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Transparency Is Not the Answer

Looking ahead of the current meltdown, there are calls for "greater transparency" to improve functioning of the financial markets. But whether this means improved availability of market information or better understanding of complex instruments, in neither case will greater transparency reduce systemic risk in financial markets. Indeed, in some cases greater transparency could make things worse. Regulators must now abandon their belief in the tired trinity of greater transparency, more disclosure and better risk management by firms. Instead they must turn to finding ways to develop a systemic approach to regulation, including pro-cyclical provisioning and system-wide stress testing, and confront the vicious market cycle of rising asset prices accompanied by higher leverage, and the even more vicious cycle running in reverse.

COMMENTARYoctober 11, 2008 EPW Economic & Political Weekly14Transparency Is Not the AnswerJohn Eatwell, Robert ReochJohn Eatwell is at Queens’ College, University of Cambridge and Robert Reoch is with New College Capital, an investment advisory firm in London.Looking ahead of the current meltdown, there are calls for “greater transparency” to improve functioning of the financial markets. But whether this means improved availability of market information or better understanding of complex instruments, in neither case will greater transparency reduce systemic risk in financial markets.Indeed, in some cases greater transparency could make things worse. Regulators must now abandon their belief in the tired trinity of greater transparency, more disclosure and better risk management by firms. Instead they must turn to finding ways to develop a systemic approach to regulation, including pro-cyclical provisioning and system-wide stress testing, and confront the vicious market cycle of rising asset prices accompanied by higher leverage, and the even more vicious cycle running in reverse. The “Bailout Bill” passed by theUS Congress requires the secretary of the United States Treasury to “re-view the current state of the financial markets and the regulatory system and submit a written report to … Congress not later than April 30, 2009, analysing the current state of the regulatory system and its effectiveness at overseeing the participants in the financial markets, … and providing recommendations for improvement”. The Bill was produced in haste. It is im-portant that regulatory reform should be considered more carefully.Already there is a head of steam building up behind that proposition that “greater transparency” should be a dominant theme of the reform package. Precisely what is meant by “greater transparency” is not made clear: does this refer to improved availability of market information or to en-hanced understanding of the structure of complex instruments? Unfortunately in neither case will “greater transparency” reduce systemic risk in financial markets. Indeed, in some cases greater transparency could make things worse.Current events in financial markets have demonstrated beyond all reasonable doubt that the sophisticated market-sensi-tive risk models deployed by banks and other financial firms, and espoused so en-thusiastically by the regulators, have totally failed to ensure stability in finan-cial markets. On the contrary, to the ex-tent that anyone believes them any more, the models have been a major factor in the failure of credit markets since in the faceof extreme events, they all tended to endorse the same actions at the same time – guaranteeing widespread illiquidity. One of the drivers of the consequent lemming-like behaviour has been the greater transparency that regulators have campaigned for over the past 20 years or so. Greater transparency meant that more firms shared the same information, had access to the same procedural knowledge and even the same modelling – so it is hardly surprising that they all behaved in the same way.The risk modellers should not be blamed. Their models are not capable of measuring market liquidity risk, nor are they intended for that task. A firm’s risk model seeks to price the risks that are the result of its actions in the marketplace. They are necessarily market sensitive, and greater transparency will tend to increase that sensitivity. But it is not just that mar-ket sensitivity may increase the likelihood of stampedes. In the presence of the sys-temic externalities, such as liquidity risk, even the most transparent competitive market will be inefficient, and therefore risk will be mis-priced. The current tur-moil is clearly a systemic event. There is no way it could have been accurately priced by an individual firm. Greater transparency will only add to the illusion of accuracy, and, by reinforcing herd be-haviour, may well make things worse. In-deed, a number of writers have suggested that the requirement to mark complex in-vestments to market, hence increasing transparency, has been an important ele-ment in rapid de-leveraging and subse-quent financial collapse.The second interpretation of the case for “greater transparency” rests on fre-quent references to securitised market in-struments that “no-one understands”, and “no-one knows how to price”. Once again the call for greater transparency is mis-conceived. What is at issue is not the trans-parency of such instruments but their complexity and the controls employed by buyers and sellers. Firms have bought complex instruments without understand-ing the risk, often relying exclusively on rating agencies to assess the risk, and in most cases have relied on valuations pro-vided by sellers. Banks have sold complex products to unsophisticated investors with little attention to whether the investment is appropriate or whether the risks are un-derstood, and have provided valuations using models that cannot price liquidity risk accurately. Where all parties involved believe in a particular asset class and in the rating of such assets, and where both
COMMENTARYEconomic & Political Weekly EPW october 11, 200815sides of a transaction are financially moti-vated to see the transaction completed, then no amount of transparency will result in greater stability.Of course reducing informational in-efficiencies can often be worthwhile and may result in greater market efficiency. And ensuring that complex instruments come with “full disclosure” at least places some responsibility on buyers to under-stand what they are buying. But transparency has nothing to do with the systemic risk that is the proper object of regulation. Indeed the persistent emphasis on transparency is a dangerous diversion from the massive task of regula-tory reform that is now required in the United Kingdom and the United States. Unfortunately, for the past 20 years or so the regulators have swallowed the argument that superior market sensitive risk management by firms would result in greater overall stability. They must now abandon their belief in the tired trinity of greater transparency, more disclosure and better risk management by firms. Surely it must now be recognised that that regulatory model has failed? Instead they must turn to finding ways to develop a systemic approach to regulation, including pro-cyclical provisioning and system-wide stress testing, and confront the vicious market cycle of rising asset prices accompanied by rising leverage, and the even more vicious cycle running in reverse. Those who argue that greater trans-parency is the answer, do not understand the question.Navigating the Future in the Midst of Global UncertaintyD N GhoshThanks to the central bank’s relative caution on the financial sector, India is somewhat protected from the full force of the global meltdown. Yet, there is no doubt that the economy will be affected by the fallout. Policymakers need to take advance action in four areas: growth (moderating a slowdown by picking up the slack in investment), liquidity (the central bank stepping in) when needed, solvency (improving intelligence) and inflation (using quantitative controls if necessary).Arecession is a merciless killer, but like a hurricane it gives clear warning well before it strikes. No one can complain that the Wall Street catastrophe came without notice. An assessment of the International Monetary Fund, made just six months ago predicted a loss of $ 1,000 billion in the financial sector and a sharp downturn in the global economy. Disturbing trends had surfaced well ahead of the current crisis, in particular, of a massive increase in leverage. Indebt-edness in the household sector in the United States jumped from 50 per cent of gross domestic product (GDP) in 1980 to 71 per cent in 2000 and then to 100 per cent in 2007. And in the financial sector, indebtedness jumped from 21 per cent of GDP in 1980 to 83 per cent in 2000 and then to 116 per cent in 2007. If these were not warnings enough, what else could have been?I have two reasons for starting with this preamble. The first reason is that so far as the financial sector is concerned, we in India are fairly insulated, having built up several strong firewalls in the past. Per-haps a bit of self-congratulation may be in order. It is good to go over the thought that the ongoing US crisis would have created terrible uncertainties for our financialsector had we opened ourselves to the full blast of free flow of capital and free capital account convertibility. That cautious approach seems to have paid dividends, as of now. For this, the Reserve Bank of India (RBI) richly deserves credit, thanks to the stubbornness with which the just retired RBI governor Y V Reddy held out against pressures from powerful quarters and against the uncharitable crit-icism that the central bank was wallowing in the backwaters of chauvinistic nation-alism.Thesecond is the politics of policy-making. We have to be watchful in the real sector, and if that sector starts wob-bling, any policy measures to deal with that will have to have strong political underpinnings. But achievingpolitical consensus is, more often than not, quite a daunting task. Note the recent happenings in theUS. Even in a country with a tradi-tion of bipartisanship, resolving the push and pull of various pressure groups that have inevitably surfaced in the run-up to the presidential elections while devising a bailoutpackage has by no means been easy. Here, with the shadow of national elections looming largeandregional interests raising their voices, we are in for difficult times. Failure to act quickly may have unpredictable consequences.Against this backdrop, I make a few quick guesses in four areas: growth, liquidity, solvency, and inflation. First, on growth. The major countries in Asia, namely, China and India, will continue to report moderate growth. Our exposure to theUS economy is not that large, but as the Wall Street financial crisis spreads to the real sector of that country, certain vulner-abilities in India’s growth trajectory will show up. If the information technology (IT), D N Ghosh (dnghosh1@dataone.in) is the chairman of ICRA.

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