Beyond Bank Transparency

As my colleague David Callahan discussed here last week, the current issue of The Atlantic includes an article written by Frank Partnoy and Jesse Eisenger entitled “What’s Inside America’s Banks.” The authors make the point that the financial health of the big banks is, at best, obscure because of the inadequacy of financial statement disclosure. This is, without doubt, an accurate criticism of the mega-banks that dominate the financial system. Unfortunately, the article comes up far short of the mark analytically and in prescribing solutions. Partnoy and Eisenger are both keen analysts of finance, but this cover story in a national magazine is a missed opportunity to clarify the fundamental weakness and inefficiency of the current financial system.

The authors’ criticism focuses on lack of transparency. They propose a return to the principles of the New Deal, identifying “twin pillars of regulation:” straightforward disclosure standards and credible enforcement against executives who perpetrate fraud and abuse. This agenda is wholly inadequate to address the issues of the 21st century.

Today’s financial markets are dominated by powerful innovations that have emerged over the last three decades, a trend that Partnoy wrote about in his book Infectious Greed. For example, sophisticated quantitative analytics enable derivative contracts on the prices of hundreds of asset classes. Derivatives are not just another form of investment. They are inherently complex. The risks involved in even simple derivatives defy understanding, even by the mathematicians and physicists employed at the mega-banks; and many derivative contracts are far from simple.

Derivatives markets have a powerful affect on the real marketplaces and the economy. The size of the aggregate market exposure to the price of a given financial asset or commodity is no longer limited to the supply of the asset or commodity. Risk can be, and is, routinely synthesized and propagated throughout the system. And technology enables the deployment of enormous amounts of capital at speeds that far exceed human perception and decision-making.

The focus on transparency is not a bad thing. It simply misses the point that the financial markets are dominated by risks that are incalculable and rewards that are unconscionable. No amount of disclosure can provide protection. The authors seek simplified bank disclosure, specifically a plain language statement setting forth the consequences of “worse case scenarios.” However, that very proposal reveals the unfortunate analytical shortfall of the article. Identifying a “worst case scenario” is at the very core of the problems of the financial sector. The entire structure is based on statistical projections of how badly things may go wrong based on historic price movements. The economic health of the world relies on the assumption that past performance predicts future results.

If the financial crisis taught us nothing else, it is that statistical models can be informative, but can never tell us what will actually happen.

Transparency in the financial markets is wanting, but the real problem is that banks and other financial institutions that serve an essential social purpose (that is to say, are “too-big-to-fail”) are allowed to engage in activities that impose levels of risk to the world economy that are massively disproportionate to any value they deliver. This behavior may be rational for the institutions and the executives that govern them – the relatively certain profit may outweigh the risk of loss to shareholders and employees. But the costs and benefits of these activities to society as a whole involve an entirely different calculation.

The only sensible solution is for society to proscribe activities that individual market participants find rationally profitable through laws and regulations imposed for the common good. There is nothing wrong with requiring capital reserves to protect against “worse case scenarios,” but the futility of calculating the adequacy of a bank’s balance sheet unless its activities are meaningfully restricted should be painfully obvious.

This leads to the inevitable conclusion that the element of financial reform known as the Volcker Rule is critically important. As in their “twin pillars” concept, the authors yearn for a simplified Volcker Rule that prohibits “proprietary trading” by federally insured banks without further elaboration. They would leave it to the courts to sort out what is proprietary trading and what is not. Yet they also observe correctly that distinguishing proprietary trading from risk mitigating hedging or inventory accumulation for customer service is devilishly complex.

The truth is that the Volcker Rule’s provisions that establish standards for hedging and customer market making provide detailed analytics that ad hoc enforcement through judicial process could never accomplish. Indeed, the proposed implementing rules are challenging to those who are unfamiliar with modern quantitative analysis. But that genie escaped its bottle long ago. For those who are in the business, the rules make sense. The industry’s talking points that criticize complexity in the rules are intended to prey upon the desire of non-quants to understand the written rules. But lawyers are badly in need of meaningful standards if the prohibition of proprietary trading is to work.

A more draconian alternative to the proprietary trading prohibition might have been a better approach, but that is the approach Congress took. It can be implemented so as to reduce systemic risk dramatically, but the implementation must be precise.

The Atlantic article makes some important points. But the dangers inherent in the 21st century financial markets are very different from those that plagued the system in the Great Depression. Wishing for a simpler financial system will not make it so.