Fixing information asymmetries

By Felix Salmon
July 2, 2010
blog entry yesterday about the way in which Goldman's interaction with AIG helped to exacerbate the financial crisis, I got a very interesting email from a former Goldman employee:

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In the wake of my blog entry yesterday about the way in which Goldman’s interaction with AIG helped to exacerbate the financial crisis, I got a very interesting email from a former Goldman employee:

Insofar as the law is never going to be perfect, it’s certainly good that we are nice to our neighbors even when the law doesn’t require it, but when you find yourself saying, “Yes, this action was legal and within the rights of the agent, but helped precipitate great social harm,” you’re looking at a good candidate for a change in institutions, and legal institutions, for all their shortcomings, are the easiest ones to change. Ratings-based collateral deals might be a good target for regulation; the big liquidity hit that a credit downgrade can cause feels like exactly the sort of creditor-run that bankruptcy is supposed to prevent.

I like the idea that contracts concerning collateral should not reference credit ratings. In general, the less standing that credit ratings have, both legally and in private bilateral contracts, the better. They’re invidious things: no one should use a triple-A rating as a business model (see GE and the monolines), and a ratings downgrade in and of itself shouldn’t be able to precipitate a liquidity crisis: such things should never be self-fulfilling, since that just introduces needless systemic dangers into the financial architecture.

The former Goldman employee continues:

Should I have tried to call Treasury/SEC/some NY insurance regulator when it was obvious from our standpoint that AIG had no idea how much trouble it was in? When reminded of my duties to Goldman clients I basically translated that in my head to “Don’t short AIG.”

If Goldman employees reckoned that shorting AIG was a breach of corporate ethics, it’s hard to justify the fact that Goldman was happily shorting AIG for its own account.

As for the first question, back in October, Lloyd Blankfein said that Goldman should have been in more contact with regulators. But he seemed to put the onus on the regulators, rather than the banks:

We have to build a culture whereby firms are required to share concerns about systemic risks with regulators…

Regulators could establish a multi-firm business practices committee to examine issues such as underwriting standards. If practices slip, regulators would be among the first to know. They should ask questions such as: “Where are policies being stretched and pressures building? Where are you seeing concentrations in risk, crowded trades or one-way bets?”

I worried at the time that there would be big conflicts between banks’ responsibility to share information with regulators, and their duty of confidentiality to their clients. But it’s also increasingly clear to me that it’s silly to expect regulators to know exactly what questions to ask. If any employee of any bank sees a systemic risk, that person should have the legal obligation to take their concerns to the systemic risk regulator.

More generally, the problem here is that Goldman makes money from knowing or seeing stuff that other people don’t know or don’t see. It saw problems in the housing market which AIG was oblivious about, and took advantage of the information asymmetry there to make money. That’s how markets work. At some point, however, it risked setting up a negative feedback loop in which AIG would lose so much money that it would get downgraded and then be forced to put up even more money and then be downgraded further, etc etc. And I think that regulators should be within their rights to tell banks not to put on systemically-dangerous trades. Bringing down a small hedge fund is OK. Bringing down AIG, by contrast, ultimately benefits no one. As Goldman is slowly finding out.


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