In the aftermath of the acute phase of the Great Financial Crisis, the roles and responsibilities of the bank regulators were dramatically reshuffled and added to (see BIS report).  Did all of these changes make the global bank regulators fit for purpose?

No!  In fact, all of these changes have made the financial system more prone to a financial crisis.

That is a pretty damning statement.  Are there any facts to support it?

Yes!  The starting point for demonstrating why the statement is true is the Information Matrix.

Information Matrix

The Information Matrix was created by asking two related questions to determine if the buyer or seller is making a fully informed decision or is blindly betting.  When both buyer and seller are fully informed, the transaction takes place in the Perfect Information quadrant.  When there is an asymmetry where only the buyer or the seller is fully informed, the transaction takes place in the Information Asymmetry quadrants (Lemon Problem and Antique Dealer Problem).  When neither the buyer nor seller is fully informed, the transaction takes place in the Blind Betting quadrant.

If you were going to create a financial system, which quadrant of the Information Matrix would you want all the transactions to occur in?

If you are like most of the non-PhD economists I talk to, you would want the transactions to occur in the Perfect Information quadrant.  [I would like to say this is also true of PhD Economists, but there are too many articles to count in leading peer review Economic journals showing this is unlikely to be true of most PhD Economists.]

The non-PhD economists I talk to who don’t want the transactions to occur in the Perfect Information quadrant share one common trait:  they work for Wall Street.  All of them subscribe to what I refer to as the Goldman Sachs Theory of the Perfect Financial Market.  This is a market where investors are blindly betting on opaque securities based on a story Wall Street tells about the securities’ value.

There are a couple of problems with the Goldman Sachs Theory of the Perfect Financial Market.  First, there is no reason to think it properly allocates capital across the economy.      It appears to only benefit Wall Street and its desire to sell these high margin opaque securities.  Second, financial crises emerge from the opaque corners of the financial system.  They emerge when the story told by Wall Street about the value of these opaque securities is called into doubt.  Buyers know when this happens, there is no logical stopping point in the downward price spiral of these opaque securities other than zero.  Hence, they “run” to sell these securities and try to get as much of their money back as possible.

So what does this have to do with the question of are bank regulators fit for purpose?  None of the reshuffling or additions to bank regulators’ responsibilities address the opacity in global financial system.  Not only is opacity not addressed, but bank regulators were given the task of spotting financial crises before they emerge from the Blind Betting quadrant.

Why would anyone think bank regulators are capable of doing this?  The central bankers and bank regulators didn’t see the Great Financial Crisis coming.  Of course, they couldn’t see it coming as it emerged from the opaque corners of the global financial system.

Unless you get rid of these opaque corners, there is no reason to thing central bankers and bank regulators will do a better job of see a crisis coming.  They are like drunks looking for their dropped key under the street lamp because that is where the light is.

However, by giving the central bankers and bank regulators the responsibility for seeing a financial crisis coming, we now have governmental entities saying all is clear.  This is a really big problem.  It encourages risk taking (i.e., blind betting). And that makes the financial system more prone to crises.