Transparency Is Not Enough; Combatting Comprehension Asymmetry

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consumption and those salacious and ostentatious “real housewives”, could not pay ... out that the treasurer of Oran
Transparency Is Not Enough; Combatting Comprehension Asymmetry A speech by Jon Lukomnik1 to the Transparency Task Force September 28, 2017, Boston, Massachusetts USA The title of this talk is “Transparency is not enough; Combatting Comprehension Asymmetry”. Let me illustrate why with a true story about my sworn testimony, more than two decades ago, before a special joint committee of the New York State legislature. Some of you are old enough to remember 1994. For others, though, it may seem like ancient history so here is a brief reset. Rather than starring in GEICO insurance company commercials, Boys II Men had the top song of the year, “I’ll make love to you”. In movies, “The Shawshank Redemption”, “Pulp Fiction”, and “Forrest Gump” all debuted. In politics, Bill Clinton was President and John Major was Prime Minister. In sports, or rather crime, OJ Simpson led the world on a low-speed car chase in his white Bronco and was charged with a double murder. I would tell you who won the World Series, but there wasn’t one that year, due to a player strike. And, if you were in the financial markets, all that was overwhelmed by one huge event: Orange County, California, declared bankruptcy. Yes, that the wealthy area best known today for the conspicuous consumption and those salacious and ostentatious “real housewives”, could not pay its bills. It turned out that the treasurer of Orange County had been investing in some risky derivatives and got burned. All of a sudden, derivatives, then relatively new financial instruments, because the focus and worry of every regulator in the United States. Warren Buffet called them “time bombs” and “financial weapons of mass destruction”. People were even afraid to mention their name; derivatives became “the D word”. At the time, I was running New York City’s pension funds, and we owned more than $6 billion in mortgage derivatives. As you might imagine, it wasn’t long before I was “asked” to testify before a special joint house and senate hearing at the state legislature. I was at the witness stand, in the well, looking up at lawmakers. I was sworn in. “Do the City pension funds had any derivatives?” I answered truthfully, “yes sir, more than $6 billion in mortgage derivatives in our fixed income portfolio”. The legislators sat up straighter and started firing questions: “Why?” “Aren’t you aware of the risks?” “I thought bonds were supposed to be low-risk.” “How do we know you’re not the next Orange County?” Now, you can call how I answered that flurry of questions and accusations, either total transparency or obfuscation. You may think those two are mutually exclusive, but, as you’ll see they’re not. “Well,” I said, “let me tell you how we control risk. We use something called Macauley’s duration. That’s a measure of time weighted cash flows. It measures how much bond prices will move, inversely, with interest rates. With mortgages, of course, the key is prepayment risk, so we use prepayment bands to look at projected prepayment speeds under different interest rate scenarios and compare them to realized prepayments. And then…” You could see the synapses of the legislators’ brains shut down as their eyes glazed over.

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Jon Lukomnik, Executive Director, IRRC Institute and co-Author What They Do WIth Your Money and The New Capitalists

When I finished, the Chairman said simply, “I don’t think we have any more questions for Mr. Lukomnik, do we? Next witness.” Now, I was totally truthful and totally transparent with my answer. But I don’t know if I was totally helpful. I suspect that level of transparency did not elucidate. No. This is a transparency conference. I should be transparent. In fact, I should be more than transparent. I should be honest. The truth is that this was a case where transparency did not to increase understanding. Even as I was decreasing information asymmetry, I was increasing, to coin a phrase, “comprehension asymmetry”. So how does this relate to the state of asset management today? Andy and I met for the first time at a London Business School event for the launch of our book, “What They Do With Your Money: How the Financial System Fails Us and How to Fix It”, which Stephen has already mentioned. It was a great session, packed with, as they say in London, the great and the good. We had finished our talk about how increased complexity and a diminution of purpose had resulted in stagnant productivity in the finance sector for 130 years. As importantly, we had cited a laundry list of incremental improvements that we thought could move the industry forward, when our moderator, Professor Chris Higson, surprised us with this question: “If you could only have one of those reforms, what would it be?” That is a tough question to answer when you’ve just explained that your book is realistic, and that there is not one big fix, but lots of little ones focused on everything from motivation to information, from rethinking regulation to changing how economics is taught. Finally, however, while we could not settle on one reform, we could settle on two. The first would not surprise anyone here. Transparency, we said. Let every fee paid to everyone in the transaction chain be public: Who pays it. For what. To whom. And those fees should be comprehensible; this would be transparency of the type Stephen talks about with the nutrition statement. It makes no sense to mandate transparency that fits the letter of the law but leaves the investor more confused than when he or she started, a la my testimony to the New York State legislature. We were recommending not just transparency, but comprehension. We said, at the time, that we knew no economist who thought markets worked best when they were opaque. But classical economists also assume rationality, which infers comprehension of the information presented. We recommended, and still do recommend, transparency with guardrails around it so that it is comprehensible by all. However, there is a second question that often is not asked: Transparency towards what The website of The Transparency Task Force quotes Justice Brandeis: “Sunlight is the best disinfectant”. I agree. We need sunlight. But we need to focus it correctly, so that it kills what we want disinfected, rather than withering what we want to thrive. We want to disinfect the bad germs, not the good bacteria that keeps us healthy. Because transparency sometimes burns away not the problem, but the constraints that have been holding the problem in check. Consider, for example, executive compensation in the United States. For years, activists (myself included) argued to have executive compensation disclosed. And disclosed in some detail. And we succeeded. We assumed, of course, that such disclosure would control “runaway” CEO compensation.

The reverse has happened. In 1980, CEO to worker compensation was about 42-1. Twenty years later, at the turn of this century, it was about 120-1. Today, it’s around 347-1, depending on whose survey you use. There are plenty of reasons for this, from the increased acceptability of “winner-take-all” in American society, to the decline of unions, to who hires compensation consultants, to cults of personality built around charismatic CEOs, but transparency actually played a role as well. We, who supported more and more executive compensation disclosure, thought that it would shame some boards and CEOs into constraining pay. Instead, it resulted in the ability to publicly look at competitors’ compensation. And then CEOs began playing a grown up version of “mine is bigger” by demanding, and receiving, a larger compensation package than his (and it is still usually his) peers. And yes, for those of you here from the UK, that is a not-so-subtle warning about Prime Minister Teresa May’s idea to create a public register of executives who have faced shareowner complaints over their pay. Now don’t misunderstand: I support the transparency measures. But they need to be combined with some idea of what will happen if there are unintended consequences. You cannot count on CEO’s simply being shamed into more constrained pay plans; that implies that people willing to take tens of millions of dollars can feel shame in the first place. So, here is another limitation to transparency. It must be deployed with purpose, and it must be part of a system which enables people to make use of the information transparency unveils. Let me give you a hypothetical. If someone committed a crime in broad daylight, then went on YouTube and said “I did it”, but no one punished him or her, then we’d have transparency. But to what end? So if what we want to do is make the asset management industry, from the portfolio manager to the trader to the counterparty to the exchange to the proxy advisor to the transfer agent to the score of other intermediaries work for the end investor; for the individual who is saving for retirement, a house, a child’s college, a vacation, or even just to have a cushion to ride out the inevitable bumps and surprises of life, we have to make sure that transparency serves a purpose. Transparency may be a disinfectant, but we need to combine it with purpose. So, the second reform we told Professor Higson was fiduciary obligation, a fancy phrase that means, simply, the intermediaries should act on behalf of the person whose money it is. So, purpose and fees would be explicit. With only transparency, without a fiduciary standard, investment advisors can act contrary to the best interests of their clients, and, as long as they disclose somewhere in the mountains of small print that govern their accounts, they are held harmless. But, combine transparency and fiduciary duty with an individual’s right to redress in instances of wrongdoing and you would have a market for asset management that could police itself. Everyone would know what they were supposed to be doing -- acting on behalf of the owner of the assets -- and the fees they made would have to be disclosed so that any corrupting influence against that purpose would be soon spotted. In conclusion, transparency is not enough. For transparency to work, there has to be relatively equal understanding of the information provided by that transparency and it needs to be deployed with purpose. It does no good to be transparent with no effective recourse, nor to replace opacity with comprehension asymmetry. Simply put, transparency is a condition necessary for markets to work, for commerce to improve society, for both the perception and reality of a fair society. But in and of itself, it is a condition necessary, but not sufficient. We must make sure transparency serves a purpose. Thank you.