Fix finance by shedding light on its complexities

In his Bloomberg column, Mark Buchanan makes the case for shedding light onto all the opaque corners of the global financial system.

Regular readers know that your humble blogger has been making this argument since the beginning of the financial crisis.

The question is how to shed light into the opaque corners.

I support the simple notion of transparency under which all the useful, relevant information is disclosed in an appropriate, timely manner.  For banks, this would mean they provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Under the FDR Framework, market participants are responsible for any losses on their investments and therefore they have an incentive to use this information to assess the risk of each bank and adjust their exposures to what they can afford to lose given this risk.

One benefit of my solution is that it ends financial contagion.  Another benefit is that it subjects the banks to market discipline for the first time in decades and puts pressure on the banks to reduce the risk of their organizations.

Economists teach us that a financial market is a powerful technology for processing information. It brings everyone’s knowledge and greed into play, devouring every available scrap of information to achieve optimal risk sharing and put resources to the best possible use. 

That’s the theory. In practice, things often don’t work that way. 

The 2008 financial crisis demonstrated that the information processor, confounded by overly complex securities and specious AAA ratings, can easily misallocate resources and ultimately grind to an inglorious halt.

Actually, the information processor was not confounded by overly complex securities, but rather was deprived of the information it needed as financial regulators let Wall Street create sizable parts of the financial system that were opaque (think structured finance securities and banks).

When a technology fails, we naturally look for a fix.

And the fix for opacity is to shed light by requiring transparency.

If markets don’t digest information very well, we ought to ask why, and whether some re-engineering could help them do better....

 It wasn't an inability to digest information very well, it was a lack of information.

Let’s start with a simple observation: The overwhelming complexity of today’s markets renders banks unable to judge risks as rationally as standard theories of finance assume they do.

It is not complexity that renders banks and other market participants unable to judge risks, but rather the lack of information caused by the lack of transparency.

For example, the unsecured interbank lending market froze at the beginning of the financial crisis and remains frozen because banks with deposits to lend could not and still cannot assess the risk and solvency of banks looking to borrow.

Why can't the banks with deposits to lend do this?

Because, as the Bank of England's Andrew Haldane says, current disclosure by banks leaves them resembling 'black boxes', i.e., banks don't disclose the information needed for an independent assessment of their risk and solvency.

As I said, the problem is not with the market's ability to process information, but rather with the lack of information itself.

The health of any decent-sized financial institution depends on a vast web of links to other institutions that even the most sophisticated risk manager cannot hope to penetrate.

To make things specific, consider the interbank lending market, which played a leading role in the financial meltdown of 2007 and 2008. Banks use the market to manage demands for cash by shuttling funds among themselves, often overnight. 

If Bank A wants to judge the risk of lending to Bank B, it’s not enough to look at its assets and liabilities. If Bank B has loans outstanding to Bank C and Bank D, its creditworthiness depends on the state of those banks, too, which in turn depends on that of other banks to which they have made loans. Given the rich network interdependence, Bank A can’t possibly gather enough information to judge Bank B or any other....

This is the argument that the banks and the financial regulators put out to justify the notion of financial contagion and why the banks needed to be bailed out (if one bank failed, they would all fail).

Let me show why under the FDR Framework this argument is wrong.

Under the FDR Framework, all market participants, including banks, are responsible for losses on their exposures.  This is very important as it makes assessing the risk of any bank an easily solvable problem.

It becomes solvable because even if Bank C and Bank D fail, in theory Bank B has limited its exposure to what it can afford to lose without failing itself.

From the perspective of Bank A, even if it doesn't know how creditworthy Banks C and D are, all it has to do is look to see if Bank B has limited its exposure to what it can afford to lose without failing itself.

If it has, that says something about how conservatively Bank B manages its risk.  If it has not, that says Bank B is a riskier bank.