Late last week, the Pope cited the need for ethical behavior in finance.  To achieve this, he called for restoring transparency across the global financial system and a method for certifying financial products that provide transparency.

Regular readers know providing this certification is exactly what the Transparency Label Initiative does.  It uses a label to distinguish between where the buyer could know what they own and where bankers can misbehave behind a veil of opacity.

The Initiative is funded by investors.  As a result, it has no conflicts of interest.  Also, unlike the SEC’s process for setting disclosure requirements, the Initiative’s process for awarding a label isn’t subject to capture by Wall Street.

While I heartily welcome the Pope’s endorsement of what the Transparency Label Initiative is doing, I was surprised to hear from so many “why is this a big deal?  After all, transparency is a necessary, but not sufficient condition.”

Hmmm…..

The following is a short list of where transparency is both necessary and sufficient:

Restores Ethical Behavior

Judge Louis Brandeis made the case for why a financial system requires transparency in Chapter 5 of Other People’s Money.  Here he 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.

Shorter: bankers and financial advisors behave ethically when their actions can be seen by everyone and they will be called out for behaving unethically.

Ends the Too Big to Fail Banks

Investors know that in exchange for disclosure so they can know what they own they will be held responsible for all losses.  In the case of the Too Big to Fail banks, this disclosure isn’t made.  As a result, investors expect to be bailed out.  This expectation was reinforced with the 2008/2009 bailout of the Too Big to Fail banks.

The only way to end this expectation, is for the Too Big to Fail banks to provide the necessary disclosure.  Of course, the banks are reluctant to do this as it ends their ability to privatize the gains and socialize their losses.  The regulators are also reluctant to do this as investors are likely to rapidly cut back their exposures to these banks when they realize just how much risk these banks are taking.  This rapid withdrawal of funding has the potential to trigger the next phase of the Great Financial Crisis.

Enforces the Volcker Rule

The Volcker Rule says financial institutions with access to deposit insurance should not take proprietary bets.  If these financial institutions had to disclose their current exposure details at the end of each business day, they would not make proprietary bets.

Why?

Because everyone could see if they are taking proprietary bets and there are plenty of traders who would be happy to minimize the profitability of these bets when they occur.  The best way to think of this is you are playing poker.  All of your cards are face up while everyone else’s cards are known only to themselves.  When you have a good hand, everyone drops out.  When they can beat your hand, they stay in and raise the stakes. You expect to lose money playing poker this way.  The same principle applies to financial institutions’ proprietary bets if they have to disclose.

Predicts, Prevents and Responds to Financial Crises

In the run up to the Great Financial Crisis, the macroeconomics profession failed to see the crisis coming.  The Queen of England asked why.  The profession blamed it on the failure of imagination of a bunch of bright people.

Of course, the reality was the economics profession doesn’t understand the role of transparency in the global financial system.  Its seminal article on bank runs suggests there are multiple causes of bank runs including sunspots.  The fact sunspots could not be ruled out suggests there is an X factor that explains bank runs and financial crises the authors didn’t spend the time to identify.

And what is the X factor?  Transparency.  This can be easily shown using the physical model of a transparent security (using a clear plastic bag) and an opaque security (using a brown paper bag).  The story you tell about the value of the contents of the clear plastic bag can be Trusted and Verified.  The story you tell about the value of the contents of the brown paper bag can only be Trusted.  When the story is called into doubt, there is no logical stopping point in the downward valuation of the contents of the brown paper bag other than zero.  Investors know this.  They run to get their money back when the story associated with the opaque security is called into doubt.

Knowing this, we can predict when a financial crisis is likely to occur.  There is a significant amount of opaque investments.  We can also prevent financial crises. Bring transparency to the opaque corners of the global financial system.  Finally, we can respond to financial crises by making sure the losses embedded inside the opaque securities are realized (think Sweden and Iceland that forced their opaque banks to write down the value of their loans to what borrowers could afford to repay).

Given this short list, you can see why the Pope and I think restoring transparency across the financial system must be done as soon as possible.

I wonder what is on the transparency is necessary, but not sufficient list that is so important there is a need to not support and even put down those of us who call for transparency.