In a 10,000 word papal encyclical on the global financial system, the Pope looks at who is doing God’s work.  He sides with those of us attempting to restore transparency and against Wall Street.

The Pope starts by calling for a “clear ethical foundation” for the global financial system.

Why is this ethical foundation necessary?

it is impossible to ignore the fact that the financial industry, because of its pervasiveness and its inevitable capacity to condition and, in a certain sense, to dominate the real economy today, is a place where selfishness and the abuse of power have an enormous potential to harm the community.

Bankers have shown they are capable of getting around the regulations that would force them to behave ethically.  When they engage in rigging the financial markets for their benefit, they cause great damage to the rest of us.

The global financial system is designed to enforce ethical behavior.  Transparency is the tool for achieving this.  As Justice Louis Brandeis observed:

Publicity is justly commended as a remedy for social and industrial diseases. Sunlight is said to be the best of disinfectants; electric light the most efficient policeman.”

The Pope goes on to observe Wall Street and the City have managed to make a mockery of the regulatory enforcement of transparency.

it must be noted that in the economic-financial world there are conditions in which some methods, though not directly unacceptable from an ethical point of view, still constitute instances of proximate immorality, that is, occasions that readily generate the kind of abuse and deception that can damage less advantaged counterparts. For instance, to commercialize certain financial instruments is in itself licit, but in a asymmetrical situation it would be possible to take advantage of a lack of knowledge or of the contractual weakness of either counterpart. In itself this amounts to a violation of due relational propriety, which is already a grave violation from an ethical point of view.

Regular readers will immediately recognize the Pope has just described as unethical Wall Street’s motivation to generate and sell securities in the Blind Betting quadrant of the Information Matrix.

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

The Information Matrix was created by asking two related questions to determine if the buyer or seller is making a fully informed decision.  When both buyer and seller are fully informed, transactions take place in the Perfect Information quadrant.  When only the buyer or the seller is fully informed, transactions take place in the Information Asymmetry quadrants (Lemon Problem and Antique Dealer Problem).  When neither is fully informed, transactions take place in the Blind Betting quadrant.

It is behind the veil of opacity that exists in the Blind Betting quadrant where the unethical behavior by bankers takes place.  For example, bankers rigged the price of money, also known as LIBOR, by submitting false estimates of their cost to raise unsecured funds.

The Pope then described the securities that occupy the Blind Betting quadrant.

The complexity of numerous financial products currently renders such asymmetry an inherent element of the system itself and puts the buyers in a position inferior to those who commercialize these products—a situation that from several aspects leads to the surmounting of the traditional principle of caveat emptor. This principle, on the basis of which the responsibility to assess the quality of the good acquired should rest above all with the buyer, in fact presupposes a parity in the capacity to safeguard the proper interests of the contractors. This actually does not exist in many cases both from the evident hierarchical relationship that comes to be established in certain types of contracts (for example, between the lender and the borrower) as well as in the complex structuring of numerous financial instruments.

Blind Betting quadrant securities put the investors in a position inferior to Wall Street.  The investors, whether buying or selling, cannot assess the quality of the investment because they lack access to the necessary information to do so.  Examples of this type of security include subprime mortgage-backed securities and related derivatives.

The global financial system is designed to force most transactions into the Perfect Information quadrant where transparency can assure ethical behavior.  Unfortunately, it  cannot force all transactions into the Perfect Information quadrant.

Wall Street knows this.  Wall Street also knows investors like a good story.  Wall Street also knows it makes a significantly higher profit selling and trading the opaque securities.  Wall Street combines these by creating complex financial products whose opacity means that are sold strictly based on a good story Wall Street tells.  These products all occupy the Blind Betting quadrant.

The Pope goes on to call for the Transparency Label Initiative.

Correspondingly, every time unreliable economic-financial instruments are introduced and diffused, they put the growth and the diffusion of the wealth into serious danger creating systemic problems and risks that amount to the “intoxication” of the organism.

We understand the demand, felt more and more today, that public authorities should provide a certification for every product generated by financial innovation, in order to preserve the health of the system and prevent negative collateral effects.

The Initiative puts a label, a form of certification, on securities where the buyer can know what they own.  These securities preserve the health of the financial system.  Investors can assess the risk of these securities and limit their exposure to what they can afford to lose.  The act of rebalancing their holdings in the face of changing risk results in market discipline and a healthy financial system.

Securities that don’t qualify for a label are blind bets.  The investor is trusting a Wall Street valuation story with no way of verifying its accuracy.  The Initiative recognizes investors like a good story and therefore opacity is a legitimate asset class.  Investors will allocate some of their portfolio to it.  However, the goal of the Initiative is to limit how much is allocated to these blind bets because they create systemic problems (think subprime mortgage backed deals and related derivatives).  What the lack of a label does is reminds investors they need to be sure they are being compensated for the risk of losing their entire investment.  Does it really make sense to invest in a good story when the upside return is 5% and the downside is a loss of 100%?

The Pope recognizes the regulators are not fit for purpose of enforcing transparency regulations.

Experience and evidence over the last decades has demonstrated, on the one hand, how naive is the belief in a presumed self-sufficiency of the markets, independent of any ethics, and on the other hand, the compelling necessity of an appropriate regulation that at the same time unites the freedom and protection of every person and operates to create healthy and proper interactions, especially with regards to the more vulnerable. In this sense, political and economic-financial powers must remain distant and autonomous and at the same time directed, beyond all proximate harms, towards the realization of a good that is basically common, and not reserved only for a few privileged persons.

As regular readers know, Wall Street has captured the process by which disclosure requirements are set.  It was this capture that allowed Wall Street to sell securities like the opaque subprime mortgage backed deals and related derivatives.

The Pope understands something is needed beyond just national regulators.

Such regulation is made even more necessary in view of the fact that among the major reasons for the most recent economic crisis was the immoral behavior of agents in the financial world, where the supranational dimension of the economic system  makes it easy to bypass the regulations established by individual countries. Moreover, the extreme volatility and mobility of capital investments in the financial world permit those who control them to operate smoothly beyond every norm that does not aim at an immediate profit, often blackmailing by a position of strength even legitimate political authority.

The Transparency Label Initiative was established to provide a supranational response to force disclosure so investors could know what they own or are thinking of buying.  Since investors exist around the world, the Initiative looks at securities issued around the world to see whether or not they qualify for a label.

For example, the global Too Big to Fail banks do not qualify for a label.  As the Pope accurately points out, these banks were able to blackmail the political authority into giving them a bailout.  If they provided the disclosure necessary to merit a label, they would lose this leverage.  Investors could know what they own and adjust their exposure to the risks these banks were taking.  The result would be market discipline on the banks and an end to the need to ever bail them out again.

Or as the Pope said,

The regulations must favor a complete transparency regarding whatever is traded in order to eliminate every form of injustice and inequality, thus assuring the greatest possible equity in the exchange. Likewise, the asymmetrical concentration of information and power tends to strengthen the more stronger economic agents and thus to create hegemonies capable of unilaterally influencing not only the markets, but also political and regulatory systems. Moreover, where massive deregulation is practiced, the evident result is a regulatory and institutional vacuum that creates space not only for moral risk and embezzlement, but also for the rise of the irrational exuberance of the markets, followed first by speculative bubbles, and then by sudden, destructive collapse, and systemic crises.

In summary,

A healthy financial system also requires the maximum amount of information possible, so that every agent can protect his or her interests in full, and with complete freedom. It is in fact important to know if one’s capital is used for speculative purposes, and also to know the degree of risk and the adequate price of the financial products to which one subscribes. Much more than the usual savings of the familiar type, it is a public good to protect and search for an adverse optimization of risk.

I couldn’t have said it better myself and I have been saying this since well before the acute phase of the Great Financial Crisis a decade ago.