During the run-up to our recent financial crisis, deregulation was in vogue.  However, since the crisis began, our global financial regulators have been hard at work reversing deregulation by creating literally dozens of new complex regulations.

Was the pre-crisis deregulation a good idea?  Is the post-crisis creation of complex regulations a good idea?  The starting point for answering these questions is a third question.

Was the financial crisis the result of too few regulations or was the financial crisis the result of inadequate enforcement of the existing regulations?

If the crisis was the result of too few regulations, then creating new regulations or re-instating repealed regulations is an appropriate response.  If the crisis was the result of inadequate enforcement of existing regulations, then more regulations is not necessarily an appropriate response.

In Transparency Games, I used the investigations conducted by different countries into the causes of the global financial crisis to show the crisis was the result of a lack of enforcement of existing disclosure regulations and not the result of too few regulations.  This is a very important point and needs to be repeated.

The global financial crisis occurred because the financial regulators failed to enforce disclosure regulations and let opacity creep in to large segments of the financial system.

Let me provide one example of the failure to enforce existing disclosure regulations:  Too Big to Fail banks.  The lack of disclosure made and still makes these banks, in the words of the Bank of England’s Andy Haldane, “black boxes”.  This opacity prevented the banks from being subject to market discipline and the related restraint market discipline would have placed on the banks’ risk-taking.  Without market discipline restraining their risk-taking, the banks grew to a size where the fear of contagion meant they would always receive a taxpayer bailout.

Of course, this investigation into the cause of the financial crisis is the last result the global financial regulators would want to see.  It points out the responsibility regulators have for the financial crisis and the fact regulators are prone to failure when it comes to enforcing regulations.

Instead, regulators have created a series of myths about the financial crisis and their response. In her speech on regulation, Ms Sabine Lautenschläger, Member of the Executive Board of the European Central Bank and Vice-Chair of the Supervisory Board of the Single Supervisory Mechanism, offers up several of these myths.

At the global, European and national level, we have tackled almost everything that can limit, reduce or prevent risks to and risks caused by banks.

Myth 1: Regulators are capable of preventing another systemic financial crisis.  It simply isn’t true.  Evidence of this fact is the failure of the bank regulators to prevent the banks from failing at the beginning of the financial crisis.

The general public, politicians, academics, supervisors and even bankers – simply everyone – called for comprehensive and tough rules for banks and for their close supervision….

Myth 2:  Everyone was calling for comprehensive and tough rules for banks.  That is simply not true.  Most of her list consists of the members of Wall Street’s Opacity Protection Team (politicians, academics, supervisors and bankers).  Notably absent from her list were investors.  investors wanted transparency so they could assess the risk of each bank and adjust their exposure accordingly.

At the moment in Europe, we are a long way off from self-regulation. And I hope that it will stay like this, even if people like to quickly forget bad memories.  I do not believe in self-regulation, at least not in financial markets.

Myth 3: The financial crisis showed that self-regulation doesn’t work.  What the financial crisis showed is in the absence of transparency and the resulting market discipline on bankers self-regulation doesn’t work.  The financial crisis also showed in the absence of transparency and the resulting market discipline on financial regulators to enforce regulations, regulations alone don’t work either.

You cannot have stable and functional banks without comprehensive regulation and energetic supervision. A sustainably stable banking sector demands a set of regulations which can keep up with the innovativeness of the financial sector and progress in banking, but which sets adequate limits in order to uncover and correct abnormal trends and excessive risks in their business activities. To this end, the rules have to be adaptable and both leave room for discretion and provide leeway for a clever supervisor with good judgement skills.

Myth 4: Financial regulators can do a better job of restraining bank risk taking than the entire financial market, including the financial regulators.  This myth is self-evidently false.  There is simply no reason to think in the presence of transparency the financial regulators are better than the market at assessing the risk of individuals banks or all of the banks.  More importantly, based on the failure of the regulators to restrain bank risk-taking in the run-up to the financial crisis, there is no reason to believe in the presence of transparency the regulators are better at exerting discipline on and restraining risk-taking by the banks than the market.

Myth 5:  Financial regulators are capable of correcting abnormal trends in bank business activities.  This myth is being exposed by the regulators requiring the banks to hold more liquidity in the form of government securities at the same time central banks are artificially suppressing the yield on these securities.  If and when interest rates increase, the banks will suffer massive mark to market losses.  Oops.

Please do not get the idea I am against both regulation and regulatory supervision.  I happen to think there is a role for both regulation and regulatory supervision.  Unlike the regulators, I think this role is the suspenders in a “belt and suspenders” solution for restraining bank risk-taking.  The primary means for restraining bank risk-taking and the belt in the solution is market discipline made possible by transparency.

Regulators have an important role in making sure investors exert market discipline.  Their role is resolving banks when they fail.  When investors think they will be held responsible should a bank fail, they have a strong incentive to exert discipline.