As journalists and columnists continue to churn out articles on the tenth anniversary of Lehman Brothers’ collapse, it is worth pointing out the financial crisis highlighted the need to answer the question “what kind of financial system do we want”.

The answer provided by the Committee to Save the Banks is the financial system that existed before Lehman’s collapse.

The answer provided by Economists and financial regulators was the pre-crisis financial system, but with a lot more regulations and that mythical cure-all higher bank capital requirements.

Interestingly, neither of these is the financial system suggested by 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

If you or I were designing a financial system, the quadrant of the Information Matrix we would like all transactions to occur in is the Perfect Information quadrant.

Why?

It makes explicit in exchange for the information investors, and this includes banks, need to know what they own, investors are responsible for all losses on their investment exposures.  Knowing they are responsible for losses, investors know to limit their risk to what they can afford to lose.

Limiting their exposure based on the risk of the investment produces several unique benefits.

It is the source of market discipline.  Investors reducing their exposure as the risk of an investment increases produces downward pressure on the value of the investment.  This sends a clear message to reduce risk.

It ends financial contagion.  There isn’t any spill over to other investors when each investor limits their exposure to what they can afford to lose.

It caps the size of financial institutions so they are not Too Big to Fail.  There is a maximum size a bank can reach before it is too large for even the experts armed with modern information technology to be able to assess its risk.  As a bank approaches this size, market discipline in the form of higher cost of funding kicks in (investors recognize they need much greater compensation to blindly bet on opaque securities).  Faced with a decrease in its profits and stock price from further growth, bank management has an incentive not to grow further.

It prevents financial crises.  Financial crises require opacity.  Opacity prevents investors from being able to answer the simple question “does the investment have any value”.  When investors realize they cannot answer this question because they do not have the necessary information, they try to get their money back.  Hence, the panic associated with crises.  By ensuring investors have access to this information, crises are averted.

It allows the financial system to evolve over time to meet the changing needs of the real economy.

It frees the financial system from dependence on the regulators.  Regulators still have a job to do, but it is one they are fit for purpose for (as oppose to preventing a financial crisis they cannot see coming because it originates in the Blind Betting quadrant securities).

Finally, there is no reason to think information asymmetry or blind betting optimally allocates resources or contributes to financial stability.  This eliminates the other three quadrants of the Matrix.

Of course, we aren’t the only ones who wanted this type of financial system.  This was the type of financial system the policymakers in the 1930s wanted.  The fatal flaw in their redesign of the financial system was creating the SEC and making it responsible for disclosure.  It took several decades, but Wall Street eventually captured the process by which disclosure requirements are set.  The result was opacity and the financial crisis.

What FDR’s administration should have done is set up an investor funded Initiative to enforce adequate disclosure.  The Transparency Label Initiative was set up to fill this void.  It uses labels to signal to investors whether or not an investment provides the disclosure the investor needs to know what they own.

Investors can use the labels to limit their exposure to opaque securities.  As investors do this, it puts pressure on issuers to provide the necessary disclosure to qualify for a label.