Since it was created as part of the 2010 Dodd-Frank Act, the Office of Financial Research has shown why it shouldn’t exist and why the global financial system would be safer without it.
OFR doesn’t work in theory, let alone in the real world.
As I described in Transparency Games, OFR was unleashed upon us by those members of the Economics profession who failed to see the Great Financial Crisis coming. Backed by half a dozen Nobel Prize winning Economists, the supporters of OFR claimed it would operate like the National Weather Service and warn us of impending storms in the global financial system.
That sounds really good. Except there is one enormous problem with this claim. It is untrue because it doesn’t acknowledge where financial crises actually materialize in the global financial system.
Regular readers are familiar with the 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|
These readers know financial crises arise in the Blind Betting quadrant of the matrix. It is in this quadrant that securities are valued based on stories told by Wall Street. When the stories fall apart, the absence of transparency means there is no logical stopping point in the decline in the value of these securities. Hence, investors have an incentive to sell these securities as soon as they recognize the valuation story is coming undone. It is this race to sell that is the financial crisis panic financial regulators see.
Opacity is the necessary condition for a financial crisis. Opacity also prevents the OFR from providing a useful warning about a potential crisis. After all, if you cannot see the build-up of risk, how can you possibly be expected to credibly warn about it?
Please note, if the financial system provided the transparency necessary so the OFR could operate like the Weather Service then there would be no need for the OFR.
Investors know they are responsible for all losses on their investments. Hence, they have an incentive to limit their exposures to any security to what they can afford to lose. The Transparency Label Initiative turns opacity into an asset class. This helps investors limit their exposure. They know buying opaque securities is blindly betting and they are likely to lose 100% of their investment. With investors limiting their exposure to what they can afford to lose on both transparent and opaque securities, financial crises are eliminated. So what is there for OFR to warn about?
Since its creation, the GOP has been looking to get rid of the OFR. The Financial Choice Act that passed the House of Representatives specifically repeals the authorizing legislation that grants it independence from the Treasury. The Mnuchin led Treasury has suggested reducing its staffing by almost 40%. A small step in the right direction. More could and should be done now that the first Director of the OFR has announced his retirement.