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LONDON - The complexity of the global financial system and the imbalance of information available to market participants means the ability to track risk has declined "probably forever", Moody's Investors Service said yesterday.
"It is extremely unlikely that in today's markets we will ever know on a timely basis where every risk lies," analysts at the ratings agency, led by chief international economist Pierre Cailleteau, wrote in a report.
The warning touches on a hot topic in the credit crisis that engulfed markets in 2007.
The problems faced by markets, sparked by losses on securities linked to US sub-prime mortgages, were made worse as institutions became increasingly uncertain about which market participants were exposed and how big the losses might be.
A number of investment banks were forced to rapidly revise higher and higher write-offs running into billions of dollars, as the risk of new losses came to light.
All of that contributed to a stand-off in interbank lending markets, with rates surging higher as banks sought to hoard cash, leading to a co-ordinated effort by the world's biggest central banks in December to ensure liquidity was available.
One of the key reasons for the lack of information on the extent of risk and its location has been financial innovation leading to greater complexity, Moody's said.
"The combination of financial innovation, opacity and leverage is generally explosive," the ratings agency said.
"Financial innovation often leads to an uneven distribution of the information available to the different parties at risk.
"The problem in the case of extreme complexity of inter-connecting financial systems is that it is hard to see how the level of information could reach levels adequate to enable reasonable risk management standards," the agency said.
Ratings agencies have been viewed as one of the means for increasing information available in the market, but Moody's said this had proved "somewhat unrealistic when the incentive structure of [sub-prime] loan originators, sub-prime loan borrowers and market intermediaries also shifted in favour of less information".
The agency said overall, the financial system suffered from flawed incentives that encouraged excessive risk-taking.
But it said regulators and policymakers tolerated this, as it was the way to maximise growth - even though it would inevitably lead to regular crises - saying this was the "Faustian pact" they had implicitly agreed to with the financial industry.
- REUTERS
