In Transparency Games, I talk about Wall Street’s Opacity Protection Team. One member of this team is the regulatory ideologue. The regulatory ideologue asserts the best way to make markets work is regulations. Regulations used to structure markets, products and participant behavior.
Before going further, let me say I believe there is a critically important role for regulations in the global financial markets. So I would never say, “get rid of all financial regulations and rely solely on transparency”.
However, where I and the regulatory ideologues part way is whether you base your financial system on transparency and regulations are used as a complement to it. The regulatory ideologues argue regulations come first and then possibly, maybe in a “belt and suspenders” sort of way transparency.
From my perspective, why propose a regulation if the combination of transparency and caveat emptor solves the problem? Regulations should occur where this combination is unlikely of producing the desired outcome.
Of course, my perspective is in direct conflict with the regulatory ideologues. They want to charge ahead with regulations. A classic example of this is bank capital requirements. They are a complex regulation its champions assert will produce any number of desired outcomes. Unfortunately, as shown by the collapse of the Irish banking system in 2007/2008, this complex regulation is prone to failure.
Heaven forbid you should point this out to a regulatory ideologue. Like the other members of the Opacity Protection Team, their response is go on the offensive and make assertions like “transparency is not very effective at managing risk and/or making financial markets work”.
Let me debunk the two parts of this assertion. The first part is transparency is not very effective at managing risk. It is not transparency that manages risk. Transparency is necessary to manage risk as it provides the information so that risk can be assessed and subsequently managed. The second part is transparency is not very effective at making financial markets work. Transparency doesn’t make markets work. The financial crisis showed the presence of transparency was the necessary condition for financial markets to work. As the governor of the Bank of England observed, during the peak of the crisis, financial markets with transparency continued to function (think stock markets) and those without froze (think private label structured finance and interbank lending).
Of course, having their first assertion debunked, like the rest of the Opacity Protection Team, they fall back and offer yet another assertion “transparency doesn’t work because investors don’t have the ability to use the disclosure well”.
Let me debunk this assertion too (by the way, in Transparency Games, I debunk 60 different assertions I have heard from the Opacity Protection Team). For transparency to be effective, it doesn’t require that every investor be able to use it. It is the investors who can use the disclosed information well who drive the pricing of a security. They are buyers of a security when the price is too low and sellers when the price is too high.
If the regulatory ideologues haven’t gone quiet yet, like the rest of the Opacity Protection Team, they offer up increasing ridiculous assertions like “real life experience shows transparency solutions have not been very effective at producing desired outcomes”. Such as? Time for a new assertion. “There is a long list of market failures policymakers have tried to address using transparency and disclosure”.
By the way, I have to agree with this last assertion. There are market failures for which the combination of transparency and caveat emptor will not produce the desired outcome. That is why I said there is a critically important role for regulation. However, you need transparency in place first so then you can use regulations to address the remaining market failures.