In his speech, Hyun-Song Shin, the Head of Research for the BIS, asked “Why do we need financial regulation at all?”.

This is a great question because it leads directly to the related question “if we need financial regulation, what regulation do we need?”.

In Transparency Games, I answer both questions as follows:

• We need financial regulations because we learned in the Great Depression a financial system based solely on caveat emptor (buyer beware) is prone to financial crises.  Why is it prone to financial crises?  Because investors are prone to buying Wall Street’s stories and taking on more exposure than they can afford to lose in the absence of disclosure.  When there is no information to value a security or tell if a bank is viable, any rumor that suggests a security is valueless or a bank cannot repay its depositors can trigger a run.  After all, there is no information to show the rumor is false.  If the run spreads across enough securities/banks, there is a financial crisis.
• The regulation we need to stop rumor driven financial crises is disclosure.  Specifically, each bank/security must disclose all the information an expert would need to assess the bank/security so an investor could know what they own.  When investors know what they own, they are not affected by rumors.  This ends runs. When investors know what they own, they can limit their exposure to what they can afford to lose.  This ends contagion.  When investors know what they own, they can assess the risk of a bank/security.  This limits the susceptibility to Wall Street’s storytelling.

So what other financial regulations do we need?

I am a supporter of deposit insurance.  When the agency responsible for guaranteeing bank deposits is also the agency in charge of bank supervision and regulation, it reinforces market discipline.  Unsecured debt and equity investors know the agency will step in and wipeout their investment if the bank takes on so much risk it threatens the deposit insurance fund with losses.

Macro-prudential regulation and stress tests are examples of regulations that aren’t needed.  In both cases, they create moral hazard and reduce market discipline.  For example, the government’s saying a bank passed a stress test and could survive financial armageddon is the equivalent of saying “an investment in the bank is low risk”.  Once said, the government has created the moral obligation to bailout investors who it is reasonable to assume relied on the government’s saying the investment in the bank is low risk.