Improving Transparency and Order in the Financial System

In order for the world financial actors to start playing by the rules and within their means, more eyes need to be squared on them—basically, the market needs more transparency.”


By Jeff Fritz

A pattern’s emerging.  The economy has failed often enough that its flaws have become more predictable after each passing cycle.  Worse, no one is innocent.

It starts, as always, with society’s individual consumers and institutions (the actors in the market), who all eventually fall prey to a collective shortsightedness—they believe the growth of the present will continue indefinitely into the future.

In reality, not so much.

Such thinking is how economic bubbles form, usually—as the mid-twentieth century economist, Hyman Minsky, explains—by three basic progressions.  First, market actors take on a little debt to purchase investments and meet interest costs.  Next, these actors increase their debt loads until they can only afford the interest, still confident that the economy will continue expanding.  Then finally, they take on so much debt that it necessitates increasing prices to be safely financed.

From globalpoliticalawakening.blogspot.com

But of course, just like Ponzi schemes, this house of cards came tumbling down.  Taking the recent Housing Meltdown as an example, house prices plummeted, borrowers defaulted, forcing them to sell their assets en mass, further pushing down prices.  Then the inevitable happened: the government stepped in and covered private blunder with public savings.

In most industries, the resulting chaos would result in ‘creative destruction,’ where capital would be redistributed in a more efficient manner.  But the financial sector is different; when it plunges into chaos, capital is destroyed outright.

Isn’t there a ways to avert all this?

Some think so.  And their suggestions come in threes—the first trinitarian set strengthens the market’s eyes; the other, its endurance.

We begin with Daniel Roth’s Wired.com article, Road Map for Financial Recovery, where he argued that in order for the world financial actors to start playing by the rules and within their means, more eyes need to be squared on them—basically, the market needs more transparency.

Of course, many would say that the government receives more than enough financial data in the form of tax filings, quarterly and annual reports, disclosures, etc, more so now than ever before, especially in the wake of such corporate collapses as Enron.  The problem is however, this sheer quantity of financial transparency becomes opaque when the government turns its attention to actually sifting through all this data, something that becomes all but impossible for its relatively small number of underpaid auditors.  Add to this how each company prepares its financial documents using different templates, headings, accounting structures, etc, making analyzing multiple sets of documents against each other exceedingly tedious.

However, here is where technology can come in to the rescue.  As Roth points out, new software, such as XBRL, can be used to standardize all forms of financial information to be documented and forwarded to government auditors.  If the government required that such software were used by all companies—including pension funds, insurance companies, hedge funds, investment banks and other such institutions that make up the ‘shadow’ banking system—government auditors would have a much easier time sifting through the mounds of financial data they receive.  Moreover, they could then potentially create specialized algorisms and software to electronically scan through these standardized forms to find illegal irregularities.

[pullquote]Create an army of citizen regulators; with all this data available to the public, company’s will then have to face the ire of special interests[/pullquote]

But to make this process even more effective, it must be decentralized—cue Roth’s three-tiered manifesto.  First, comes ‘setting the data free’ whereby all these financial documents (preferably in a standardized form) is made public and easily accessible to the public.  This leads to ‘empowerment of the investors,’ since once an investor receives access to a company’s fully standardized financial data, he or she can manipulate it in novel ways to discover information not normally found in your basic financial statement.  And third, create an army of citizen regulators; with all this data available to the public, company’s will then have to face the ire of special interests who will now have the power to quantitatively assist government auditors to weed out dishonest public or private institutions.

Moving on to the second trinitarian solution, we look to Raghuram Rajan, a former chief economist of the IMF.  In a recent, Economist.com, online discussion, Rajan outlined three principles for improved financial regulation that may complement the transparency efforts just outlined; these being: comprehensive, contingent and cost-effective.

These principles promote that all new regulations passed to temper the market should be comprehensively applied to all leveraged financial firms, so as to avoid money being transferred from heavily regulated institutions to more lightly regulated ones—a practice that has recently burned the balance sheets of many banks globally through their investments in barely regulated subprime debt packages.  Moreover, these regulations should be contingent on enforcing financial restrictions most at times of excess, then less in times of soberness—thereby both avoiding subterfuge and being cost effective.


Regulations that meet these requirements, Rajan argues, include asking institutions to develop ‘contingent-capital’ arrangements where money is set aside when times are good and raising capital is cheap, then infusing that money back into the system in times of crisis and capital is scarce—thereby protecting the taxpayer.  One version of this would be for banks to issue debt, “which would automatically convert to equity when … two conditions are met: first, the system is in crisis, either based on an assessment by regulators or … objective indicators; and second, the bank’s capital ratio falls below a certain value.”

These two conditions ensure that banks that screw up by their own means don’t avoid the debt they’ve earned, while also ensuring that well-capitalized banks avoid the negative impact of forced debt conversion.  It also provides an incentive for banks to quickly raise new capital when they foresee losses on their books, rather than depend on the public to bail them out.

Other ideas that Rajan mentions, is a requirement for important and leveraged financial institutions to buy fully collateralised insurance policies that will protect them in times of crisis.  As well, he believes that those financial institutions that are ‘too big to fail’ be required to develop a detailed plan so that should it ever go bankrupt, it can do so quickly and with as little damage as possible to the outside system—similar to a will left behind to the children of a deceased parent.

Reading this far, it should be heartening to know that the ideas for plugging the holes in our collective market boat are out there—these proposals and many others not already covered above.  Standardizing and decentralizing the auditing process, alongside introducing innovatively comprehensive, contingent and cost-effective regulations—even if a few of these measures were introduced, it’s possible that they would push back the date of the next market collapse by years.

And in doing this, we can only hope that Theodore Roosevelt’s famous quote will at last be felt: “Let the seller beware as well as the buyer.”

ARB Team

Arbitrage Magazine

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