The idea regulations and regulatory enforcement will prevent the next financial crisis is a joke.  It completely ignores the fact Wall Street’s core competency is innovating around existing regulations.

I first encountered this competency while working at the Fed in the early 1980s.  At the time, I put together a comprehensive list of financial innovations and their potential impact on both monetary policy and bank supervision.  The Fed’s economists informed me I was wasting my time as these innovations wouldn’t impact monetary policy.  In 2008, these very innovations were at the heart of the financial crisis.  I guess they had an impact on monetary policy after all.

Wall Street’s ability to innovate was recognized in the 1930s.  Policymakers realized it would be impossible to ensure the stability of the financial system by means of regulation.  Simply put, Wall Street can innovate faster than Congress and the agencies overseeing the financial system can put in place regulations.

Worse, Congress understood even if it somehow got ahead of Wall Street’s ability to innovate, Wall Street would push for deregulation.

So the question was how to deal with the fact Wall Street always wins when it comes to financial regulations?

Their answer was to build the financial system around transparency and the principle of caveat emptor (buyer beware).  By making investors responsible for all losses on their investments, policymakers gave investors an incentive to use the information disclosed to assess the risk of an investment and limit their exposure to what they could afford to lose.

The reason policymakers chose transparency is it, and it alone, can keep pace with Wall Street’s innovations.  For example, each time Wall Street creates a new security the question of what information do investors need to know what they own if they buy this security comes up.  Ensuring this information is available means transparency keeps up with Wall Street’s innovations.

In the 1930s, policymakers believed the SEC could ensure disclosure of the information investors needed to know what they own.

In the 1980s, this was undone by the Reagan Administration and its push to have the SEC recognize Wall Street as its client.  From there, it took a couple of decades for Wall Street to capture the process by which the SEC sets disclosure requirements.

The result of Wall Street’s capture of this process was the Great Financial Crisis.  The crisis was an earthquake along the opacity fault line in the global financial system.

The response to the Great Financial Crisis wasn’t a restoration of transparency to all the opaque corners of the global financial system.  Rather, it was a blizzard of new regulations (in the US, see the Dodd/Frank Act).  Regulations the Trump Administration is now in the process of rolling back/gutting.

Of course, Wall Street is still innovating.

The Transparency Label Initiative was started to permanently break Wall Street’s grip on the disclosure process and ensure investors have the information they need to know what they own even for Wall Street’s latest innovations.  The presence of a label says investors have the necessary information.  The absence of a label says the security is opaque and investors should be looking for a high rate of return to compensate them for making a blind bet.