Whither Stress Testing?

OK, the stress of stress testing has come and gone, now what? If that is the first and last time we do this, it was a meaningless PR exercise.

Stress testing needs to be put on a solid, repeatable, and repeated basis.

First - Publish the stressors. What was the formula used to compute capital adequacy? Can I have that in XBRL, please?

Second - This is fun, let's do it every quarter! How long have people been complaining about financial statements being retrospective instruments? We need to embrace forecasting fully. We need to build up a body of time series of these things. Published in XBRL with no tweaking by the Fed. Transparency rocks!

Third - What's the error bar? Let's say I got my wish, and every quarter every bank in the US reported a matrix of capital adequacy forecasts across some increments of inflation and unemployment. Is that enough? No. We also want the probability assigned by the bank to each cell, and the uncertainty band around their reported figure.

Fourth - Why stop at banks? In this era of large companies sucking at the government teat to survive, we should be able to demand similar forecasts of other recipients. The capital market needs to eventually take up the responsibility of holding public companies up to a requirement of disclosure, not the regulators. In the meantime, regulators should prime the pump, and establish the set of data items to be provided. Standard setters, make some standards for prospective disclosures, please.

Death By Success - A Threat To XBRL?

Talking to my friend and co-worker Yossi Newman, he brought up an interesting concern. Would the increasing use of XBRL cause a chorus of nay-sayers to form that could seriously threaten XBRL's path to world domination ubiquity?

Umm, no.

I think the number of applications of XBRL around the world has already put us past that possibility. Failure in one market could affect acceptance in that market, but that will only put that market behind others, which will eventually put pressure on them to catch up.

My larger concern along similar lines relates to asset bubbles. Our long run of good news ( no nuclear war, pandemic, global famine, etc.) has created a huge amount of investment funds chasing investments. This leads to asset bubbles. Any advantage will be pounced upon in the search for 'alpha'. XBRL is just such an advantage. The result could be that enormous pressure could be put on the vendors and supply chain of XBRL quite suddenly, too suddenly for them to adjust. A classic case of 'be careful what you wish for'.

The Great Taxonomy Landgrab

With the SEC mandate on the use of XBRL arriving in June, it is almost time for XBRL's 15 minutes of fame and buzzword status.

One aspect of that moment in the sun that I anticipate is an outpouring of taxonomies foisted on an unsuspecting public, by organizations with tenuous-at-best connections to the subject matter of the taxonomy. I believe this will follow the pattern of the flowering of XML Schemas earlier in the history of the web.

This will all shake itself out in a few years, but for a while it will be a rough ride. I'd like to think that this will make XBRL acknowledgement by XII process more valuable, but at the same time it challenges the meaning and governance around that process.

FreeRisk Bait and Switch

Thanks to my friend John Turner, I just watched the video of a presentation about FreeRisk at O'Reilly's ETech conference.

The presentation listed a few problems in our current system of rating credit and investing in debt.

• grade inflation in debt rating as NRSROs attract business with generous ratings
• funds forced by law to invest according to ratings from only a few agencies
• meaninglessness of the rating itself
• opacity of the rating model
• lack of diversity in modeling

They propose FreeRisk as a solution to the problems, which they have flipped into a set of requirements.

• accessible
• open
• diverse
• transparent

Cool, but how does that actually solve all of those problems identified earlier?

• Grade inflation - FreeRisk models are still opaque, so we don't know if a company has bought special preference or not.
• Forced acceptance - FreeRisk needs legislation to eliminate the privileged position of established NRSROs, and/or privilege some part of its own leaderboard as an NRSRO.
• Meaninglessness - Models are still opaque, so scores are still meaningless.
• Opacity - Continues.
• Diversity - With continued opacity, we have no clue whether models are diverse or not.

So on my analysis, FreeRisk isn't doing to well at solving the problems it wants to solve, mainly due to model opacity. Solving model opacity isn't easy.

The first problem is that the market will pay handsomely for good models, so there is a clear incentive to keeping them opaque. FreeRisk must be assuming the OSS model will transfer to finance, a big assumption.

The second problem is knowing where to stop in the desire for transparency. Let's take a simple model such as the Altman Z-Score as an example. I'm not happy just getting a real number in a certain range for an answer. I ask for the model. I get a formula using certain financial accounts and weights. Where did the weights come from? Why those accounts and not others? I need to know the design methodology of the model, and the database used to derive the parameters.

FreeRisk currently supports an API that allows for scoring based on a single period's data. Even the Piotroski Score needs two periods of data to work. More troubling, the simple Piotroski and Altman Z methods touted during the presentation are methods for evaluating the corporate entity, not the debt instrument. The debt instrument has to be evaluated for its terms and conditions. We are still very far away from having public T&C databases available in XBRL and Common Logic.

More troubling still is the belief that all credit scoring is model based. This is certainly not true today. It won't be true even when T&Cs are in XBRL and CL. There is still an element of judgement, of interviewing senior management, of reading the news on a company, that comes into play.

There is a lot of free floating moral outrage powering the FreeRisk presentation. But we should step back from that and think dispassionately about changes to our financial system. Should NRSROs really be expected to be aware of bankruptcy before it is announced? To whom do NRSROs owe a fiduciary obligation to force companies into bankruptcy by downgrading their debt? Do we really want debt market volatility similar to equity market volatility based on quicksilver changes in ratings?

Here are some of the things I took away, even if they were unsaid.

• we need finer grained ratings than the current scales provided
• we need to take named NRSROs out of legislation
• some funds should create softer cutoffs for investing
• the buy side should fund the NRSROs, not the issuers

The last is the most important. It removes one of the largest reasons for distortion of ratings. It aligns the interests of the NRSROs with the capital markets.

It would be great if the buy side funded the public company financial statement audit as well!