Disclosure is Nontrivial

I'm a fan of disclosure because I think it's one of those equilibrium like wearing hockey masks, where individuals may not want to wear one if no one else is because of marginal costs in eyesight, signalling toughness, but if everyone wears one they are all likely to have more teeth and functioning neurons.

Yet, it's a nontrivial problem identifying the data that might be useful. Good data tends to be very business-specific, different for credit card portfolios, direct vs. indirect lending, home equity, commercial real estate: each have different key risk factors. As previously, Moody's did not think it had to know what the loan-to-value ratio was on the mortgage collateral, and bank examiners also never mentioned this as a bad thing prior to 2007, one shouldn't be optimistic that the current bugaboos will be relevant.

Too often disclosures focus on things that don't matter, and they become fetshized. For example, many have pointed out that leverage for the largest investment banks was crazy-high in the last crisis, 25-1 in some cases. True, but they were high for decades for most of these investment banks, and cross-sectionally, the relationship between leverage and future failure rate or ratings is weak. It's a really weak signal because having 10-1 leverage in some assets is much safer than having 30-1 assets in another, and banks know this and game accordingly.

Another example of regulator focus is VaR, which is applied to a subset of traded assets within a bank. I'm a fan of VaR, having set up a VaR for KeyCorp's trading operations in the 1990's, and found it immensely useful as a monitor on our positions. Yet, for risk capital, or the risk of the bank in total, it was irrelevant. The assets relevant to this calculation are usually quite small as a percent of total assets (<5%), and often part of market-making operations that generally have pretty flat exposure to big factors like interest rates or the S&P500. Thus, in the past crisis the big 7 US money center banks showed an average daily VaR (99%) of about $120MM in early 2008, and then through March 2009 lost about $7T (trillion) dollars in market cap. Being of 1000x smaller magnitude highlights its irrelevance.

So, if you have a good idea, send a 3-5 page PDF version of your proposal or paper, with a separate title page and abstract, by October 15, 2011 to: Hamid Mehran (Hamid.mehran@ny.frb.org) and JAR (jar@chicagobooth.edu) specifying "FRBNY/JAR Conference" in the subject line ($50 submission fee). There's a conference the following year in NYC sponsored by the Fed and the Journal of Accounting Research entitled “Disclosure, Transparency, and Financial Reporting in the Financial Services Industry."

My idea would be to take the bank consultants at Oliver Wyman or First Manhattan, and certify them as our standard bearers. No penalties, just full reviews, with their own subjective criteria, which is as well explained and more rational than anything coming of the FRB/OCC/OTS/SEC/HUD/FDIC/NCUA/FTC. Sure that would give them a lot of power and a huge wealth transfer, but consider the billions spent on bank regulation that is so transparently pointless, we could do better for one tenth the cost.