In the 1930s, policymakers faced a decision on how to prevent future financial crises and another Great Depression.  They could redesign the financial system so it was dependent on regulators or dependent on the combination of transparency and caveat emptor (buyer beware).  They chose transparency and the market discipline it makes possible when investors practice caveat emptor by limiting each of their exposures to what they can afford to lose.

Why did they make this choice?

They understood the problem with regulation is twofold.  First, you need to have regulations in place that would actually prevent a crisis.  This of course is an impossible task.  Wall Street has an incentive to innovate to get around the existing regulations.  So the next crisis is not likely to be like the last crisis.  Second, regulators would have to strenuously enforce these regulations at all times.  Of course, this too will never happen.  Ultimately regulators will succumb to pressure by politicians to ease off on enforcement.

In a recent interview, Paul Volcker provided further insight into why regulations are not a good substitute for transparency.  There is no better example of this than the Volcker Rule which prohibits banks from making proprietary bets.

It’s inherent in the process of regulation: Regulation tends to breed more regulation. I tell the story all the time: When I became chair of the Federal Reserve, when the non-bank market was not well developed, the banking market was very different. There was no interstate banking, no big banks by today’s standard.

The Federal Reserve was responsible for a regulation called Truth in Lending. It is a very simple concept. It says that banks must be honest when making a loan. They must explain what the interest rate is and how they calculate it, how frequently it is compounded, what happens when you don’t pay, and so forth and so on. Banks were always [complaining] when I was in New York, “Another damn regulation, unnecessarily complicated, for a simple idea.”

When I went to Washington, I told the staff, “I want a simple Truth in Lending regulation — I want no more than 100 pages.” Staff said, “We can’t do it.” And I said, “Go do it anyway.” Then they finally, reluctantly, came up with a 100-page regulation and put it out for comment. Who do you think all the comments were from? The bankers. “You didn’t take care of the particular way that we advertise or whatever and we want another provision in there.”

So, it grew beyond 100 pages because the banks themselves were proposing the regulation.

Now you get something like the Volcker Rule. The traders say, “I want real freedom. I don’t want to worry about what is a proprietary trade — my idea is making money for the bank and for me, regardless of communicated intent. It is too complex.” So they talk to the regulators, and the regulators try to make very detailed rules about what is and what isn’t [ . . . ] I think you can do it a lot more simply than that….

This is why regulation gets so detailed. As you get regulation, you try to find ways around it. And then you have more regulation.

Is it better to have simpler regulation?

No, because the bankers will exploit it if the regulator does not have the authority and confidence to enforce the rules ex post. You don’t have to get rid of every proprietary trade — you see it ex post. If you see a bank doing proprietary trading and it is no secret (you look closely enough), you tell them to stop.

What about when you see something wrong?

We didn’t mention the enormous lobbying weight put on regulation — millions and millions and millions of dollars going into political contributions. That influences the congressional attitude toward the regulators.

Mr. Volcker you are right, it can be much simpler than that.

As regular readers know, requiring banks to provide transparency and disclose their current exposures eliminates proprietary betting.  As JP Morgan’s London Whale episode demonstrated, traders know if their position is exposed, there are lots of other market participants who will trade against them.  As a result, traders won’t engage in proprietary betting as the potential for profit on the position is minimized and the potential for loss is maximized.

And one of the benefits of transparency is it acts as a counter balance to all the lobbying the banking industry does.  Specifically, the market exerts discipline on the bankers to reduce risk and on the regulators to enforce regulations.  The market does this regardless of how much is spent on lobbying.