McKinsey, the large international consulting firm, provide one of my favorite quotes to emerge from the financial crisis:
After Lehman’s demise, participants in the global financial system could not assess their exposure to Lehman, its subsidiaries, and each other because there was no standard system for identifying counterparties in the maze of subsidiaries and affiliates from which banks, insurers, asset managers, and other market participants transact.
Why do I like the quote?
It highlights everyone realized how opaque the large, global financial institutions were at the time of the crisis (this is completely separate from how opaque the securities these firms were investing in were).
It also highlights the need to bring transparency to these firms so investors can assess the risk of these firms and limit their exposure to these firms based on what the investor can afford to lose given the risk. Clearly, investors, including other banks, could not limit their exposure because they didn’t even know who they were taking on exposure from.
A decade has passed since the crisis began. Let’s turn to Economists Stephen Cecchetti and Kim Schoenholtz for more on how the problem of opacity is being addressed.
Large firms were not the only organisations unable to compute (let alone manage) their consolidated risk exposures in a timely way. For the authorities, identifying vulnerabilities and estimating systemic risk – creating a global risk map – was beyond anyone’s capacity (even if someone had thought of trying)….
Correcting these deficiencies in the financial infrastructure is not a trivial matter. Simplifying the problem requires the creation of a unique, universal, and permanent identification system for both institutions (financial and nonfinancial) and instruments.
There is nothing more appealing than Economists holding forth on how to solve an information technology problem. Why would they remotely think they are experts and know what is required to simplify the problem?
The solution cited is the solution preferred by the banks. Why?
So where do we stand? The identification system has advanced substantially. There is now broad acceptance of the need for both legal entity identifiers and financial instrument identifiers.
Think about this for a second. A decade has passed since the beginning of the financial crisis and the banks are still as opaque to themselves, the regulators and the financial markets as they were the day the crisis began. The banks love this solution because it delays for long periods of time their having to provide transparency.
Having designed an information system to bring transparency to structured finance products, I can tell you there is an alternative solution that could have been implemented years ago. Of course, this would have meant making the Too Big to Fail banks transparent and subjecting them to market discipline.
As much as I criticize the Office of Financial Research and Data, it could have been designed to perform a useful role. It could have “hosted” a large database that included all the banks’ current exposure details. Each bank would be responsible for mapping its exposures to the appropriate field in the database. As an incentive to make sure this is done right, any exposure that isn’t properly mapped would require the bank to hold 100% capital against.
Please note, this solution would be inexpensive for banks to implement. It doesn’t require massive updating of their computer systems. It simply requires the banks to export the data they have mapped to the appropriate field in the database.
All market participants then would have had access to the database.
Unfortunately, this is not the solution currently being pursued with the blessing of the Economics profession.