In the 1930s, policymakers had to make a choice.  They could redesign the financial system so it was dependent on transparency or make it dependent on 1000s of regulation and their enforcement.  Policymakers chose transparency.

Why?

Because policymakers understood the combination of transparency with caveat emptor (buyer beware) subjects all firms to market discipline at all times.  Market discipline is the result of  investors using the disclosed information to assess the risk of an investment and then continually adjusting their exposure to the investment to what they can afford to lose given the assessed risk.

Transparency also prevents financial crises.  When investors know what they own, they don’t panic. [A point I have illustrated numerous times using the Information Matrix.]

Policymakers also understood relying on regulations and their enforcement doesn’t work.  Regulations and the degree to which they are enforced vary over time.  Regulations that might prevent a financial crisis if they were strictly enforced are rendered meaningless when not strictly enforced.

A speech by Sabine Lautenschläger, Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB illustrates the flaw in relying on regulations and the assumption they will always be strictly enforced.

So, the key question is: how can we prevent such crises in the future? To answer that question, we need an intimate knowledge of the things that led to the crisis in the first place…. The short version is that risks were too high, rules were too soft, and supervision was too lax. Ten years on, this has changed – or has it? Are banks now better regulated and supervised? Are risks under control?

The necessary condition for the Great Financial Crisis was opacity across large sectors of the global financial system.  Opacity hid the risks investors, including banks, were taking on.

Ten years later, the issue of restoring transparency across the global financial system has still not been addressed.  Banks are still opaque.  There are still large opaque sectors like derivatives in the global financial system.  So from the perspective of has anything changed in removing the necessary condition for a financial crisis, the answer is no.

But what about rules and supervision of the opaque banks?

We seem to be seeing an old story unfolding before our eyes. In times of crisis, everyone agrees that tougher rules are needed. But as soon as things start to get better, rules are suddenly seen as preventing banks from doing good business and the economy from growing.

Consequently, rules are softened, banks are “freed”, the economy grows, and the seeds for the next crisis are sown – because such growth cannot be sustained in the long run. Sustainable growth needs to be financed by stable banks that price risks correctly and cover them with adequate capital. It’s a simple lesson, but it seems to be quite a hard one to learn.

Failing to implement the rules is a clear risk. But given the global scale of the banking sector, another risk is that the rules will be implemented unevenly. This would enable banks to go wherever the rules are softest. In the worst case, some countries might try to turn this into a business model. But let me assure you: light-touch regulation is not a viable business model. We have seen it before, and we know what comes next….

We need to fight the misguided attempt to sacrifice global stability in order to make national banking sectors more competitive. The risks involved outweigh the returns. And what’s more, those who reap the returns are often not those who bear the risks.

Clearly there is a problem even agreeing on the rules to implement.

rules are important and they need to be implemented. But rules alone are not enough. You also need people to check whether banks are following the rules. You need supervisors…. Dealing with a global banking sector that is constantly evolving requires supervisors who know when it’s time to act, who are willing to act and who are able to act. From this, everything else follows.

Is there any reason to think bank supervisors will or are even capable of doing this?  They certainly didn’t demonstrate they had this ability in the run-up to the Great Financial Crisis.

What has changed so the idea of a bank supervisor standing up to the CEO of any of the global Too Big to Fail banks is no longer laughable on its face?

Nothing!

We have literally 100s of new regulations, but the politics of bank supervision remain the same.  How do you convince a political appointee or a politician they should support a bank supervisor who is standing up to one of these CEOs when everything appears to be going well?

You can not [this was extensively documented in the Nyberg Report on the Irish Financial Crisis].

One of the benefits of transparency is the market doesn’t have a problem standing up to a CEO of a Too Big to Fail bank.  The market lets the CEO know in terms the CEO can understand.  Specifically, his firm’s share price falls and its cost of funding increases.