Monday, April 18, 2011

Objection to FDR Framework: Too Big to Fail are Too Big to Understand

This is the first in a series of posts that addresses objections to fully implementing the FDR Framework.

Objection:  A $2 trillion financial institution is too complex for every market participants to be able to analyze.

Response:  Under the principle of caveat emptor [buyer beware] in the FDR Framework, the investor takes the responsibility for bearing all the losses on their investments and therefore they have an incentive to do their homework.  With its deposit guarantee, the government is limiting the number of investors who are subject to caveat emptor when investing in a financial institution.  The investors who exceed this limit are perceived to have the capability to do the analysis for themselves or to hire a third party expert to do the analysis for them.

Objection:  A $2 trillion financial institution is too complex for any market participant to be able to analyze.

Response:  Those investors, like shareholders and lenders and counter-parties, who are not protected by the government guarantee have to deal with the complexity.  They have three choices:

  1. Follow Warren Buffett's advice and not invest in a company they do not understand;
  2. Hire a third party expert, like a mutual fund manager, to analyze the data and make the investment decision for them; or
  3. Analyze the data for themselves.

An example of an investor who could analyze the data for themselves is the financial institution's competitors.  They have the in-house expertise.  These firms also have an incentive to analyze the data because they have numerous exposures, like loans and derivatives, to the financial institution.

Objection:  A $2 trillion financial institution is too complicated to report at the current asset/liability level.

Response:  There are three types of complexity for financial institutions:

  1. Complexity based on organizational structure;
  2. Complexity based on the sheer number of assets and liabilities; and
  3. Complexity based on the specific asset or liability.
Fortunately, the modern database handles all this complexity.  It is the modern database that allows the management of a $2 trillion financial institution to actually know what is going on.

It is the modern database that is at the heart of the successful implementation of the FDR Framework for financial institutions.  It is the database that makes it possible to provide the market participants with all the useful, relevant information in an appropriate, timely manner.  Just like management, these participants, which range from financial regulators to credit and equity market analysts to financial competitors to pricing services to rating services to counter-parties to investors, can use the database to find the answers to their questions.

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