Tuesday, March 19, 2013

To understand finance, recognize that complexity creates opacity

In an interesting Bloomberg column, Mark Buchanan looks at the increasing complexity of finance and observes that it is making the financial system less stable.

Regular readers know that this is the direct result of the opacity that complexity is introducing into the financial system.

The financial system is based on the FDR Framework that combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).

It is the responsibility of the government to be sure that all market participants have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess this information and make a fully informed decision.

It is the responsibility of the investor to absorb any losses that occur on their investments and therefore they have an incentive to use the information made available and to limit the size of their investments to what they can afford to lose.

By limiting their investments to what they can afford to lose, investors prevent the possibility of financial contagion.  When everyone can afford their losses, then the collapse of one financial institution does not bring down other financial institutions.

Where the global financial system broke down in the run up to the financial crisis and where it is still broken is in the large swathes of the financial system that are hidden behind a veil of opacity.  This includes banks and structured finance securities.

Leading up to the financial crisis, both areas had "cheerleaders" who suggested that the risk of the banks and the structured finance securities was very low.  In the case of banks, the cheerleaders were the financial regulators.  In the case of structured finance securities, the cheerleaders were the rating firms.

Market participants listened to these cheerleaders because they thought the cheerleaders had access to all the useful, relevant information in an appropriate, timely manner and that the cheerleaders were conveying the unbiased results of their independent assessment.

The result was that market participants underestimated the risk of the investments and invested more than they could afford to lose.

Complexity also helps financial institutions hide the risks they create. 
Despite the advertising of the International Swaps and Derivatives Association and others who create and sell derivatives, these products are only sometimes used for hedging and much more frequently for speculation. 
In the latter case, they are exceedingly useful in obscuring information that would be crucial to the proper judgment of values and risks. 
Consider the derivatives that helped Italy’s Banca Monte dei Paschi di Siena SpA hide hundreds of millions of dollars in losses as it sought a taxpayer bailout. Anyone making deals with a bank enmeshed in a largely invisible web of contracts with far-flung counterparties does so with a very incomplete view of the risks involved.
Monte dei Paschi is a classic example of why banks should be required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.
The basic complexity of the market allows for the completion of deals that would never get signed in a world of full transparency and understanding. 
Unfortunately, traditional financial theory -- which assumes that individual actors have perfect knowledge and make only rational decisions -- ignores this point, blinding itself to a huge source of systemic risk.
Please re-read Mr. Buchanan's comment as it is the key to understanding how we got ourselves into the financial crisis and what it is going to take to end the financial crisis and fix the financial system.
Any science has to begin with basic insights first, learning which details really matter and which may not. 
The network perspective is still some way from making confident proclamations of recipes for specific regulations on derivatives, banking transparency and so on. But some of its insights already eclipse those of traditional financial economics, and any work on crafting better regulations should certainly take these insights into account.... 
The ideas aren’t terribly profound: The networks approach simply acknowledges that the details of how financial systems are wired up, of who is linked to whom, play a crucial role in financial stability. The linkages determine how shocks travel through any market and strongly influence who has access to what information.
The network highlights were there are opaque corners in the financial system that must be see the sunlight of transparency.

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