Recently, I stumbled across the research agenda for the Imperial College London’s Brevan Howard Centre for Financial Analysis.  The Lion’s Share of this agenda the Information Matrix solves.

I have put the Information Matrix where it fits into the research agenda:

The main aim of the Brevan Howard Centre’s research agenda will be to analyse the market and other failures that appear to be so prevalent in the financial system and make suggestions for improvements.

The only sensible and reasonable starting point for analyzing the market and suggesting improvements is understanding why the global financial system is designed the way it is.  The Information Matrix explains this design.

Information Matrix

	Does Seller Know What They Are Selling?
Does Buyer Know What They are Buying?		Yes	No
	Yes	Perfect Information	Antique Dealer Problem
	No	Lemon Problem	Blind Betting

The global financial system is designed to push all investments into the Perfect Information quadrant.  The government, through entities like the SEC, is responsible for ensuring investors have access to the information they need so they can know what they own.

Why would the financial system be designed this way?

Two reasons.  First, there is the belief informed decision making produces a better allocation of resources than does blind betting.  Second, there is the belief informed decision making generates market discipline which doesn’t exist when investors are blindly betting.

Investors understand how the financial system is designed.  In exchange for disclosure, they know they are responsible for all losses on their investment exposures and do not expect to be bailed out should losses occur.  As a result, investors continually perform the fundamental risk/return assessment and adjust their exposures to what they can afford to lose.  It is this ongoing adjustment as the risk of their exposures changes that generates market discipline.

Understanding systemic risk will be at the heart of these efforts.

This might be a little bit of a problem, because the way the global financial system is designed to function systemic risk doesn’t exist.

Before you disagree, look at how the Brevan Howard Centre says even if all market participants limit their exposures to what they can afford to lose, there is this mythical creature called systemic risk stalking the financial system just waiting to trigger a financial crisis.

The regulatory structure in place before the crisis failed because it was based on an incorrect premise. This was that if individual banks and other institutions and investors were prevented from taking excessive risks, there would be no build-up of risk in the financial system and financial crises would be prevented. This proved to be incorrect because of systemic risk.

Regular readers know financial crises emerge from the Blind Betting quadrant.  Why? It is here investors engage in excessive risk taking as they buy what they are told are low risk securities that in reality are very high risk.

The regulatory structure failed, but not for the reason cited.  The regulatory structure failed because the responsible government agencies did not ensure disclosure so investors could know what they owned.  Investors could Trust the valuation story they were told by Wall Street/the City, but they could not Verify if it was true.

Examples of securities for which investors trusted Wall Street/the City without being able to verify the truth of their valuation story included the subprime mortgage-backed deals and unsecured bank debt securities at the heart of the Great Financial Crisis.  When the valuation story was called into doubt, investors engaged in a “bank run” to get their money out of these securities.  Why?  In the absence of disclosure, there is no logical stopping place for the decline in the valuation for these securities other than zero.

Why did the government agencies fail?  The process the agencies used to set disclosure requirements was captured by Wall Street and the City.

As used by the Brevan Howard Centre, systemic risk is the result of “individual banks and other institutions and investors” investing more in the Blind Betting quadrant of the Information Matrix than they could afford to lose.  The Centre incorrectly asserts it was the role of the regulators to prevent this from occurring.  This would be an impossible task.  Rather, it is the role of the regulators to ensure sufficient disclosure so investors can know what they own.

Currently, systemic risk is not well understood at all.

Why should the concept of systemic risk be understood?  When you know about the Blind Betting quadrant and why the financial system is designed the way it is, you know systemic risk is a mythical creature created by regulators looking for an excuse for why there was a financial crisis on their watch.

Despite the fact systemic risk doesn’t exist, look at all the ways the Brevan Howard Centre proposes to study it.

One possible categorisation involves five elements. These are (i) panics; (ii) crises caused by drops in asset prices; (iii) contagion; (iv) deficiencies in the financial architecture; and (v) foreign exchange mismatches.

The traditional analysis of crises focused on panics. More recently, there has been more analysis of crises caused by drops in asset prices. There are many reasons asset prices can drop. The most important one is a fall in the price of real estate. Banks and other financial institutions are heavily involved in lending to buyers, property developers and others engaged in the industry. When property prices fall, often because of the bursting of a bubble, some or all of these borrowers can default and this can lead to a financial crisis. There are many other reasons asset prices can fall such as the bursting of bubbles. Others include rises in interest rates, sovereign default, mispricing due to limits to arbitrage, the business cycle, mispricing due to “flash crashes”, and political interventions of various kinds. Although there has been progress in understanding many of these causes of financial instability, there remains much to be done. For example, even such basic things as the pricing of real estate are not understood.

Progress has been made in understanding and countering some of the remaining three categories of systemic risk. For example, the implementation of swap facilities by central banks during the recent crisis prevented a reoccurrence of many of the problems that were at the heart of the 1997 Asian Crisis. There has also been some work on designing the financial architecture. Relatively little progress has been made on understanding contagion.

There is a reason little progress has been made on understanding contagion.  Contagion is a symptom of opacity in the financial system.  It reflects blind betting by investors, banks in this case, with the result they have greater exposure to each other than they can afford to lose.

If banks were transparent as they are suppose to be, contagion would go away.  Why?  Because each bank would limit its exposure to the other banks to what it can afford to lose given the real risk of the other banks.  Why would banks limit their exposure to each other?  Market discipline.  Ultimately, banks that don’t limit their exposure to each other would face dramatically higher costs of funds from investors.

There remains much work to be done in many other areas too. For example, the roles of the central bank in liquidity provision, and the creation of asset price bubbles through low interest rates and quantitative easing need to be extensively researched. Civil and criminal penalties on banks and other corporations and their managers that engage in illegal behavior would seem to have an important role to play but little research on the optimal level of damages and fines has been done. All in all, we will have plenty to do.

I agree with the Centre there is much work to be done.  Think of all those academic papers to be written using the Information Matrix to explain financial crises, panics, drops in asset prices, contagion and deficiencies in the financial architecture.

Speaking of which.  The Transparency Label Initiative was started to address the deficiency in the financial architecture that made the Great Financial Crisis possible.  That deficiency was shown by Wall Street/the City capturing the process by which disclosure requirements are set.  The Initiative fixes this problem and makes investors the only market participants who set disclosure requirements.  This is appropriate, because without investors, there is no market.