Regular readers know that under the FDR Framework contagion is not a risk as market participants limit their interconnectedness to what they can afford to lose.
Why?
The FDR Framework combines the philosophy of disclosure with the principle of caveat emptor (buyer beware). As a result, market participants set the size of each of their exposures based on what they can afford to lose given the risk of each exposure.
Market participants do this because the combination provides them with access to all the useful, relevant information they need to independently assess the risk of each exposure and makes each market participant responsible for all losses on their exposures.
However, contagion is a risk in our current financial system as opacity across wide swathes of the financial system has led market participants to underestimate risk and therefore become too interconnected.
Contagion will remain a risk until such time as transparency is brought to all the opaque corners of the financial system including bank balance sheets and structured finance securities.
- For banks, transparency takes the form of disclosing on an ongoing basis their current global asset, liability and off-balance sheet exposure details.
- For structured finance securities, transparency takes the form of disclosing on an observable event basis all activities like a payment or delinquency that involve the underlying collateral before the beginning of the next business day.
With transparency, market participants can go through the process of assessing the risk of each of heir exposures and, where appropriate, reducing their interconnectedness so that it properly reflects the risk of the exposure.
It took four years plus a string of scandals but in 2012 bankers began to acknowledge publicly their past failures and failings.
Perhaps (some admitted), reputation was critical after all. Perhaps customers should not come last. Maybe, irreplaceable executives were more easily replaced than thought. Maybe some businesses really were too complex to manage. Maybe bonuses tied to risk-taking should not be paid until the risks taken had matured. And yes, in retrospect the industry could not be trusted to regulate itself.
That these lessons had to be relearned by many highly paid professionals is disgraceful. That they are being learned at last is progress.
May the momentum continue – for there are three banking basics yet to be grasped or if grasped, then embraced by many senior bankers. The first is that the financial institutions for which they are responsible require a more stable financial system. ...
Since the advent of the crisis, the financial world has received a refresher course in the basics of banking. In 2007 we rediscovered credit risk; 2008 – liquidity risk; 2009 – market price risk; 2010/11 – sovereign risk. (And coming soon to a theatre near you: geopolitical risk.)
These risks are not new but what has dawned is the degree to which the interconnectedness of the financial system now amplifies such threats.
Thus balance sheet values for an otherwise sound institution may plunge because of the forced sale of assets by less sound members of the fraternity. Wholesale funding flees those suspected of weakness. Exposures to “risk-free” sovereign debt can tie vulnerable banks to vulnerable countries. And it does not stop there. Even those financial firms free from direct sovereign exposure remain at risk if their financial counter-parties are so exposed.
Interconnectedness and the domino effects it can trigger are now a fact of financial life.A fact of life that is created by opacity across wide swathes of the financial system. And therefore, a fact of life that can be eliminated by restoring transparency to all the opaque corners of the financial system.
As we have witnessed, the loss of confidence in large financial institutions can cause a loss of confidence in the system as a whole. Had AIG been allowed to fail, the impact would have been felt on both sides of the Atlantic.
But here’s the rub: should (when) such threats return, the public may be in no mood to bail out the behemoths – and the public purse may be insufficient to do so.Fortunately, there is no reason that the public should be called on to bail out the behemoths again. By simply restoring transparency, all market participants can and will reduce their exposures to what they can afford to lose (recall market participants know that in return for access to all the useful, relevant information they are held responsible for all losses on their exposures).
Banks will also reduce their interconnectedness and exposures as market participants will exert restraint on their risk taking behavior. This restraint will take the form of less access to and a higher cost of funding if the bank is seen as too risky because of its interconnectedness.
If banks need a sound and stable system in which to pursue success, it is equally true that a stable system depends on the perception that the most interconnected banks are sound and stable. This becomes all the more urgent with the prospective removal of government guarantees.
Markets must believe that when faced with financial loss, banks will either: 1) be able to stand on their own two feet; or 2) be able to be closed down without sparking systemic contagion. Such confidence can come only from a system in which banks’ risk-taking is kept within their loss-absorbing ability.
This in turn requires sharply less leverage than in the past and more loss-absorbing capital in the future.What is required is the banks provide ultra transparency.
With ultra transparency, market participants can confirm that a bank is able to stand on its own two feet (in the 1930s, ultra transparency was in fact the sign that a bank could stand on its own two feet).
Requiring ultra transparency has several beneficial results besides increasing the stability of the financial system by reducing the interconnectedness of the market participants. These benefits include lower leverage and higher loss-absorbing capital.
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