Mapping Toxicity: bringing transparency to risk assessment

Regular readers know that this blog has been the leading advocate for bringing transparency to all the opaque corners of the financial system.

It is transparency that allows market participants to assess risk and adjust the amount and pricing of their exposures so they are compensated for the risk they are taking.

It is the principle of caveat emptor and the knowledge that the they are responsible for all losses on their exposures which gives market participants the incentive to use the disclosed information and limit their exposures to what they can afford to lose based on the risk of the exposure.

By limiting their losses to what they can afford to lose, market participants end concerns about financial contagion.

With that as background, I would like to share with you an article that shows how close the academic community is to understanding the FDR Framework and what your humble blogger has been saying about the role of and need for transparency.

The fiscal crisis of 2007–2009 caught people—including expert economists—off guard.

Not yours truly who is on record for having predict it.

And even as the crisis unfolded, useful insight was hard to come by. 

No they weren't.  I offered a transparency based solution before the financial crisis heated up that would have moderated the impact of the financial crisis.

"At the end of the day, most policymakers and economists had some idea as to what was going on, but not as much as one would hope," says Arvind Krishnamurthy, a professor of finance at the Kellogg School of Management. 

Based on the policies that have been implemented since the beginning of the financial crisis, there is zero evidence to back up this observation.

Why should this be? 

Why were the over-leveraged, so-called "toxic" real estate assets that contaminated the rest of the economy invisible even in plain sight? 

Great question.

Why were opaque securities that hid their toxicity allowed to be created in a financial system that is based on transparency?

According to Krishnamurthy, the problem is that financial reporting practices are too outdated to capture the information necessary to accurately assess modern macroeconomic health.

"In trying to document the crisis [after the fact], you start to look for the data you need and you find it's not exactly there," Krishnamurthy says.

Professor krishnamurthy's comment is true whether you are looking for the data you need to assess structured finance securities or banks.

"Our measurement of financial activities might have been good in the 1940s or '50s, but it's very poor currently given how much the financial sector has changed."

Current financial reporting focuses on assets and liabilities on a cash balance sheet. "If you look at an industrial firm like GM, their assets are the various manufacturing plants. These are all tangible things, and when you look at the financial statements, you can see it all fairly clearly," Krishnamurthy explains. 

Transparency exists for non-financial firms.  That is why the stock market continued to function throughout the financial crisis without government intervention.

The trouble is that firms like Goldman Sachs and Morgan Stanley assume contingent economic exposures, through financial instruments like derivatives, that do not show up clearly on their balance sheets.

"A simple derivative security might be one in which, when real estate prices go up by 10%, this company will make an extra $5; and if they go down, they'll lose $5, so the risk is commensurate to the $5," Krishnamurthy continues. 

"But you can’t really see the $5 of risk on financial statements.  You see that the firm has a derivative, perhaps tied to real estate, but you can’t see if the firm is exposed to real estate risk of order $5, $50, or $500. Right away this obfuscates things." 

Risk, rather than cash instruments, says Krishnamurthy, is the attribute of our financial sector that defines its overall health. And this risk goes largely unreported in financial statements to the government or the public.

Please re-read the highlighted text again as Professor Krishnamurthy makes a very important point about how current disclosure practices for financial institutions do not provide the information necessary to evaluate the risk these institutions are taking.

Where I disagree with the Professor is that the government is not restricted to financial statements, but in fact has a monopoly on all the useful, relevant information for assessing a bank's risk.  This is a fact as the bank regulators have examiners full-time at each of the major banks. These examiners see all of the exposure details needed to assess the risk of each bank.

"If you work at Goldman Sachs, the way you measure your own risks is entirely different than these types of [public] accounting statements," he says. "You'd measure things like, 'How much money do I make or lose if real estate prices go up or down by 10%?' That's the principal number you're interested in."....

The basis for assessing risk at Goldman Sachs or any other financial institution is the exposure level detail.  It is only by knowing what the exposure is that the question of how much will they make or lose if prices go up or down by 10% can be answered.

This is why I have repeatedly called for banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

The irony is that while few financial firms report this data, "most companies collect it for internal purposes in fairly sophisticated ways," Krishnamurthy says. 

Unlike assets and liabilities on a balance sheet, risk is fundamentally dynamic, so assessing it requires a different approach from classical financial reporting.... 

It takes requiring the banks to provide ultra transparency.  With the exposure details, market participants can independently assess the risk of the bank and its various positions for themselves.

Few firms are motivated to [provide this information], since it is expensive and the letter of the law does not require it....

Actually, it is not very expensive to provide ultra transparency from an IT perspective.

It is expensive to provide ultra transparency from the perspective that it will eliminate certain types of activities that banks currently engage in like betting through proprietary trading and manipulating benchmark interest rates like Libor.

Professor Krishnamurthy is right that the letter of the law does not require that banks disclose their exposure details.  Until the 1930s, ultra transparency was the sign of a bank that could stand on its own two feet.  So it was provided voluntarily.

In the last 30 years, bankers have preferred to hide behind opacity as it hides what they are doing and allows the banks to privatize the gains from misbehavior and socialize any losses.

"The truth is that it's easier to not invest in standardizing data reporting and remain relatively opaque. But this is where a government can step in for the common good," Krishnamurthy says. "One way to do this is expand regulatory filings that require banks to use a common language. It seems possible that if everyone communicates risk in the same way, eventually they will disclose it on, say, SEC filings." 

It is in fact the government's responsibility in our financial system to step in for the common good and require banks to provide ultra transparency.

What this kind of new financial reporting could enable, argues Krishnamurthy, is a "50,000-foot view of the economy's 'risk map,'" which would illuminate pockets of toxic risk and illiquidity in the overall landscape, like those that caused the recent financial crisis.

Much more importantly, what ultra transparency will do is to subject banks to market discipline and let market participants do their own independent assessment of risk.

The result will be a stable financial system that is free of financial contagion and the need for taxpayers to bailout the banks.