Risk Transparency, Defined

Despite best efforts to define and commit technology to effective actualization of transparency, the notion of transparency remains vague and is often left to the best efforts of information providers.

The critical need for transparency came to the forefront after the near-catastrophic financial and economic events during 2007 to 2008. In its aftermath, transparency has become the centerpiece of the lexicon of managements, investors, other market participants, and regulators alike. However, while there is wide recognition for the need of transparency, there are very few standards or guidelines that are applied consistently within institutions or entities, let alone across financial or economic systems.

Challenges of achieving transparency
Before we get into a discussion about transparency, we should not underestimate the challenge of managing the risks of a financial institution or a related enterprise. The difficulty of this task gets amplified with rapid financial innovation, dynamic, interconnected local and global economies, volatile markets, competitive pressures, and the demands of regulation.

The need for transparency of risk within this paradigm is hardly undeniable, but has to surmount several hurdles to be effective. The major obstacles in the way of effective transparency include: the enormous complexity of financial risk; the constraints of having to compute risk measures on legacy systems and associated technologies that are often incompatible; rigid regulatory regimes; and disparate standards and practices for internal and external disclosure.

Establishment and rigorous implementation of standards for transparency will go a long way in ensuring efficient and effective deployment of bank capital, a scarce resource indeed. Continual observation and attention as to how these standards are followed as markets and products evolve is essential for ensuring that elusive risks do not accumulate and raise the odds of institutional and market stress events.

Definitional construct of risk transparency
Transparency is hardly a new concept or requirement. The desirability and provision of transparency has existed since the advent of modern banking. Transparency is the result of proactive communication of information that reflects the state of an entity or a system. As it applies to financial risk, transparency can be defined as timely, actionable information that provides accurate and reliable representation of the prevailing risks of financial institutions and markets.

As a simple construct, transparency in an institution should be considered as being achieved when recipients of risk information have:

1. A fair representation of its prevailing risk profile and underlying components
2. How its current risk profile is different from prior periods
3. Reasonable explanations for what accounts for the changes

This is a straightforward goal and financial institutions and other market participants have been willing to, and indeed have, provided generally relevant information that contributes to overall transparency.

However, effective actualization of transparency requires a great deal of commitment and attention. Its foundations are rigorous standards and practices for risk management as well as communication. But unlike well-defined standards for computation of disclosure of risk parameters and other financial metrics, the notion of transparency remains vague and is often left to the best efforts of information providers.

The requirement that these standards be followed in letter and in spirit is crucial for preventing phenomenon like the regulatory arbitrage that was widespread across the banking and insurance sectors for well over a decade prior to the 2008 financial crisis. Fundamentally, regulatory arbitrage is a form of transparency arbitrage. This stems from disparate regulatory frameworks and form over substance vis-à-vis risk capture and ensuing capital requirements. A well-known example is apparent in the financial guarantees of enormous face values that were provided by financial products of a subsidiary of a large insurer. These financial products existed in a regulatory no man’s land, with enormous need for providing cash collateral associated with downgrades of guaranteed securities and exposures.

Sanjay Sharma is the Chief Risk Officer of Global Arbitrage and Trading at RBC Capital Markets in New York. He oversees the risk of several trading strategies with a global footprint across a multitude of asset classes and instruments.  His career in the financial ... View Full Bio