Regular readers know that complexity is a form of opacity. When a financial product is complicated, it is much harder to value and there is a dramatically higher chance that a buyer will mis-price the risk of and overpay for the product.
As Yves Smith of Naked Capitalism observed, nobody on Wall Street is paid for developing low margin, transparent products.
JPMorgan Chase & Co. (JPM)’s $5.8 billion trading loss this year showed that the financial system is getting too complicated for even respected institutions, the president of China’s sovereign-wealth fund said.
“You are creating a system that very few people understand, much less the regulators because the regulators haven’t the incentives like the bankers,” Gao Xiqing, president of China Investment Corp., said today at a lunch hosted by the Economic Club of New York....If the only people who understand the system are the bankers, it becomes critically important that the banks provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.
Ultra transparency puts information into the hands of the bankers who understand what is going on. As a result, they can adjust their exposure to each other to lessen, if not completely eliminate, the risk of contagion.
Ultra transparency also puts information into the hands of other market participants who might question what is going on inside an individual bank or across the banking system.
He expressed concern about a society in which “all the best engineers are engineering financial products.”
“You have all the smartest kids to design these products, the only purpose of which is to get money out of other people’s pockets,” he said. “That is not very good.”Please re-read the highlighted text as this is the type of behavior that occurs when opacity is allowed in vast swaths of the financial system.
Behind the veil of opacity, bankers focus on extracting money rather than supporting the real economy.
Bringing transparency to all the opaque corners of finance has the benefit of refocusing banking on supporting the real economy and having the best engineers engineering real and not financial products.
Gao said he tries to avoid relying on financial models in his own investments because he doesn’t trust them.Please re-read the highlighted text as Gao is offering another reason that transparency needs to be brought to all the opaque corners of the financial system. Simply put, in the absence of transparency there is no way to check to see if the financial model accurately reflects reality.