You cannot win the battle for financial stability until you know what causes financial instability (aka financial crises).

But not knowing hasn’t stopped a parade of former policymakers, Economists and financial columnists from using the tenth anniversary of the collapse of Lehman Brothers to pronounce the financial system safer and less prone to a crash.

As evidence the financial system is safer, many of them cite the increase in bank capital levels since Lehman’s collapse.  Hmmm….  According to the Bank of England’s Andy Haldane, bank capital levels were dramatically higher still in the 1920s (see Chart 13: Long-run UK and US Leverage Ratios).  That didn’t prevent the Great Depression.  Nor did even higher capital levels prevent the Panic of 1907 or the financial crises in the 1800s.

It is pretty clear there is no link between bank capital levels and a safer financial system.  But if bank capital isn’t the key to financial stability and a safer financial system what is?

Transparency.

There is a reason why the policymakers who lived through the Great Depression redesigned the financial system so it was based on the combination of transparency and caveat emptor (buyer beware).

Let me use the Information Matrix to demonstrate this reason.

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

People like a good story.  This is true whether the investment Wall Street is telling them the story about is in the Perfect Information quadrant or in the Blind Betting quadrant.

The key difference between investments in the two quadrants is in the Perfect Information quadrant investors can Trust, but Verify Wall Street’s story.  In the Blind Betting quadrant, opacity (the absence of the necessary information) prevents investors from being able to verify Wall Street’s story.

Whether the story can be verified or not results in a vastly different response when Wall Street’s story is called into doubt.  In the Perfect Information quadrant, the story can be verified and the doubt dismissed.  In the Blind Betting quadrant, the story cannot be verified.  Not only is the doubt not dismissed, but the logical follow-up question arises:  is the investment worth anything?  This too cannot be verified.  Investors recognize this and, as behavioral economics suggests, naturally panic.  The result is a classic financial panic as investors “run” to get their money back.

The policymakers in the 1930s recognized forcing the financial system into the Perfect Information quadrant was the key to financial stability.

Unfortunately, Wall Street managed to capture the process by which financial disclosure requirements was set.  Gillian Tett described the result.

Just like the Information Matrix predicts.

So what have policymakers done since 2008 to restore transparency across the global financial system?

Absolutely nothing.

Instead, lead by the Committee to Save the Banks, policymakers have come to believe in trade-offs where none exist.

The basic thought was that we won the battle for financial stability and lost the hearts and minds of people. Tim argued powerfully, and I think correctly, for the proposition that you could promote confidence [in the financial system] or you could promote vengeance, but it was going to be pretty hard to promote confidence by promoting vengeance.

There is no reason policymakers cannot promote transparency and send bankers to jail for misbehaving.

Instead of policymakers restoring transparency.  It has been left to the only new entrant in the battle for financial stability: the investor funded Transparency Label Initiative.