Institute for Financial Transparency

Shining a light on the opaque corners of finance


How Much Financial Regulation is Enough?

As we passed the tenth anniversary of the financial crisis, the discussion has turned to the appropriate level of regulation and supervision of the global financial system, big banks in particular.

In response to the financial crisis, a blizzard of new regulations, like higher capital requirement, were passed.  In addition, new responsibilities, like macro-prudential regulation, were handed out to the financial regulators.

Given these changes, it is only natural to ask whether or not the right mix has been achieved.

My answer is NO!  There is good reason to believe all these new regulations and new regulatory responsibilities actually make a crisis more rather than less likely to happen.  To understand why this is true, we need to look at the Information Matrix and where financial crises actually come from.

Information Matrix

                                      Does Seller Know What They Are Selling?
Does Buyer Know What They are Buying? Yes No
Yes Perfect Information Antique Dealer Problem
No Lemon Problem Blind Betting

Financial crises originate in the Blind Betting quadrant.  Securities sold in this quadrant are sold based on a story about their value rather than based on investors being able to do the fundamental risk/return assessment.  When the story comes to be called into doubt, there is no logical stopping point for the decline in their value other than zero.  Hence, owners of these securities have an incentive to “run” as soon as their is doubt and try to get their money back.

A classic example of a security in the Blind Betting quadrant are bank stocks and unsecured bonds.  Since banks do not disclose their current exposure details, there is no way for the market to assess the risk of any bank.  Hence, they are prone to runs.

With this background, we are now able to evaluate all the new regulations and regulatory responsibilities and see what their impact would be on preventing a financial crisis.

In her speechSabine Lautenschläger,  the Vice-Chair of the Supervisory Board of the European Central Bank , observed:

The crisis also shattered many beliefs about how the banking system works and how it should be regulated and supervised.

There was a time when many people believed that the market could bring about a stable and efficient banking sector on its own. They thought that market forces would ensure banks had sustainable business models that were resilient to the ups and downs of the economy. We now know that this did not turn out so well.

Why didn’t it turn out the way many believed?  Because banks are in the Blind Betting quadrant of the Information Matrix.  In this quadrant, there is no market discipline.  Market discipline only occurs in the Perfect Information quadrant where investors are able to assess changes in each bank’s risk profile and adjust their exposures accordingly.

She then went on to observe:

In fact, there are three pillars that support a stable banking sector: regulation, supervision and market discipline. The crisis made clear that all of these pillars were in need of some repairs.

So what was done to improve market discipline?

And this brings us to the third pillar of a stable banking sector: market discipline. With all this talk about rules and supervision, we must not forget that banks operate in a market economy. So why not use market forces to keep risks in check?

There is nothing like the prospect of failure and financial loss to keep a lid on risk-taking. And this, as a general rule, is the essence of market discipline. Investors who stand to lose their own money will be more cautious than investors who can offload losses onto someone else.

Agree.  So what has been done to promote market discipline by moving banks into the Perfect Information quadrant so investors can actually do the fundamental risk/return assessment?

But, as I said earlier, markets have not always exerted discipline. During the crisis, bank failures were rare. But why?

Well, first, there was a lack of tools to resolve failing banks – particularly across borders. And second, there were fears of contagion and a meltdown of the entire financial system.

So, in the end, governments often stepped in and propped up failing banks with public funds. There was no chance for the market to impose discipline.

This has changed. In Europe, we now have a single resolution mechanism for banks. It was designed to ensure that banks can fail in an orderly manner without damaging the financial system.

Nothing was done to improve market discipline.  What has changed is now Wall Street gets to tell the story about the potential value of the banks and substitute comments from bank supervisors for ratings.

The issue of fear of contagion and a meltdown of the entire financial system is still with us.  After all, investors don’t have the information necessary to actually value the banks.  So as soon as the story about bank valuations is called into doubt, runs begin.

As I have been saying since before the financial crisis began in 2007, what is needed to prevent a crisis is transparency.  There is no reason bank securities should not be in the Perfect Information quadrant.  All this requires is they disclose their current exposure details.