Periodically, a reporter will try to highlight why a security is a risky investment and will undermine their analysis by suggesting transparency is somehow to blame.

A recent example of this is a post on Ratesetter.  The company is in the peer-to-peer (P2P) lending business.  This business is based on the notion of using transparency to link borrower and lender.

In the article’s lead, the reporter notes a potential benefit of lending occurring in transparent P2P lenders and not opaque banks is market participants can see and assess what is going on and hence prevent a financial crisis.  The reporter then concludes:

This line of reasoning has numerous failings.

So what could these failing be?  I had to wade through most of the article to find out.

After acknowledging the company’s disclosure actually lets you know what lending the company is doing, the reporter highlights a number of questionable disclosures involving the loans.  Here, the reporter acts just like a good investor. The reporter questions the disclosures made about the individual loans and questions just how risky these loans really are.  Let me say upfront, I think in asking these questions the reporter did an excellent job.

However, I was still left wondering what were the numerous failings of transparency.

It is at this point, the reporter provides two false claims about transparency.

Claim 1: Disclosure might not be in the best interest of the company.

How exactly does this level of disclosure hurt a lender?

From the perspective of a borrower, they compare multiple lenders and choose the lender who offers them the best terms.  So disclosure to investors has no impact here.

From the perspective of the lender’s competitors, they already know what terms the lender offered.  How do they know?  The borrower told them in an effort to play the lenders off against each other to get a better deal. So no impact here.

From the perspective of an investor in the lender, they have a choice between investing where they can know what they own or buying securities in a black box bank.  Finance theory is based on the notion investing where you can know what you own is less risky than blindly gambling and therefore the return required by investors is lower.  So big positive impact here for disclosure.

So what is the negative of loan level disclosure?  It subjects the lender to market discipline.  If investors see the lender making riskier loans, they demand a higher return on their money and reduce the amount of money they are willing to provide the lender.  This just happens to be the argument behind why transparency prevents financial crises.

Claim 2:  Disclosure doesn’t show if investors are being properly compensated for risk they are taking.

The focus of transparency is on making sure there is sufficient disclosure so an investor can know what they own and assess if they are being properly compensated for the risk they are taking.  It is up to the investor to use the disclosed data.  Either they or their trusted third party expert can use the disclosed data to make this assessment.

The reporter wraps up by making the point the benefits of disclosure are lost if the information being disclosed is inaccurate.  Agreed!

However, this isn’t a flaw in transparency, but rather a feature.  Investors understand the failure to generate accurate disclosures is a red flag suggesting there is more risk and hence the need for a higher rate of return. This market discipline provides plenty of incentive for the company to correct any inaccuracies and not to have any new ones in the future.