Mapping Toxicity
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Policy Finance & Accounting Economics Feb 1, 2013

Map­ping Toxicity

Bring­ing trans­paren­cy to risk assessment

Based on the research of

Markus K. Brunnermeier

Gary B. Gorton

Arvind Krishnamurthy

The fis­cal cri­sis of 2007 – 2009 caught peo­ple — includ­ing expert econ­o­mists — off guard. And even as the cri­sis unfold­ed, use­ful insight was hard to come by. At the end of the day, most pol­i­cy­mak­ers and econ­o­mists had some idea as to what was going on, but not as much as one would hope,” says Arvind Krish­na­murthy, a pro­fes­sor of finance at the Kel­logg School of Management.

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Why should this be? Why were the over-lever­aged, so-called tox­ic” real estate assets that con­t­a­m­i­nat­ed the rest of the econ­o­my invis­i­ble even in plain sight? Accord­ing to Krish­na­murthy, the prob­lem is that finan­cial report­ing prac­tices are too out­dat­ed to cap­ture the infor­ma­tion nec­es­sary to accu­rate­ly assess mod­ern macro­eco­nom­ic health.

In try­ing to doc­u­ment the cri­sis [after the fact], you start to look for the data you need and you find it’s not exact­ly there,” Krish­na­murthy says. Our mea­sure­ment of finan­cial activ­i­ties might have been good in the 1940s or 50s, but it’s very poor cur­rent­ly giv­en how much the finan­cial sec­tor has changed.” 

Cur­rent Finan­cial Report­ing Falls Short

Cur­rent finan­cial report­ing focus­es on assets and lia­bil­i­ties on a cash bal­ance sheet. If you look at an indus­tri­al firm like GM, their assets are the var­i­ous man­u­fac­tur­ing plants. These are all tan­gi­ble things, and when you look at the finan­cial state­ments, you can see it all fair­ly clear­ly,” Krish­na­murthy explains. The trou­ble is that firms like Gold­man Sachs and Mor­gan Stan­ley assume con­tin­gent eco­nom­ic expo­sures, through finan­cial instru­ments like deriv­a­tives, that do not show up clear­ly on their bal­ance sheets.

A sim­ple deriv­a­tive secu­ri­ty might be one in which, when real estate prices go up by 10%, this com­pa­ny will make an extra $5; and if they go down, they’ll lose $5, so the risk is com­men­su­rate to the $5,” Krish­na­murthy con­tin­ues. But you can’t real­ly see the $5 of risk on finan­cial state­ments. You see that the firm has a deriv­a­tive, per­haps tied to real estate, but you can’t see if the firm is exposed to real estate risk of order $5, $50, or $500. Right away this obfus­cates things.”

Risk, rather than cash instru­ments, says Krish­na­murthy, is the attribute of our finan­cial sec­tor that defines its over­all health. And this risk goes large­ly unre­port­ed in finan­cial state­ments to the gov­ern­ment or the pub­lic. If you work at Gold­man Sachs, the way you mea­sure your own risks is entire­ly dif­fer­ent than these types of [pub­lic] account­ing state­ments,” he says. You’d mea­sure things like, How much mon­ey do I make or lose if real estate prices go up or down by 10%?’ That’s the prin­ci­pal num­ber you’re inter­est­ed in.”

The oth­er attribute that must be mea­sured and report­ed more accu­rate­ly, says Krish­na­murthy, is liq­uid­i­ty. The clas­sic exam­ple of a liq­uid­i­ty prob­lem is a bank that has a bunch of assets in real estate loans that are all com­ing due over the next 20 years. On the oth­er hand, its lia­bil­i­ties are short-term deposits from account hold­ers,” he says. The bank can poten­tial­ly get them­selves in a liq­uid­i­ty prob­lem because the assets are long term and far less liq­uid than its lia­bil­i­ties: If all the depos­i­tors come to the bank and ask for their mon­ey, the bank will have to close up because the money’s com­ing in over the next 20 years. The mod­ern finan­cial sec­tor is per­pet­u­al­ly in this posi­tion of short liq­uid­i­ty,’ and it’s impor­tant to mea­sure how much they are short liq­uid­i­ty because liq­uid­i­ty melt­downs are cen­tral to finan­cial crises.”

The irony is that while few finan­cial firms report this data, most com­pa­nies col­lect it for inter­nal pur­pos­es in fair­ly sophis­ti­cat­ed ways,” Krish­na­murthy says. Unlike assets and lia­bil­i­ties on a bal­ance sheet, risk is fun­da­men­tal­ly dynam­ic, so assess­ing it requires a dif­fer­ent approach from clas­si­cal finan­cial report­ing. You can’t get at it if you take a sin­gle snap­shot — you have to ask what-if ques­tions,” he con­tin­ues. This is what most finan­cial firms do inter­nal­ly. They con­struct what their finan­cial posi­tions will do in giv­en sce­nar­ios, and then they aggregate.”

The truth is that it’s eas­i­er to not invest in stan­dard­iz­ing data report­ing and remain rel­a­tive­ly opaque. But this is where a gov­ern­ment can step in for the com­mon good.” — Arvind Krishnamurthy

So-called stress test­ing” is anoth­er, more pub­lic, method of mea­sur­ing risk and liq­uid­i­ty. A bank con­structs a what-if sce­nario: say, what if unem­ploy­ment goes up and stock mar­ket falls by this much, how much mon­ey will the bank lose?” Krish­na­murthy explains. That’s what the Fed­er­al Reserve did in 2009, and now it hap­pens every six months for all the big banks.”

Exter­nal­iz­ing and Aggre­gat­ing Risk Assess­ments

How­ev­er, these ad-hoc, often inter­nal risk assess­ments can­not help paint a broad­er pic­ture of the econ­o­my unless they can be exter­nal­ized and aggre­gat­ed. Few firms are moti­vat­ed to do this, since it is expen­sive and the let­ter of the law does not require it. Also, firms may have dif­fer­ent tech­no­log­i­cal lan­guages,” as Krish­na­murthy puts it, for describ­ing their risk and liq­uid­i­ty. These lan­guages would have to be stan­dard­ized across the finan­cial sec­tor in order for use­ful report­ing to occur.

The truth is that it’s eas­i­er to not invest in stan­dard­iz­ing data report­ing and remain rel­a­tive­ly opaque. But this is where a gov­ern­ment can step in for the com­mon good,” Krish­na­murthy says. One way to do this is expand reg­u­la­to­ry fil­ings that require banks to use a com­mon lan­guage. It seems pos­si­ble that if every­one com­mu­ni­cates risk in the same way, even­tu­al­ly they will dis­close it on, say, SEC filings.”

What this kind of new finan­cial report­ing could enable, argues Krish­na­murthy, is a 50,000-foot view of the economy’s risk map,’ ” which would illu­mi­nate pock­ets of tox­ic risk and illiq­uid­i­ty in the over­all land­scape, like those that caused the recent finan­cial cri­sis. Krishnamurthy’s paper Risk Topog­ra­phy,” coau­thored with Markus Brun­ner­meier of Prince­ton Uni­ver­si­ty and Gary Gor­ton of Yale Uni­ver­si­ty, takes its title from this anal­o­gy to mapping.

Krish­na­murthy com­pares the mea­sure­ment of risk to that of the gross domes­tic prod­uct (GDP) dur­ing the Great Depres­sion. It was obvi­ous right after the Depres­sion that mea­sur­ing GDP was rel­e­vant, but nobody was doing it in the ear­ly 1900s — the data didn’t exist,” he explains. We are in a sim­i­lar sit­u­a­tion today. We’d like to have a risk map of the econ­o­my drawn, say, every six months as the ter­rain changes. Our hope is that, in 15 or 20 years, we’ll have accu­mu­lat­ed data that some bright PhD stu­dent will use to design a bril­liant the­o­ry about the caus­es of finan­cial crises. But the stu­dent will need the data about risk to build it with. That’s where we’re starting.”

About the Writer

John Pavlus is a writer and filmmaker focusing on science, technology, and design topics. He lives in Brooklyn, New York.

About the Research

Brunnermeier, Markus K., Gary B. Gorton, and Arvind Krishnamurthy. 2011. “Risk Topography.” SSRN Working Paper, Social Science Research Network.

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