Posted by: Aaron Pressman on October 11, 2007
Sometimes, the short tenure of finance reporters or bloggers creates confusion, such as the coverage of risk disclosures by Wall Street firms like Goldman Sachs (Symbol: GS) over the past few days. Some of the current bunch, it seems, were not a-splash in these waters 13 years ago when an unexpected, sharp rise in interest rates led to a series of derivatives-related miscues (to put it mildly) and surprise losses at corporate stalwarts like Procter & Gamble and Eastman Kodak as well as the bankruptcy of Orange County, California.
After the smoke had cleared, our fine regulators at the Securities and Exchange Commission led by a fairly activist chairman, Arthur Levitt, went into hyperdrive. Ultimately, the SEC adopted in 1997 a series of new rules forcing public companies to disclose more about the risks they were taking, particularly in financial markets.
Wall Street and other finance types complained that it couldn’t do so, didn’t need to do so and that it would be confusing to do so. So the SEC helpfully offered what’s known in the world of regulators as a “safe harbor.” If you disclosed your many risks using a popular technique of the time — the time being 1997 — known as “Value at Risk,” or VaR for short, you were golden. Here’s the SEC’s whole Q&A spelling out how the rule worked.
The idea wasn’t to force companies to disclose the actual measures they used day to day to run their businesses, nor did anyone think that the required revelations would be 100% spot-on. But the new standard measures would allow investors roughly to compare how much risks companies were taking and reward or penalize appropriately.
That’s why it’s a bit silly to read criticism of VaR or the other disclosures in Goldman’s quarterly reports, as in this Felix Salmon post. The disclosures aren’t meant to be a precise and exact gauge of the firm’s risky activities but a rough measure that can be compared to peers and to the firm’s results over time. And in that sense, the disclosure have performed exactly as expected. Goldman and other firms have substantially increased their reported VaR over the past year or so. When market turmoil hit - no surprise - they lost some money. You might credit the string of quarterly disclosures for helping the stock market better anticipate what was about to happen, though obviously there was a lot more than that at play. Goldman shares peaked back in June.
Most importantly, has the system worked overall? Has increased disclosure, however imprecise, brought some market discipline to risk taking? I’d have to say that it has. A study released by the New York Fed this summer, for example, concluded that the better a firm’s disclosure practices, the better its risk-adjusted returns and the better its stock performance.