Financial regulators remind me of the drunk looking for his lost car keys under the street light because that is where the light is.  Despite the Great Financial Crisis being an earthquake along the global financial system’s opacity fault line, they continue to believe examining the transparent areas of the financial system will allow them to anticipate a crisis.

Using a physical model of two securities, it is easy to show this could not possibly be true.  One security uses a clear plastic bag to symbolize its transparency.  The other security uses a paper bag to symbolize its opacity.

No matter what story I tell about the transparent security, I am never able to convince anyone the value of its contents has changed significantly.  Why?  Because everyone has the ability to trust my story, but then verify if it is accurate or not.  Clearly, they can see it isn’t true.

On the other hand, my storytelling prowess allows me to convince most people the value of the paper bag security has changed significantly.  Why?  Because all they can do is trust the story I tell about the value of the paper bag security.  They cannot independently verify if the story is accurate or not.  As a result, they exhibit all the classic behaviors we associate with a financial crisis like a desire to “run” to get their money back.

Is there any reason to think acting like a drunk looking for their lost keys by examining the transparent areas of the global financial system, which are made up of the equivalent of thousands of clear plastic bag securities, provides any insight into when a financial crisis is likely to occur?

Clearly, the answer is no.

There is reason to think addressing the opaque sectors of the global financial system, which are made up of the equivalent of thousands of paper bag securities, by bringing transparency to these sectors would have an impact on financial crises.  It would directly reduce the chances of a financial crisis occurring.