July 22, 2010
Dodd-Frank: “It will finally bring transparency to the kinds of complex, risky transactions that helped trigger the financial crisis.”
Posted by Bobby Bartlett

That’s President Obama yesterday on Dodd-Frank. Of course, there was no need for me to wait until yesterday to hear this sentiment: Lack of transparency has been a consistent theme surrounding financial reform since the collapse of AIG. (Although let’s pretend that I had a good reason to wait until now for participating in this great forum.)

I’ve found this persistent non-transparency motif a bit puzzling given that it seems to substitute for concrete analysis of the role of transparency in systemic risk regulation. For me, a natural starting point for examining whether (and how) to legislate for more transparency in financial markets is to ask: exactly how were markets lacking in transparency and why might this affect financial stability? Yet as far as I can tell, these questions have been rather inconsistently addressed in the political dialogue surrounding financial reform--a confusion that, not surprisingly, appears in Dodd-Frank. This seems especially true when it comes to some of the most notable regulations affecting the shadow banking sector.

For instance, a recurring theme in the Act focuses on the need for regulators to have access to more data on activity within the shadow banking sector. One of the most prominent instances is in Title III governing over-the-counter derivatives. In addition to imposing a clearing requirement, Title III also requires an extraordinary amount of data reporting to the CFTC (in the case of swaps) and the SEC (in the case of security-based swaps). Among these requirements, clearing organizations must now provide to the relevant agency “any information determined by the [agency] to be necessary to perform its responsibilities under this Act” (sec. 3106), while derivative repositories (which will receive transaction data for cleared and non-cleared trades) must make available to the agencies “all data obtained by the swap repository, including individual counterparty trade and position data” (sec. 3105). And to ensure there is no doubt that these reports are meant to police systemic risk, the data must also be made available (in either case) to “the appropriate Federal banking agencies, the Financial Services Oversight Council, and the Department of Justice …" Likewise with respect to the new private fund registration requirements, Section 5004 of the Act authorizes the SEC to collect “systemic risk data” to be shared with “the Board of Governors of the Federal Reserve System, and to any other entity that the Commission identifies as having systemic risk responsibility.”

Whether regulators previously lacked data to monitor systemic risk, however, is far from self-evident. After all, the regulatory disclosure regime prior to 2008 was fairly substantial. Anyone worried about systematic build up of leverage in the financial sector could see it in the Fed’s Flow of Funds reports, which since the early 1990s have revealed a remarkable inflation of financial firms’ balance sheets. Likewise, for individual firms, regulators (non-bank and bank) had at their disposal a number of means to examine a firm's financial health. Rather, the post-mortems on the SEC’s Consolidated Supervised Entity Program as well as the OTC’s oversight of AIG suggest the problem was one of organizational competence rather than access to data. Of course, Dodd-Frank seeks to address this organizational/structural challenge by establishing the Financial Risk Oversight Committee, but this seems to confirm that the primary problem for financial regulators has been structural rather than a lack of transparency.

Other aspects of Dodd-Frank focus instead on market transparency but similarly lack any systematic sense of how more “transparency” is necessary to avert another financial collapse. As Mike discussed, the move to create central clearing in OTC derivatives seems to be motivated in part to enhance price transparency, but as he notes, this is a rather peculiar means to enhance the transparency of the OTC market: many (most?) of the derivative transactions that will clear can already be obtained via private sources (e.g., CMA). More meaningful, perhaps, is the obligation to provide to the public “aggregate data on swap trading volumes and positions” (§§3104(j) & 3203). Although ISDA and DTCC have gone a long way to provide public data on swap activity, the marketplace currently lacks reliable data concerning the aggregate volume of swap trading, so this could indeed be useful information for market participants to estimate systematic risk thereby enhancing asset pricing. But until I see it implemented, it’s unclear how useful or comprehensive it will be. If it’s just the disclosure of notional volumes, I’m not sure what value it will provide above and beyond the data currently out there.

So like Mike, I’m ultimately underwhelmed by the Act’s attempt “to bring transparency to the kinds of complex, risky transactions that helped trigger the financial crisis.” To the extent financial institutions choose to build large, correlated portfolios of CDOs (Merrill Lynch), obligate themselves to backstop asset-backed commercial paper facilities (Citigroup), or write a few billion dollars of CDS on CDOs/RMBS (AIG), Dodd-Frank gets this information into the hands of the Financial Stability Oversight Council, but otherwise provides little additional public transparency. (In fact, section 3104(j) specifically requires that any public reports of aggregate swap data must be “in a manner that does not disclose the business transactions and market positions of any person.”)

Mike (and others) have suggested that, in the end, perhaps this is as it should be given that regulating systemic risk is primarily a job for a prudential regulator. I find myself less sure. Prudential regulation has long promoted public disclosure by financial institutions to encourage market discipline (i.e., Call Reports in the U.S.; Pillar 3 disclosures in Basel II), and for good reason: The history of bank failures suggests that banking regulation is tough--regulators can use all the help they can get. And mandating the disclosure of a bank’s portfolio exposures arguably facilitates this aid by providing a bank’s creditors with information to assess its credit risk, in the process helping to deter concentration risk. At the same time, there’s reason to believe financial institutions will not be forthcoming with this information given both the costs it imposes on management through better monitoring of portfolio risk and the positive externality it creates for competitors. Yet while these considerations suggest why some form of mandatory disclosure may be necessary in the domain of prudential regulation, they also explain why bank disclosure tends to be a mixed bag: in both the US and Basel II, banks are required to disclose aggregate portfolio data but not any granular data that might compromise a bank’s proprietary information, even though this granular data is needed to estimate a bank's portfolio risk.

I certainly don’t mean to suggest that greater transparency in the market would have averted the financial crisis. On the contrary, my examination of the monoline industry (which did disclose details concerning insurers’ CDO portfolios) provides mixed results on how effectively the market used this information to assess the risk of Ambac and MBIA, the two largest monoline insurers of multi-sector CDOs. Moreover, any attempt to leverage market discipline also has to confront the extent to which explicit and implicit government guarantees can impair investors from actually exerting some form of market discipline. Neither of these problems, however, seem to justify Dodd-Frank’s disregard for the traditional approach to prudential regulation in which both regulators and markets are perceived as partners in a common enterprise. If non-transparency in shadow banking is a problem (and I tend to believe it is), exploring ways to ensure information is efficiently provided to markets while protecting firms’ proprietary information seems a necessary step to take in our endeavor to minimize systemic risk.

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