Today the latest recipients of the Nobel prize in Economics were announced.  One winner, Bengt Holmstrom, wrote a January 2015 working paper for the BIS on understanding the role of debt in the financial system.

On Twitter, I offered up an assessment of the paper.  I called it garbage and asserted the author didn’t understand transparency, the role it plays in the financial markets and the paper alone should have disqualified him from consideration for the award.

Paul Romer, an NYU Professor and soon to be Chief Economist at the World Bank, suggested my critique was too harsh.  He suggested the paper makes a valid point.  Specifically,

Same as for medical insurance. Sometimes better not to have some types of information, e.g. on pre-existing conditions.

Let me debunk this notion as it pertains to financial markets (in Transparency Games, this is one of 60+ false claims pushed by the Opacity Protection Team I debunk in an appendix).

As regular readers know, in the 1930s FDR and his administration redesigned our financial markets.  Specifically, they based the financial markets on transparency combined with caveat emptor (buyer beware).

The elegant notion they introduced was not only should investors have access to the information they needed to assess each investment’s risk/reward tradeoff, but each investor should know they were responsible for any losses incurred on any investment they made.  By making investors responsible for any losses, it gave each investor the incentive to assess the disclosed information either by themselves or by having a trusted 3rd party assess the information for them.

Of course, investors don’t have to assess the disclosed information.  Instead, investors can blindly bet on a security.  However, the failure of an investor to assess a security’s risk/reward doesn’t end the investor’s responsibility for absorbing all losses that result from the investor’s exposure to the security.

The financial system FDR and his administration introduced doesn’t distinguish between investments like money market securities or bonds or stocks.  It doesn’t distinguish between an investment intended to be held overnight or for 30 years.  It doesn’t create a special category of securities sold to the public that are exempt from providing investors with access to the information needed to assess the securities’ risk/reward.

In this financial system, there are no safe assets.  Each investment has risk.  Some investments have more risk than others.  In this financial system, all investments require investors have access to the information needed to assess the risk/reward of the investment so they can know what they own because all investments come with the requirement investors take the losses on what they own.  By design, all investments are always information sensitive.

The financial system FDR and his administration introduced recognizes the amount of disclosure needed varies greatly between investments, that some investments are easier to assess than others and that some investors are better at assessing the disclosed information. For example, almost everyone can assess insured deposits at a bank. Insured deposits require minimal disclosure. The FDIC insurance logo, what is paid on the deposits and any fees suffices. In contrast, far fewer investors can assess bank stocks and unsecured bank debt.  This assessment requires a significant amount of disclosure. An investor has to know the bank’s current on and off-balance sheet exposures and how they are performing in order to assess the bank’s risk/reward.

While the financial system FDR and his administration introduced produces numerous benefits, let me focus on three of them:

1. It subjects issuers of securities to market discipline.  If their risk goes up, so too does the cost of their securities as investors reduce their exposure based on the changing risk/reward of the investment.
2. It eliminates the need for bailouts.  All investors, and this includes banks, know they are responsible for the losses on their investments.  As a result, they know they should limit their exposure to any investment to what they can afford to lose on that investment given its risk.
3. It allows those investors who are best at assessing the risk/reward of a security to effectively set the price range for the security.  This limits the misallocation of resources due to an individual security or a category of securities being mis-priced.

This is the system FDR and his administration put in place in response to the Great Depression.  But what system was in place before that?  It was a system based entirely on caveat emptor.  In this system, it was assumed buyers would force issuers to disclose all the needed information.  FDR and his administration learned from the Roaring 20’s and the Pecora Commission investigation into the subsequent financial market collapse this wasn’t true.  Hence, they introduced transparency and made it the responsibility of the government to ensure it was provided.

So back to explicitly debunking the notion sometimes it is better not to let investors have access to all the information they need to assess the risk/reward of a security.  By definition, when we don’t let investors have all the information they need, we are talking about an opaque security.

Is there any reason to think buying and selling opaque securities delivers the same three benefits listed above?  No.

How exactly are investors suppose to enforce market discipline on issuers to restrain risk taking if they don’t know what they are buying and cannot assess its risk?  They cannot.

Since they weren’t provided access to the information they needed to assess the risk of the investment, what prevents investors from taking on too much exposure?  Furthermore, why shouldn’t they look to the government/taxpayers to bail them out of the losses on their opaque security bets? As shown by the financial crisis, investors will take on too much exposure and want to be bailed out for losses on their bets on opaque securities.

Why should buyers and sellers properly allocate resources when they are engaged in blindly betting on securities where they can neither assess the risk or reward?  There is no reason this should result in the proper allocation of resources other than sheer luck.  We know the necessary condition for the Invisible Hand of the Market to operate properly is both buyer and seller have access to the information they need.  If this weren’t the necessary condition, we are left with the idea blindly gambling and informed decision making yield the same economic outcome.

Finally and perhaps most importantly, we relearned in the financial crisis that began on August 9, 2007 opacity is the necessary condition for a financial crisis.  Financial markets freeze/collapse where there are opaque securities. Look at which parts of the capital markets froze/collapsed during 2008/2009.  Each of them involved opaque securities (including mortgage-backed bonds and unsecured bank securities like inter-bank loans).  In the absence of information, once fear over the value of a security sets in, there is no logical stopping point in the decline of the security’s value other than zero.  Hence, prices collapse as investors race to get their money out (think bank runs on opaque banks).

Where the capital markets didn’t freeze during the peak of the panic in 2008/2009 there was transparency.  This wasn’t surprising as buyers could assess the risk/reward, i.e. value the securities, and sellers knew what they owned.

This is why our financial system was redesigned in the 1930s to be based on the combination of transparency and caveat emptor.