Monday, February 6, 2012

Joseph Stiglitz says need for transparency is one of the main lessons of financial crisis

In his Guardian column, Nobel prize winning economist Joseph Stiglitz says the need for transparency in the financial system and particularly transparency of bank exposure details is one of the main lessons of the financial crisis.

Naturally, regular readers are pleased when an individual of Professor Stiglitz's stature confirms the need for ultra transparency.

Professor Stiglitz establishes the need for ultra transparency by looking at the Greek sovereign debt restructuring.

Nothing illustrates better the political crosscurrents, special interests, and shortsighted economics now at play in Europe than the debate over the restructuring of Greece's sovereign debtGermany insists on a deep restructuring – at least a 50% "haircut" for bondholders – whereas the European Central Bank insists that any debt restructuring must be voluntary.... 
"innovation" in financial markets has made it possible for securities owners to be insured, meaning that they have a seat at the table, but no "skin in the game". They do have interests: they want to collect on their insurance, and that means that the restructuring must be a "credit event" – tantamount to a default. 
The ECB's insistence on "voluntary" restructuring – that is, avoidance of a credit event – has placed the two sides at loggerheads. The irony is that the regulators have allowed the creation of this dysfunctional system. 
The ECB's stance is peculiar. One would have hoped that the banks might have managed the default risk on the bonds in their portfolios by buying insurance. And, if they bought insurance, a regulator concerned with systemic stability would want to be sure that the insurer pays in the event of a loss. 
But the ECB wants the banks to suffer a 50% loss on their bond holdings, without insurance "benefits" having to be paid. 
There are three explanations for the ECB's position, none of which speaks well for the institution and its regulatory and supervisory conduct. 
The first explanation is that the banks have not, in fact, bought insurance, and some have taken speculative positions. 
The second is that the ECB knows that the financial system lacks transparency – and knows that investors are aware that they cannot gauge the impact of an involuntary default, which could cause credit markets to freeze, reprising the aftermath of Lehman Brothers' collapse in September 2008. 
Please note that both the interbank lending and unsecured bank debt credit markets have already frozen.

The ECB has addressed this by expanding the collateral it will accept to include loans and introducing a long term refinancing operation so that banks have access to all the liquidity they need to cover investor fund withdrawals.
Finally, the ECB may be trying to protect the few banks that have written the insurance. 
None of these explanations is an adequate excuse for the ECB's opposition to deep involuntary restructuring of Greece's debt. 
The ECB should have insisted on more transparency – indeed, that should have been one of the main lessons of 2008. 
Yes it is one of the main lessons of 2008 if not The Main Lesson of 2008!

The question your humble blogger has is given that transparency was one of the main lessons of 2008, how come global policy makers and financial regulators have done nothing to address it?

I do not see any banks that are required to provide ultra transparency.  I do not see any structured finance securities that are required to provide observable event based disclosure for the underlying assets.

In short, I do not see where global policy makers and financial regulators have done anything that improves valuation transparency (ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner).

Considerable policy making and regulatory effort has gone into improving price transparency.

However, regular readers know that price transparency in the absence of valuation transparency is meaningless.  Market participants have to be able to independently value a security before they can determine whether they want to buy, sell or hold the security at the price being shown by Wall Street.
Regulators should not have allowed the banks to speculate as they did; if anything, they should have required them to buy insurance – and then insisted on restructuring in a way that ensured that the insurance paid off.
With ultra transparency, regulators would not have been responsible for exerting discipline on bank risk taking (something they failed at leading up to the financial crisis).  Instead, market participants would do it for them.

With ultra transparency, market participants could independently assess the risk of each bank and adjust the amount and price of their exposure based on this assessment.

Naturally, banks that take a lot of risk will see their cost of funding increase and their access to funding decrease.  Since higher cost tends to decrease a bank's profitability, these higher costs provide an incentive for bank management to reduce risk.
There is, moreover, little evidence that a deep involuntary restructuring would be any more traumatic than a deep voluntary restructuring. By insisting on it being voluntary, the ECB may be trying to ensure that the restructuring is not deep; but, in that case, it is putting the banks' interests before that of Greece, for which a deep restructuring is essential if it is to emerge from the crisis. 
In fact, the ECB may be putting the interests of the few banks that have written credit-default swaps before those of Greece, Europe's taxpayers, and creditors who acted prudently and bought insurance....
The one argument that seems, at least superficially, to put the public interest first is that an involuntary restructuring might lead to financial contagion, with large eurozone economies such as Italy, Spain, and even France facing a sharp, and perhaps prohibitive, rise in borrowing costs. 
But that begs the question: why should an involuntary restructuring lead to worse contagion than a voluntary restructuring of comparable depth? 
If the banking system were well regulated, with banks holding sovereign debt having purchased insurance, an involuntary restructuring should perturb financial markets less....
Or if there were ultra transparency in place and market participants could adjust their exposure knowing who was holding onto the losses on the sovereign debt or insurance.

As this blog has repeatedly said, ultra transparency is the antidote for financial contagion.
The ECB's behaviour should not be surprising: as we have seen elsewhere, institutions that are not democratically accountable tend to be captured by special interests. That was true before 2008; unfortunately for Europe – and for the global economy – the problem has not been adequately addressed since then.
One reason that requiring ultra transparency is so important is that it dramatically reduces the negative impact on the capital markets and the global economy of the institutions that have been captured by special interests.

Imagine how the Greek restructuring talks would change if everyone knew who was holding the losses!

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