn looks at a series of potential trade-offs surrounding transparency including

• between the amount of information disclosed and the ability of market participants to analyze the data and turn it into useful information and 
• between the benefit of the information being disclosed and the cost of providing the information.

Mr. Kohn observed,

Promoting greater transparency was an important theme of the initial discussions of the FPC.  Our first two policy recommendations focused on public release of information about sovereign and banking sector exposures.

Following up on this, he commented,

In transparency, as in many other aspects in life, more is not necessarily better.  Greater amounts of information can make it difficult for investors to pick out the important bits that have a significant bearing on risk.

Regular readers know that under the FDR Framework, using 21st century technology, the market is capable of analyzing vast quantities of data and assessing individual firm's and systemic risk.

To show this is true, let me walk you through the following analysis.

Based on what Mr. Kohn said, we can chart the tradeoff between the benefit of transparency and the amount of information disclosed.  The Y-axis of the chart is the benefit of transparency.  The X-axis of the chart is the amount of transparency.  Clearly, there is no benefit if there is no transparency.

Moving to the right on the X-axis, the first point of interest on the chart is the current level of disclosure.  It too has essentially no benefit.  As he said,

A lack of information also contributed to the mispricing of risk...and the lack of information exacerbated the downturn.

I have confirmed this observation by documenting on this blog that the current level of disclosure for both financial institutions and structured finance securities has essentially no benefit.  For example, the financial crisis has shown that the current level of disclosure is inadequate for use in determining if a financial institution is solvent and for valuing structured finance securities.

Continuing moving to the right on the X-axis, we arrive at the point with the additional disclosure recommended by the FPC.  Clearly, the FPC would not have recommended this disclosure if they did not associate it with a positive benefit.  As a result, we know we have also moved up the Y-axis.

Presumably, as we continue moving to the right on the X-axis and providing more disclosure, the benefit curves continues to slope up.

Under the FDR Framework, I have also recommended greater disclosure.  Where there is a disagreement is how much more disclosure is needed in order to deliver the benefits of transparency like market discipline.

I along with Jamie Dimon, Peter Sands and Bob Diamond - who would like to know who their dumbest competitor is - would say that the benefits of transparency occur at the point where all the useful, relevant information is disclosed.  For financial institutions and structured finance securities, this is the point of disclosure of all current asset and liability-level data.

Numerous economists and regulators - who appear to be trying to preserve their information monopoly - agree with Mr. Kohn's proposal that we reach a point on the X-axis before all the useful, relevant information is disclosed where so much data is being disclosed that market participants can no longer analyze the data.  At this point, like going over a cliff, all the benefits of disclosure are lost.  Furthermore, any more disclosure past this point also will yield no benefit.

Does this point where there is so much information disclosed that the benefits of disclosure or the ability of market participants to analyze it and transform it to useful information exist?  No!

At the point of maximum disclosure, where a financial institution would disclose all of its current asset and liability-level data, its competitors and third party experts would know how to analyze this data and turn it into useful information.  [Please note, this maximum point of disclosure does not require a financial institution to reveal its proprietary business strategies; a red herring argument that is frequently thrown out to deflect attention from what is needed to be disclosed.]

If the competitors could not assess this data, then they also could not analyze their own data and turn it into useful information.  If this were true, this would confirm the importance of transparency.  Financial institutions that are incapable of analyzing their own data and turning it into useful information should be broken up into smaller pieces.

It is not a requirement for transparency to enhance financial stability that all market participants be able to transform the data disclosed into useful information.  What is required is that some market participants can transform the data disclosed into useful information.

The trade-off  discussed by Mr. Kohn is actually better represented by changing the Y-axis from "benefit from transparency" to "sufficient to enforce market discipline".  This is also consistent with Mr. Kohn's intentions as it is market discipline that enhances financial stability.

With this change, the chart shows either a zero on the Y-axis when disclosure is insufficient or a one on the Y-axis when disclosure is sufficient to enforce market discipline.  

What this new chart shows is that there is no logical stopping point between what even the FPC agrees are the current inadequate levels of disclosure (zero market discipline) and what BNP Paribas' chief executive called utter transparency, current asset and liability-level data disclosure (market discipline).

Mr. Kohn also discussed a trade-off between the cost of transparency and the benefit of transparency.  He said

Collecting and publishing information is not a costless undertaking, and requirements and expectations must be based on considerations of the balance of benefits and costs.

Regular readers know that the trade-off between the cost and benefit of transparency exists.  They also know that the cost of utter transparency, current asset and liability-level disclosure, by financial institutions and structured finance securities is an insignificant figure compared to the benefit of transparency.

I am actually surprised that this is still an issue worthy of additional discussion.

Andy Haldane, who also sits on the FPC, laid out the benefits of transparency when he talked about the "cost" of the financial crisis.  Mr. Haldane talked about trillions in cost ranging from losses on structured finance securities to losses from the negative impact on global economic growth.  Presumably a sizable percentage, if not most of these losses could have been avoided had there been adequate disclosure.

When it comes to setting the optimal level of transparency, we are also dealing with a zero/one situation. Either there is adequate transparency or there is not.  The cost of not providing adequate transparency is, as Mr. Haldane showed, measured in the trillions.

Using 21st century information technology, the cost of providing utter transparency, current asset and liability-level data, is well below $50 billion per year.  It is also a cost that will decline over time as technology advances.

Equally importantly, the cost of providing utter transparency is not significantly greater using 21st century information technology than providing a lower level of disclosure that may or may not result in market discipline.  However, the risk to financial stability is significantly higher with the lower level of disclosure.

Since a crisis could occur in any year where there is inadequate disclosure, the cost/benefit analysis shows that the benefit of saving trillions a year from utter disclosure overwhelms the cost of providing this disclosure.

Optimal transparency for financial institutions and structured finance securities is the disclosure of current asset and liability-level data required under the FDR Framework.  Market participants are able to analyze the information and turn it into useful information.  It is also the information that can be easily justified disclosing under a cost/benefit analysis.