We finally have a way to measure which banks are Too Big to Fail

Business Insider carried an interesting column by Raúl Ilargi Meijer in which he reviews the idea that it is the interconnectedness of a bank rather than its size that determines the impact its failure would have on the financial system.

More importantly, he concludes that the only way to know this interconnectedness is if banks are legally required to provide ultra transparency and disclose all of the current global asset, liability and off-balance sheet exposure details.

It is nice to have a portion of the academic community backing your humble blogger's call for ultra transparency.

It is even nicer given that they showed how using existing technology, in this case the Google page ranking algorithm, can be used to make the financial system safer should ultra transparency and the "Mother of all financial databases" be implemented.

Team studies the innermost circle of the financial crisis“Too central to fail” instead of “too big to fail”: whether banks pose a risk to the financial system when they get into distress has more to do with their level of networking than with their size. 

Economic researchers at ETH Zurich have developed a method to deduce the “systemic importance” of banks from their complex connections within financial networks. 

“Between 2008 and 2010 a total of 22 banks formed the innermost circle of the financial crisis. They were so intensely connected with each other through credit relationships, mutual equity investments and financial dependencies that the distress of any single one of them could endanger the entire financial system. [..]... 

How Google Can Avert the Next Financial CrisisThe mathematical insight that turned Google Inc. into a multibillion-dollar company has the potential to help the world avert the next financial crisis. If only banks made public the data required to do the job.

Please re-read the highlighted text as the key to averting the next financial crisis is requiring banks to disclose the data required to do the job.

Sixteen years ago, the founders of Google -- computer scientists Larry Page and Sergey Brin -- introduced an algorithm to measure the “importance” of Web pages relative to any set of keywords. Known as PageRank, it works on the notion that Web pages effectively vote for other pages by linking to them. The most important ones, Page and Brin reasoned, should be those drawing links from many other pages, especially from other really important ones. 

If this definition sounds circular, it is. It also captures an authentic reality, which is why respecting it gives far superior results. Page and Brin’s breakthrough involved using mathematics to make it work. The required ideas don’t go much beyond high-school algebra, although it takes lots of computing power to make something as sprawling as the World Wide Web possible. 

What could this have to do with finance? Quite a lot. The systemic risk that turned the U.S. subprime-lending crisis into a global disaster is circular, too. We can’t identify it simply by looking for the banks with the most assets or the biggest portfolios of risky loans. 

What matters is how many links a bank has to other institutions, how strong those links are and how risky those other banks are, not least because they too have links to other risky banks. 

Something like PageRank might be just the right thing to cut through it. That’s the argument, at least, made by a team of European physicists and economists in a new study. Their algorithm, DebtRank, seeks to measure the total economic value that would be destroyed if a bank became distressed or went into default. 

It does so by moving outward from the bank through the web of links in the financial system to estimate all the various consequences likely to accrue from one failure. Banks connected to more banks with high DebtRank scores would, naturally, have higher DebtRank scores themselves.... 

What does all this mean? Well, there are plenty of caveats involved, so many that any a voice can say many a thing to discredit the report, and its validity. But in the end, we can only conclude that there is indeed a way to measure the impact of too-big-to-fail and/or too-central-to-fail financial institutions on our economies. Or at the very least that there is one that is worth examining, that very strongly promises to provide us with a way to measure it. 

We just need to feed in the data. That won't make the debt go away, but at least we would know how much it is, and, perhaps even more importantly at this point, where it is. 

But of course the data are not made available. Not by the banks themselves, and not by the regulators that are supposed to control them. And not by the lawmakers who are the only ones that would have the power to demand they're made available....

Of course the members of Wall Street's Opacity Protection Team (banks, regulators and lawmakers) are  working to prevent the data being made available to all market participants.

If the data were made available, market participants would likely use it in ways that would promote financial stability and reduce banker bonuses.  At a minimum, the Opacity Protection Team will fight to the bitter end to avoid disclosure that might reduce banker bonuses.

Still, let no-one anytime anywhere anymore tell you that the whole financial mess we've been sinking into for years now is too complex to measure. 

It's not. 

It's just that nobody wants to measure economics using scientific standards.... Here's Matt Buchanan again, putting it very eloquently: 

An algorithm alone can’t save the world, and this isn’t the final word on the best way to measure systemic risk.

Yet the apparent superiority of the DebtRank approach underscores how our ability to monitor the financial system depends wholly on the availability of data. Currently, most of the information that would be needed to calculate DebtRank or any other similar measure is simply not public. 

It is not public even though under the FDR Framework it is the government's primary responsibility to ensure that market participants have access to exactly this data.

Imagine a world in which banks and other financial institutions were legally required to disclose absolutely all of their assets and liabilities to central banks, which would in turn make that information public on a website. Regulators -- indeed, anyone -- would then be able to see the whole network and assess a bank’s situation in full clarity.

This would be ultra transparency and the "Mother of all financial databases" that your humble blogger has been calling for.

Anyone so inclined could calculate measures such as DebtRank and assess how much any particular bank is contributing to potential financial instability.

More importantly, anyone so inclined could calculate the risk of each bank and adjust the amount and price of their exposures to each bank to reflect this independent assessment.

With full transparency, it’s just possible that the core business of lenders would go back to assessing the creditworthiness of borrowers. They would need to do so to maintain a good reputation and to borrow themselves, as any risky loans they made would be known to all....

As I have said many times previously, it is this ability to assess each bank's current exposures that unfreezes the interbank lending market and keeps it unfrozen.

That is a radical idea, so radical it is almost certainly a political nonstarter.

Since the beginning of the financial crisis pursuing policies that damage the real economy and society has been politically acceptable. while protecting banker bonuses has been a political nonstarter.

Your humble blogger would like to see this reversed so that policies that may minimize banker bonuses are politically acceptable, while policies that damage the real economy and society are political nonstarters.

Regular readers know doing this requires abandoning the Japanese model for handling a bank solvency led financial crisis and adopting the Swedish model.  Rather than protect bank book capital levels and banker bonuses, the real economy and society are protected.

Rather than hide losses on and off bank balance sheets and force the real economy to contract under the burden of supporting the excess debt, banks absorb the losses on the excesses in the financial system.

A modern banking system is designed to absorb the losses and continue to operate and support the real economy as the banks have both deposit guarantees and access to central bank funding.  Deposit guarantees means that banks have a silent equity partner in the taxpayer when they have negative book capital levels.

It is the existence of this silent equity partner that allows banks to retain 100% of their pre-banker bonus earnings to rebuild their book capital levels after absorbing the losses.

But as the British physicist William Thomson, also known as Lord Kelvin, put it back in the 19th century: “What you cannot measure, you cannot hope to improve.” It’s a lasting piece of wisdom.