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A heterodox proposal

by Cyrille Thu Mar 7th, 2013 at 03:53:58 AM EST

I've been thinking about regulatory environments lately -finance, insurance, but also medical or IT.

Actually the last two will be relevant to the idea only as illustration. The proposal is about the financial world.

So, as you may or may not know, norms like Basel (2 or 3 at any rate) or Solvency 2 will require a lesser quantity of capital set aside if you have an internal process to evaluate counterparty risk. This process must be pretty thoroughly documented internally (internally is an operating word here) and will be subjected to audits.

As you also know, audit firms are paid by the company that they are auditing. Thus creating the mother of all conflicts of interest.

front-paged by afew


But how systematically relevant (aka too big to fail) institutions evaluate their risk should be of concern to all. Just like we need to make public (Ben Goldacre in Bad Pharma explains it better and more thoroughly than I could try to do, but the idea should be pretty clear anyway) all about how a pharmaceutical company conducted a trial in order that possible mistakes are detected quickly, and indeed regulation demands that this be the case.
Yes, I know, he also demonstrates vividly that the application of such regulation is appalling, and that's something that needs to be addressed, but the principle stands.

You can probably see where I'm going. Why not demand that institutions that adopt the internal process (in order to reduce their capital requirements) disclose it fully?

They might kick and scream, but at least the enforcement would be easy: if you don't do it, your capital requirements are instantly doubled. Plus, it may actually reduce their costs in the long run -things will not have to be reinvented everywhere. And it would give academics the possibility to conduct large meta-studies that would help us have a much better idea of the likelihood of rare risks.

When trotting out the idea I was told that they (in that case they meant insurers -I was talking to an actuary) spend a lot in that and want to keep it a differentiating factor. Well, you may want to allow for some patenting of truly innovative practices if that's needed. Again, enforcement would be trivial since companies would have to fully disclose what they are doing (nobody, and I mean nobody, would have an internal process and not say it, since it would be a pure waste of money: you wouldn't get the reduction in required capital).

So, what do you think? It's systematically relevant to everyone. Should this data not be more like open-source code than the secret formula they currently are?

(and while you're at it, please enforce the full disclosure of pharmaceutical and agribusiness data).

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Cross-posted on my blog Anachronicles here

Earth provides enough to satisfy every man's need, but not every man's greed. Gandhi
by Cyrille (cyrillev domain yahoo.fr) on Mon Mar 4th, 2013 at 09:33:14 AM EST
The current state of affairs is based on the integrity of the auditing process, i.e. on the laughable proposition that the combined professional ethics of bankers and auditors add up (or multiply out) to something we can all trust.

Cue LIBOR.

Cue Arthur Anderson (who?).

It is rightly acknowledged that people of faith have no monopoly of virtue - Queen Elizabeth II

by eurogreen on Mon Mar 4th, 2013 at 09:48:16 AM EST
True, but even if that were the case (bwahahaha, nice to laugh sometimes) there would still be a point in sharing it.

Because the systemic risk is linked to very rare events, and with very rare events, no single actor will ever have enough data, at any rate pooling should help us get a better idea (still imperfect of course -there will always be the super rare event that all the data in the world will not help to evaluate, but let's have as much as we can at least).

Earth provides enough to satisfy every man's need, but not every man's greed. Gandhi

by Cyrille (cyrillev domain yahoo.fr) on Mon Mar 4th, 2013 at 09:59:01 AM EST
[ Parent ]
What I mean is, the necessity for a transparent auditing process is self-evident because it's a given that the banker and his auditor are pissing in each other's pockets.

Transparency is valuable not only for evaluating systemic risks, but to (smirk) keep them honest. And that, I suppose, is why the idea will never fly.

It is rightly acknowledged that people of faith have no monopoly of virtue - Queen Elizabeth II

by eurogreen on Mon Mar 4th, 2013 at 11:29:28 AM EST
[ Parent ]
Well, if regulators see their role as preserving the nice I-scratch-your-back-you-scratch-mine arrangements, sure...

But maybe if there were enough political pressure things could change for the better (anyway the alternative is just complaining about how much worse things have become without any fightback).

Earth provides enough to satisfy every man's need, but not every man's greed. Gandhi

by Cyrille (cyrillev domain yahoo.fr) on Mon Mar 4th, 2013 at 11:39:27 AM EST
[ Parent ]
Heh... Arthur Anderson. I remember a time when they had their own elite check-in line at the Newark International Airport. Andersonians all carried those big briefcases with gold engraving; started hiding the name on them when Enron really began imploding.

'tis strange I should be old and neither wise nor valiant. From "The Maid's Tragedy" by Beaumont & Fletcher
by Wife of Bath (kareninaustin at g mail dot com) on Mon Mar 4th, 2013 at 04:58:07 PM EST
[ Parent ]
Got a linkie to Ben Goldacre?
by afew (afew(a in a circle)eurotrib_dot_com) on Mon Mar 4th, 2013 at 12:35:18 PM EST
Well, it's a 400 pages book. I don't have an electronic version.


Earth provides enough to satisfy every man's need, but not every man's greed. Gandhi
by Cyrille (cyrillev domain yahoo.fr) on Mon Mar 4th, 2013 at 01:28:45 PM EST
[ Parent ]
Bad Pharma - Wikipedia, the free encyclopedia
Goldacre argues in the book that "the whole edifice of medicine is broken," because the evidence on which it is based is systematically distorted by the pharmaceutical industry.[2] He writes that the industry finances most of the clinical trials into its products, that it routinely withholds negative data, that trials are often conducted on small groups of unrepresentative subjects, that it funds much of doctors' continuing education, and that apparently independent academic papers may be planned and even ghostwritten by pharmaceutical companies or their contractors, without disclosure.[3] Goldacre calls the situation a "murderous disaster," and makes a number of suggestions for action by patients' groups, physicians, academics and the industry itself.
by afew (afew(a in a circle)eurotrib_dot_com) on Thu Mar 7th, 2013 at 03:56:28 AM EST
[ Parent ]
Yes. And he also takes some time to explain why it's very important that trials protocols and all the trial data are made public.

Earth provides enough to satisfy every man's need, but not every man's greed. Gandhi
by Cyrille (cyrillev domain yahoo.fr) on Thu Mar 7th, 2013 at 04:33:15 AM EST
[ Parent ]
Why not demand that institutions that adopt the internal process (in order to reduce their capital requirements) disclose it fully?

That would destroy any value they might find in having an internal process so they would vigorously and successfully oppose any such requirement. They only have a PR interest in any public benefit.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Mon Mar 4th, 2013 at 10:21:15 PM EST
You may not be familiar with regulatory environments.

The whole point of an internal process is that otherwise the bank will need a higher regulatory capital to cover credit risk (in particular counterparty risk) for the same portfolio.

Making it public would not change that. And that is a significant benefit. For some reason I don't manage to dig up the figures right now, but I remember that under Basel 2 and 3 it was a drop of about 40% of the credit risk capital.

Anyway I wouldn't terribly mind if risk evaluation was no longer an internal process but a public service for which the banks/insurances would be charged.

Earth provides enough to satisfy every man's need, but not every man's greed. Gandhi

by Cyrille (cyrillev domain yahoo.fr) on Tue Mar 5th, 2013 at 03:01:07 AM EST
[ Parent ]
Perhaps the regulatory environment is healthier in Europe than in the USA, with health being considered from a public interest point of view? Here one can have all the regulations one wants so long as one does not expect them to be seriously enforced.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Tue Mar 5th, 2013 at 11:33:14 AM EST
[ Parent ]
(nobody, and I mean nobody, would have an internal process and not say it, since it would be a pure waste of money: you wouldn't get the reduction in required capital).

Secret autiting processes would still help you to avoid or contract out risks even if it didn't reduce capital requirements. Goldman made huge amount of money at the expence of AIG because they priced risks more realistically.

by Jute on Tue Mar 5th, 2013 at 08:08:19 AM EST
Maybe they could end up running an open auditing process to save required capital and a secret one to get rid of risks they don't want to take.
by Jute on Tue Mar 5th, 2013 at 08:10:17 AM EST
[ Parent ]
Well... That is one view of what happened between AIG and Goldman. I think it is under investigation and I certainly don't have the elements to conclusively establish what really happened, but it seems to have been, at the very least, fishy (while possibly perfectly legal).

But anyway, most transactions involve a disagreement on the risk of an asset, or on its true value, but in the case of financial assets it boils down to the same thing since there is no direct use. So it would not necessarily hamper any bona fide deal.

Earth provides enough to satisfy every man's need, but not every man's greed. Gandhi

by Cyrille (cyrillev domain yahoo.fr) on Tue Mar 5th, 2013 at 09:32:03 AM EST
[ Parent ]
It seems to me that the current actuality makes a strong case for my proposal.

JP Morgan apparently simply changed their risk evaluation procedures (according to the investigation by the US congress) in order to hide the size of the risks they were taking.
This would have been harder had the risk evaluation procedure been public.

And the penalty for applying a different procedure than the published one could be fairly straightforward: the bank is immediately put into receivership, the relevant chain of command lose their work contracts on the spot and need to re-apply if they want to retain their roles (needing to establish that they were innocent in order to be successful). Something like that.

Earth provides enough to satisfy every man's need, but not every man's greed. Gandhi

by Cyrille (cyrillev domain yahoo.fr) on Sat Mar 16th, 2013 at 07:42:25 AM EST


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