Transparency of financial markets questioned

Two Yale professors published a paper arguing that short-term debt markets can run more efficiently when they are lacking in transparency.
Two Yale professors published a paper arguing that short-term debt markets can run more efficiently when they are lacking in transparency. Photo by Creative Commons.

More information may not always make markets work better, say two Yale professors.

A new paper by Gary Gorton, a professor at the School of Management, and Guillermo Ordoñez, a Yale economics professor, argues that a lack of information in short-term debt markets can actually help the market run more efficiently, though it can also cause a vulnerability to external shocks. An outside expert said the paper, published in January by the National Bureau of Economic Research, ran counter to the prevailing view that financial transparency is always beneficial, and could have implications in financial regulation.

They write that banks use short-term debt, backed by collateral, as a method of transactions within the banking system. The problem with this market, Gorton said, is that it is often too expensive for firms to research the quality of the collateral underlying the loans. Instead, firms choose to assume an equal distribution of quality within the collateral held by different firms.

“So, instead of knowing which borrowers have good collateral and which have bad collateral, it all starts to look alike,” Gorton said.

The authors say the practice is an efficient way for the traders to value the collateral, but it creates fragility in the sort-term debt market. If a firm or individual begins producing information about the collateral, perhaps fearing its quality, then only firms with good collateral will be able to borrow, which leads to a credit crunch.

For example, Ordoñez said, mortgage backed-securities are often used as collateral in this market, because they tend to have a good rating and are too complex to research profitably. But if firms begin to question the general quality of that sort of asset, then it would lose its value as collateral.

“The economy can produce bad outcomes, even though everyone understands what’s going on,” Gorton said.

According to Ordoñez, there is room for regulators to counter the fragility of the market by producing information about quality of collateral, but they must first determine that the costs of the fragility outweigh the system’s benefits.

Gorton cautions that fragility is not inherently bad, because it is a natural part of credit markets. He said he prefers managing fragility rather than attempting to eliminate it.

“Even the government cannot eliminate risk completely, and nor would it want to,” he said.

Both authors said this paper’s insight — that increased information can hurt the economy — runs counter to many established opinions about transparency in financial markets. Ordoñez said that the obsession with transparency in the financial markets since the 2007 crisis could actually inhibit the functioning of those markets. However, the paper did not speculate about the origins of the 2007 financial crisis, which saw a serious credit crunch.

Gorton said that the paper’s insights are largely theoretical and did not recommend specific details about how regulation should work.

Arvind Krishnamurthy, a professor of finance at Northwestern University, agreed with the authors about the importance of their research. He added that there were many issues of “information, debt and financial crises” that modern economics had not yet explained.

“As the authorities move to put in place new financial regulations, they are very much driven by a worldview in which transparency is an unmitigated virtue,” Krishnamurthy said. “We also need to know the ‘right’ amount of opacity for the economy.”

A debt asset is generally considered short-term if it has a maturity date of one year or less.

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