Nucleus of our current financial crisis

The Financial Times put together a terrific graphic in which it lists the five main causes of bank and broker failure (bad lending, bad investments/trading, low capital, risky funding structure and M&A) and which combination of these causes brought down each bank or broker during our current financial crisis.

Your humble blogger likes this graphic because it is both very informative and because each of these causes was made possible by opacity.

The latter point bears repeating.  What made each of the causes of bank and broker failure possible was opacity.

Because of opacity, banks and brokers were not subject to market discipline that would have restrained the banks and brokers exposures to each cause of failure.

Let's look at how opacity works to allow bad lending.

When a bank has to disclose its current global asset, liability and off-balance sheet exposure details, market participants can assess both how the bank underwrites its loans and equally importantly how it charges for these loans.

Is the bank compensated for the risk it is taking on?  If not, market participants can exert market discipline by reducing their exposure to the bank and charging the bank more for funds.

With opacity, banks were free to engage in bad lending in the run-up to the financial crisis.

Let's look at how opacity works to allow low capital.

When a bank has to disclose its current global exposure details, market participants can assess the risk of the bank.  Market participants can then adjust their exposure to the bank based on this risk assessment to what they can afford to lose.

The result is a link between the risk a bank is taking and its stock price.

For example, banks with less capital will have a lower stock price for the same level of earnings as banks with higher levels of capital.  There is a natural bias for banks to have higher capital levels. In the 1930s, when disclosing a bank's exposure details was the sign of a bank that could stand on its own two feet, bank capital levels exceeded 20% of their exposures.

With opacity, banks were free to lower their capital levels as there was no link between the risk they were taking and their stock valuations.

The takeaway from the Financial Times' graphic is that the causes of the financial crisis could have been prevented if the banks had been required to provide transparency and disclose their current exposure details.