Sunday, January 27, 2013

Opacity in financial system is boon to study of financial contagion

Bloomberg ran an interesting article on Kristin Forbes and her pursuit of the study of contagion in the financial system even though her MIT economic department colleagues thought it was a dead-end.

Regular readers know that in financial systems that adhere to the FDR Framework, the study of financial contagion is in fact the study of the empty set.


Because under the FDR Framework, all market participants are held responsible for the losses on their exposures.  As a result, market participants set their exposures at a level where they don't have more exposure than they can afford to lose.

Hence, the idea of contagion doesn't apply.

How can market participants set their exposure at what they can afford to lose?

They are given access to the information they need to independently assess the risk of any exposure.  Based on the results of this assessment and the market participant's capacity to absorb any losses from the exposure, the market participant sets their exposure.

Isn't the global financial system based on the FDR Framework?


Then why is there concern over financial contagion?

Because financial regulators failed to ensure that the financial system adhered to the FDR Framework.

Specifically, the financial regulators let large swathes of the financial system become opaque.  Examples of the opaque corners of the financial system include the "black box" banks and the "brown paper bag" structured finance securities.

A financial product or corner of the financial system is opaque if market participants do not have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess this information and make a fully informed decision.

Beginning in 2007 and continuing to this day, where there is opacity the financial system has effectively frozen.  An example is the inter-bank lending market where banks with deposits to lend cannot assess the risk and solvency of banks looking to borrow and therefore are unwilling to lend.

Bottom line:  bringing transparency to all the opaque corners of the financial system would in fact prove her MIT colleagues right that studying financial contagion is a dead-end.

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