The Irish Banking Inquiry is looking into the causes of and response to the Irish financial crisis.  In doing so, it is confirming many of the points made in Transparency Games.  One point that has been confirmed is relying on financial regulators to prevent a financial crisis is foolish.

Prior to the financial crisis, there were two basic ways countries regulated their financial institutions.  First was principles based regulation.  This was pursued by Ireland.  Second was rules based regulation.  This was pursued by Spain.  Both countries had a severe financial crisis.

In his testimony, Brian Cowen, the former head of the Department of Finance and then Ireland’s Taoiseach, focused on the misjudgment of risk as the driver of the financial crisis.  He observed:

I just don’t accept that principles based regulation was the reason we had a crash. Spain had rules based regulation and still had a crash.

The fact of the matter is the global financial system is not designed to be dependent on the financial regulators to prevent a financial crisis.

In the run-up to the Irish financial crisis, Mr. Cowen says the Irish regulators offloaded responsibility for preventing a financial crisis to the banks.  Pursuing principles based regulation:

imposes very heavy duty on the management and the boards and directors of financial institutions to make sure they are working within their framework and clearly they weren’t.

The fact of the matter is the global financial system is not designed to be dependent on bank management or the board of directors to prevent a financial crisis by operating within some broad framework.

The fact of the matter is the global financial system is designed to prevent a financial crisis using the combination of transparency and caveat emptor.  Knowing they are responsible for all losses on their investment exposures, investors have an incentive to use the information transparency makes available to assess the risk of each exposure and to exercise self discipline and restrict the size of their exposures to what the investor can afford to lose.

Included in the investors who are suppose to exercise self-discipline are the banks.  To insure the banks practice self-discipline, they are suppose to provide transparency so the investors in the banks can exert market discipline on the bankers to not take on excessive risk.

Of course, bankers did not practice self-discipline as the banks were not required to provide the transparency investors needed to assess their risk and exert market discipline.  The result was a global financial crisis.