Global Bankers Must Realize Transparency Is a Two-Way Street

Federal Reserve Gov. Daniel Tarullo met last week in New York with the CEOs of the systemically important financial institutions that came under the Fed's recent stress tests. The backdrop to the meeting was Tarullo's refusal to make the parameters of the models used in these stress tests public, or at least known in more granular detail so that financial institutions can compare their results with their models.

Fed officials fear that more transparency would allow banks to "game" the system, shaping their portfolios to score better on the Fed's models. Other items were on the agenda including the Fed's proposal to prohibit any SIFI from having exposure to any counterparty that exceeds more than 10% of its regulatory capital.

Tarullo provided testimony to Congress on February 12 of last year on the issue of greater transparency and counterparty risk exposure and described the need for a global identification system for counterparties in financial transactions. That testimony laid the foundation for rule making now known as the legal entity identifier initiative. This effort is taking place under a mandate by the Group of 20 major economies. Their mandate is to create a system for identifying by computer all financial market participants and the contracts and instruments they trade, own and process. This is the minimum but most important first step toward creating transparency in the financial industry and being able to accurately aggregate counterparty risk and compare it to any regulated limit.

The CEOs have asked Gov. Tarullo to make the Fed's capital models more transparent and to change the proposed counterparty exposure limits. The rub here is how counterparties are aggregated to test against the established limits. This problem and the broader transparency issue have plagued regulators for decades. In this information-age financial system, regulators do not have the tools yet to oversee what policy makers have mandated they regulate. 

The G20's Financial Stability Board, made up of the member states' finance ministers, central bankers and regulators, is preparing a global edict to identify every financial market participant, starting with swap counterparties, with a unique, unambiguous and universal computer code. This will allow each regulator to recognize the same counterparty and its business ownership hierarchies, in the same identical way by means of a computer. This will then allow for timely, accurate and consistently applied rules for aggregating and testing counterparty risk against any established credit limits for the first time on a global basis

However, industry trade associations, particularly the Securities Industry and Financial Markets Association, are recommending that the leading financial market utilities owned by SIFIs own the regulatory apparatus that will be needed to do this. In effect, they would be shining the light on themselves. Whether to illuminate their own risk taking, their capital adequacy, their compensation structures, their exposures to one another, and to their potential for systemic contagion with common counterparties, they are asking to be allowed to centralize and control this apparatus.

Not a good outcome in our opinion. In times of stress, when regulators are most in need of such a transparency mechanism, it may not be there. The attention of financial market utility management will be focused on their own priorities, not on keeping the flashlight shining for regulators and the banks themselves.  

Banks too need to see the risks they collectively take with the same counterparties in the same way as regulators do. That's why my firm, along with our subcontractor, Semandex Networks Inc., brought world class global technology players into the debate as we had done in bringing GS1 (the global nonprofit that maintains the manufacturer, location and product codes in bar codes) into the dialogue some time ago.

Since the global identification system is to be supported by a not-for-profit entity and, therefore, no commercial or self-interests should drive it, it is up to regulators to make sure that this is done right and done right from the start. If the effort stumbles, the financial industry members (particularly the SIFIs meeting with  Gov. Tarullo  and the other global SIFIs defined by the FSB) will have a reasonable argument to make that this is not a practical endeavor (which it is) and postpone indefinitely the ability of regulators to see into those institutions they are mandated to oversee.

The FSB has set its own time line to come up with a plan so it can prepare a recommendation to the G20 at a summit in June. The Commodity Futures Trading Commission has likewise come up with a plan and asked for interested parties to submit proposals. Both requests need to be tied together and no regulator should be jumping ahead of the global initiative until all the details are worked through and all plans vetted. That will take time, more time than the schedule conceived in the rush to regulate will now allow.

Gov. Tarullo needs to take up the dialogue of transparency with the global CEOs. Transparency into financial institutions should be a public good, a global identification system should be freely available to all, and the mechanism to run and oversee this should not be a captive of the industry it is intended to regulate.

And for their part, the large banks will be able to finally start the long overdue journey toward transforming the excessively costly and error-prone infrastructure of their industry – an infrastructure that costs each of these large firms upwards of $2 billion annually.

Trading the transparency of the Fed's models for global transparency of counterparty risk seems like a good deal.

Allan D. Grody is the President of Financial InterGroup Holdings Ltd.