Substack

Friday, December 12, 2008

The problem of information flows

Mark Thoma makes an excellent point that while liquidity and solvency related concerns are being debated and addressed, we are yet to recognize the importance of a third factor - reliable information flows. Financial markets need information to work properly, but traditional information flows have completely broken down during the crisis. The collpased information structure needs to be repaired quickly if the markets are to even begin gaining some semblance of normalcy.

The credibility of ratings agencies, risk assessment models, pricing models, research analysts and advisory service providers, performance forecasts and guidances, and even plain balance sheets have all taken a massive hit as the crisis has evolved. Investors no longer even trust the price discovery mechanisms.

He writes, "There can be event that occurs in the tail of the distribution of possible events that is viewed as just that, an unusual, costly event, but not one that fundamentally upsets our understanding of how the world works while at the same time undercutting the informational flows we use to understand these markets... But this crisis has destroyed confidence in the information and the models we use, and it won't be easy to bring this back." In other words, we have a true "black swan" event that has completely shaken the foundations of our long held and entrenched beliefs and expectations.

Though only time will be able to heal the deep scars inflicted by the crisis, it is important that governments intervene to put in place structures and mechanisms that can atleast partially repair the models and information flows and thereby restore some level of confidence required to get the markets up and running. He asks the right questions,

"Is there more that the government could do, for example, with accounting standards or required disclosures that would help people evaluate the stability of a particular institution? Are there changes that could be made to give buyers and sellers more confidence that the people acting as their agents in the transaction have the right incentives? Is there some way to immediately change the regulation and structure of the ratings agencies that can help to restore confidence in their assessments of risk?"

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