21/5/2105: The Darker Side of Transparency?

World Bank paper published earlier this month and titled "The Dark Side of Disclosure: Evidence of Government Expropriation from Worldwide Firms" raises some very interesting questions about the relationship between corporate transparency and government incentives.

The paper by Liu, Tingting and Ullah, Barkat and Wei, Zuobao and Xu, Lixin Colin (May 4, 2015, World Bank Policy Research Working Paper No. 7254: http://ssrn.com/abstract=2602586)  looks at "the effects of voluntary accounting information disclosure through auditing on firm access to finance, exposure to corruption, and sales growth." The authors use data for more than 70,000 firms in 121 countries.

The authors find that "…disclosure can be a double-edged sword" with overall effect depending on institutional capital present in a specific country.

"On the one hand, audited firms exhibit a slightly lower level of financial constraints than unaudited firms." This is in line with traditional theory whereby voluntary transparency increases information quality about the firm, but also signals self-selection of better-governed and better-performing firms to the markets.

"On the other hand, audited firms face a significantly higher level of corruption obstacles." Which is really surprising, until you understand the underlying logic.

"The net effects of voluntary information disclosure on firm growth are negative, which can largely be explained by the fact that most of the countries in the sample are developing countries where institutions are weak. The beneficial effect of disclosure increases as a country's property rights protection improves. The qualitative results are robust to considerations of the endogeneity of auditing and to alternative measures of corruption and financial constraints. The findings reveal the dark side of voluntary information disclosure: exposing firms to government expropriation where institutions are weak."

In other words, in more institutionally-advanced economies, voluntary disclosure is a positive factor for the firms, even she we control for self-selection bias. But in countries where institutional capital is weak, the effect is the opposite: in presence of corrupt and accountable governments, disclosing corporate information to the markets can trigger greater effort by the government to expropriate from the reporting firm.

There are serious ramifications for policy and development economics from this study. Traditionally, we tend to push more transparency and more disclosure for the firms operating in institutionally-weak emerging markets. In doing so, we may be aiding the predatory governments who, thus, gain greater ability to corruptly capture firm assets and/or profits over and above legally required taxation. This, in turn, strengthens the corrupt state institutions and government, instead of pushing them toward adopting more rule of law-styled reforms.

Beyond this, the study results suggest that at least in some setting, less transparency and greater ability for the corporates to operate within private information markets can actually be a good thing.

What is interesting is that in public domain, very little attention is paid to this issue. The results of this study, however, are broadly supportive of Acemoglu and Johnson ("Unbundling Institutions", Journal of Political Economy 113(5), 949–92005, 2005) work on the overwhelming importance of constraining government expropriation in facilitating economic development, ex ante other reforms.

On the other hand, transparency is value-additive in the advanced economies setting, where institutions are sufficiently high quality to preempt (or at the very least, diffuse significantly) the emergence of actionable incentives for state expropriation and information-led corruption.

2/1/2014: Risk, Regulation, Financial Crises: A Panacea Worse than the Disease?

An interesting - both challenging and revealing - piece on 'preventing the future crisis' via http://www.pionline.com/article/20131223/PRINT/312239993/preventing-the-next-financial-crisis-requires-regulatory-changes.

Few points worth commenting on:

Per article: "…Record investment management industry profits as well as record market highs belie the fact we remain truly exposed to complex financial products and services not yet fully restrained since the crisis of 2008." As a logical conclusion to this, of the "three things in particular should concern all of us who are stakeholders in the finance industry as we move into the new year" the first one is:

"…complacency that another crisis can't happen because we have fixed the gaps in regulation."

So far nothing to argue with. Financial innovation (aka a path of increasing complexity) remains the main source of margins uplift in the industry. As long as that is the case, we are going to have less transparency, lower capacity to price risks and, as the result, greater fragility of the system, especially with respect to tail events.

"Nothing could be further from reality and the list of unfinished regulatory business is long. " And the article rolls on with a brief list of reforms and changes yet to take place. Alas, desired or not, these changes are hardly going to bring about any significant change in the way the sector operates. The irony is: the article warns against complacency and then complacently assumes (or even postulates - take your pick) that implementing the list of regulations and reforms supplied will resolve the problem of 'gaps in regulation'.

Really? Now, wait a second. We have a problem of 2 parts:
Part 1: complexity of system is high.
Part 2: complexity of regulation lagging complexity of system.

Matching Part 1 to Part 2 by raising complexity of regulation can only address the problem of risk buildup if and only if Part 1 is independent of Part 2. Otherwise, rising complexity in 2 can lead to rising complexity in 1 and a race in complexity.

Still with me? That is a major problem of the financial system as we know it since at least 19th century. The problem is that rising complexity of regulation is driving financial innovation probably as much as the need for higher margins. The race to match Part 1 and Part 2 above is a loss-making game for regulators, and thus, for economies at large.

If that is at least partially true, the argument should not be about regulations that are yet to be implemented, but rather about which regulations can help reducing complexity (and increase risk management effectiveness) in both Parts 1 and 2. We are still missing that argument, having departed firmly on the path of reasoning that suggests that higher complexity of regulation = higher system ability to absorb shocks. More dangerously, we are seemingly traveling along the line of logic that suggests that higher complexity of regulation = higher ability of system to 'prevent' shocks.


The article goes on to list another major source of risk: "investment management industry overconfidence that it is back in control". Specifically, "We in the industry perceive ourselves as having rectified our inability to see building counterparty, leverage and liquidity risks, masked through Federal Reserve policy by the unorthodox government support of financial markets and the nearly 10,000-point move in the Dow Jones industrial average since the financial crisis."

In reality, "Systemic risks are still building, undetected. Transparency is not increasing and the unwillingness or inability to remove government support in the markets is unprecedented."

Guess what? If you assume that more regulation + more complex regulation = better risk management, you are going to become complacent and you are going to get a false sense of security, control. This brings us back to the first point above.


And now to the non-point point number 3: "Finally, we in the investment management profession seem totally nonchalant about the current state of our existing regulatory system. It is alarmingly outdated, under-resourced and no match for the complexity of markets in the 21st century. To be clear, we are not talking about the new regulations addressing the crisis, rather the basic requirements of our present regulatory structure."

Back to point one above, then, again…


The reason I am commenting on this article is precisely because it embodies the very poor logical reasoning that is leading us to structure regulatory responses to the crisis in such a way that it will assure the emergence of a new crisis. But the real kicker is not that. The real kicker is that the very belief that regulatory system based on matching complexity of regulated services can ever be calibrated well-enough to assure stability of the system is a belief suffering from gross over-extension of faith.

A constant race to increase complexity of the system will lead to system collapse. 

17/1/2013: Transparency & Budgetary Processes

An interesting statement by Nessa Childers, MEP:

I completely agree - all budget-related submissions and proposals should be made public and the Department of Finance should publish them all on their site, linked to Budget documentation. This issue is not only about transparency and lobbying (which are very important), but also about public access to ideas and potential foregone options presented to the Government.

23/10/2012: Signs, Indicators and Noise

From time to time in the past I used to look at CDS spreads for sovereigns. I have not done so in a while. In fact, I have not even updated my database for these in a while. Why? Because something is dodgy about the sovereign assets' market that is manipulated by the sovereigns. And here's a quote from the TF Market Advisors that sums it up well enough:

"One of the effects of the central bank policies is that many of the more obscure parts of the market that you could look to for clues or early warning signs have been eliminated. Sure these markets still exist, but the information from them is so manipulated that it is difficult to get a clear read."

1. LIBOR : "Between Fed lending programs, LTRO, and the lawsuits, I have no clue what to make of LIBOR other than it probably isn’t a whole lot of use as a sign of anything."
2. EUR/USD 3 month basis swap : "...was another useful indicator showing the relative strength of US banks versus European banks. Again with LTRO and various central bank global swap lines, this measure has become useless. With banks willing to use central bank liquidity without fear of reprisals or negative stigma, they do, and this rate hovers right around where the governments would like it to be."
3. European sovereign CDS : "has become far more difficult to interpret as all these naked bans get enforced. French CDS went from 106 on the 11th of October to 65 today, in pretty much a straight line. I have difficulty thinking of one real reason that France could have done so well – they have funded ESM, instituted some domestic policies that seem dubious at best, have had weak economic data, and are marching to the beat of their own drum in the Euro in a way that indicates willingness to take on more debt, yet they are tighter. This makes it hard to figure out what is going on in European bank CDS."
4. US Treasury Yields : "...are very difficult to figure out. The Fed owns over 35% of treasuries with maturities 5 years and longer. Almost everything you would look at and try and infer from the treasury market is skewed by that."
5. Economic data "has even come under attack. In general I don’t believe the data is manipulated, particularly not for political purposes (but there are a growing number of people who do). But I do think they try and cover up their own mistakes. Jobless claims came in at 337k or something (pre upward revision) two weeks ago. There was a lot of concern, and some very good economists spoke to the BLS and came up with the conclusion that one big state had not sent in their quarter end revisions in time. There was some confirmation of this, but then some sort of denial. Missing the deadline would be an honest mistake in my opinion, it shouldn’t happen, but I can see how it could. Then last week, we posted 388k as the number. Now we have data that looks like 369k, 342k, and 388k. Is the reality that had they properly accounted for the missing number, that the claims have been 369k, 365k, 365k? If so, we have okay but steady claims. If the actual data is correct (which I don’t think it is) then we would have seen some euphoric hiring followed by aggressive firing. I find that harder to believe."

Note, I wrote about US jobless claims figure here.

There is a major problem, folks. While we can debate the numbers left, right and center, what is clear is that the current environment (political, monetary and policy) is becoming less and less transparent. The market signals are being distorted (willingly and via the law of unintended consequences) and this does not bode well for the future.