Table of Contents
In mid 2000s, the world capital market was booming. The market was flowing with cash and mega investments were underway with investors seeking new ventures that would deliver revenue higher than conservative and conventional investments. In the US, interest rates were suppressed by the Federal Reserve through its increasing purchase of treasury securities, in efforts to advance economic growth. Since interest rates were significantly low, it was becoming difficult for institutional investors to attain the returns needed to meet their future obligations and to find attractive investment opportunities.
The collateralized debt obligation (CDO) provided an inventive alternative for investors. A CDO takes cash flows from various assets, repackages them and the related cash flows, and sells shares to the cash flows to interested investors. The CDO was developed as a legitimate investment tool for pooling risk and furthering the potential market for the capital investment in debt. In addition, it allows for the development of tranches, which contain different levels of risk and expected return on an investment.
This alternative was attractive to investors since it could allow them to design their investment plans to their own idiosyncratic reward/risk profile. In addition, it allowed them to easily spread their debt investments by having a piece of bonds or loans that constitute the CDO pool. Therefore, capital started to flow towards CDO, and as the global economy advanced and the capital increased, this alternative grew. The notional value of collateralized debt obligations outstanding rose from less than US$300 billion in 2000 to approximately US$1.4 trillion by the end of 2007.
With continued growth of CDOs came rapid expansion in the use of specific derivative such as mortgage-backed security. The Mortgage-backed securities became popular investment, allowing anyone the ability to invest in mortgages. The problem with mortgage securities was the fact that many of the fundamental mortgage s were provided below the acceptable standards to investors should not have accessed such mortgage loans. Eventually, the pool of legitimate mortgage loan was exhausted and mortgage originators lowered their standards further. The aim was to profit from sales of collateral from defaulters. Most large financial institutions had invested in mortgage-backed securities. These financial institutions realized that there was considerable risk in investing in CDOs and MBSs, and in attempt to divert this risk they created credit default swaps.
The entire process was castigated by lack of proper due diligence by financial institutions in creating, selling, and purchasing derivatives and improper identification of risk and counterparty exposure.
In attempt to correct such eventualities, increased disclosure of counterparties to derivatives possessed by financial institutions would increase the transparency among investment parties and demand the parties to obtain sufficient counterparty exposure details to manage the related risks appropriately.
The cross-references of financial statements contain useful information on a company’s financial report. Though this information may be difficult to comprehend, it is important to the users of financial statements in conducting due diligence.
Aside from the overall benefits of increased transparency and disclosure to the users of financial reports and statement, there are particular benefits related to such disclosure concerning counterparties exposure and credit risk. The key advantage to disclosing particular counterparties would be to let consumers of the financial statements to make informed judgment concerning counterparties exposure and related counterparties’ credit risk (CCR). The users may identify that a financial institution has unwarranted counterparty exposure with a given entity, such that CCR is excessively concentrated. Moreover, users may relate specific counterparty with higher CCR based on its past or present financial events or dealings. The users may then factor such information and their opinions in assessing risk associated with the financial institution.
For instance, a bank A may produce financial statements with advanced quality counterparty risk disclosures. In those financial statements and reports, a bank B is listed as a counterparty for 20percent of the bank A’s overall derivative positions. In conducting due diligence, investors may be cautious that bank A would encounter significant financial difficulties in the event that bank B was to default on its obligations.
Moreover, considering the bank B records consistent losses and suppose it is involved in litigation that exposes ethical lapses in its management. Investors may result into punishing bank A by raising their risk assessment on bank A and lowering the value of its stock.
Bank A may respond by further disclosing its efforts to transfer, reduce, or avoid credit risk from that counterparty. In the event, market presumes bank A’s response and counter-risk planning as appropriate then it may reward bank A by advancing its stock price.
Another benefit of disclosing counterparty exposure is that it may result into lowered systemic risk for the financial system. According to the efficient market hypothesis, in a not-so-strong-form, stock prices oscillate rapidly to the release of any new public information. Accordingly, as soon as counterparty information is disclosed in the financial reports and statements, prices are likely to respond equally to manifest either a perceived increase or decrease in credit risks for the entity.
This would react by rewarding financial institutions that properly regulate their risks while punishing those institutions that improperly manage their risk causing higher counterparty exposure concentration and deals with dodgier counterparties. This would reduce systemic risks since it would work to naturally control the actions of financial institutions on the basis of perceived risk consequences and may result in lowering the CCR on the aggregate.
Limitations and Perceived Costs
Any suggested increase in disclosure requirements is likely to be countered. In the case of rising disclosure for the counterparty exposure and credit risk, counter is likely to emerge from the financial institutions compiling and publishing the financial statements and reports and from critics of such increased disclosure in general. Nevertheless, the arguments against more counterparty disclosure are either refutable or weak.
To start with, financial institutions is likely to counter on such proposal since it implies they have extra work to perform in preparing financial statements and reports. The discourse to this is that these institutions should already have the information in advance regardless, if the investors learned their lesson from the global financial crisis, they should be providing this information to regulators regularly. Currently, Senior Supervisor Groups compels nineteen global banks to frequently report their major 50 counterparty exposures. Of nineteen banks, seventeen have been able to successfully avail the report in a week time.
Therefore, this information is readily available and there is no any excuse for the same not being available for the management’s decision-making process. The associated cost of attaching the information into the financial statements and reports is relatively marginal in comparison to the economic benefits and thus inconsequential.
Financial institutions are also likely to contend that disclosing counterparty exposure would reduce their competitive returns against each other.It is important to appreciate that whenever private information is made public, financial institutions may be disadvantaged from a competition position. However, whenever financial institutions are demanded to disclose their financial information, the playground ought to be level. In addition, the proposed disclosures do not advocate for particular disclosures of positions and derivatives as those disclosures are needed. The proposal for disclosure is intended to be an enhancement to be applied in bringing the existing disclosures to a well-rounded level and attain an enhanced risk evaluation possible.
Finally, institutions that are engaged in proper risk management may experience a competitive advantage by disclosing their counterparty information by enhanced stock prices, which is a benefit for efficiently managing financial risks compared to the competitors.
The other most outstanding source of disputation of the increased disclosure demand for counterparty exposure come from critics of such disclosure inn general. There are those who argue that the financial statements and reports of financial institutions are simply impossible to comprehend due to the complexity and volume. They also believe that useful information from financial reports end up being confounded in the complexity of those statements and reports and may not be detected by the interested users as they conduct due diligence.
While such arguments may be legitimate, since most financial reports and statements tend to be incredibly burdensome, those who believe in not-so-strong-form effective markets are likely to cite that availed information should not be necessarily understandable to the investors so as to be priced. Furthermore, while there may be some room for more disclosures, some of which may be too lengthy, vague or too complicated, the releases for counterparty exposure tend to be simple. In addition, financial institutions have already started to admit that counterparty credit risk is available in their financial statement and reports, and clarification on risk disclosure should merely viewed as an enhancement.
Therefore, the past failures and present concerns on disclosures should not be allowed to prevent further important disclosures without carrying out due diligence.
The greatest advantage of the improved disclosure is that it tends to enhance investor confidence hence promoting investment. According to the General Manager of the Bank for International Settlements, Jaime Curuana, an attainment of a significant advancement in the quality, timeliness and comparability of financial risk disclosures by financial institutions, would without a doubt o along way in breaking the nasty cycles of contagion, bailout, asset sales and failures from risk-taking, which have paralyzed global market repeatedly over the last decade.
According to Curuana, the fundamental to advancing market discipline is consistently high-quality, sound disclosures. Major investors have accepted that financial innovations and alternatives, such as MBSs, CDOs, and CDSs have resulted into emerging risks to financial institutions. They have also realized that financial institutions have withheld some of significant credit risks. Thus, without enough information, the investment ventures in financial firms may be stalled.
It is further believed of the current work that increased disclosure may be helpful in making the financial institutions to be more accountable and transparent, both to the potential investors and regulators. In the background of counterparty credit risk, it is expected of the financial institutions to evaluate the nature of their exposures. Nevertheless, the financial meltdown made it certain that most derivative counterparties were inadequately understood and some were detrimental.
Again, setback was as a result of the employees in the financial institutions failing to conduct proper due diligence when trading derivatives in their pursuit of growth of market share and profits. If the financial firms are demanded to provide specific counterparties in their financial statements and reports, then they would go an extra mile in collecting information regarding counterparty exposure. Further, the institutions’ internal and external auditors would be diligent in examining such information and ensure that management is accountable for its reliability and accuracy. Therefore, it is a call for the present paper for increased financial reports and statement disclosures.
The global financial meltdown of 2007-2008 was as a result of various issues and led the investors of financial institutions to losses. Though it would be difficult to highlight a specific issue that may be blamed, the lack of proper due diligence and high unwarranted systemic risk resulting from chain of counterparty, were to larger extent contributing elements.
Effective disclosure may help in advancing transparency and accountability in financial markets. A specific plan that may be executed would be to demand financial firms to disclose their largest counterparties on their derivatives and compliment this with the credit risk rating for all counterparties. Such solution would advance the usefulness of the financial statements and reports for the investors and reduce the systemic risks for the financial and global market.