The reason why financial regulators are a major source of instability is they have a monopoly on all the useful, relevant current asset and liability-level information for the regulated financial institutions and when they do not use this data properly the result is a systemic financial crisis.
One potential reason regulators do not use this data properly is that regulators do not know what to do with the data. As Andy Haldane, a senior Bank of England (BoE) official, observed in a Wall Street Journal article
[T]he FSA's practice of dispatching dozens of examiners to banks to collect loads of granular information ... rarely yield much useful information for regulators, who can find themselves overwhelmed by the quantity of data.A second potential reason for regulators not using this data properly is even if some individuals working for the regulators do know how to use the data, their analysis fails to convince their bosses.
As shown by the Nyberg Report on the systemic causes of the Irish banking crisis, individuals working for the regulators are forced to convince a bureaucracy that is naturally biased towards believing the financial institutions that everything is okay.
Regardless of which reason is correct, the failure to draw the right conclusions from the data generates instability in the financial system. It is one thing if the regulators misjudge the solvency of a single financial institution. It is entirely another thing when regulators misjudge the solvency of every financial institution. The latter results in a systemic financial crisis.
Mr Nyberg said the absence of sufficient information on the underlying quality of loan books at the banks impacted on the options considered by the Government when it decided to introduce the bank guarantee in 2008.
In short, without accurate information, the regulators managed to blow up the Irish financial system. This includes both the banking system and the sovereign credit worthiness.“If accurate information on banks’ exposures had been available at the time it seems quite likely to the commission that a more limited guarantee combined with a state take-over of at least one bank might have been more seriously contemplated,” his report said.
The experience of the Irish regulators is not unique. For example, the US regulators misjudged solvency with regards to the Less Developed Country Loans Crisis, the Savings and Loan Crisis and the recent credit crisis.
That regulators have a monopoly on all the useful, relevant information for financial institutions is an exception to the way the global financial system works.
From the time they were introduced at the federal level in the early 1930s, disclosure and reporting requirements have constituted a defining feature of American securities regulation (and of American/global financial regulation more generally).
President Franklin Roosevelt himself explained in April 1933 that although the federal government should never be seen as endorsing or promoting a private security, there was ―’an obligation upon us to insist that every issue of new securities to be sold in interstate commerce be accompanied by full publicity and information and that no essentially important element attending the issue shall be concealed from the buying public.’
Our modern financial system is built on the FDR Framework which combines a philosophy of disclosure and the principle of caveat emptor [buyer beware]. Without disclosure, the system does not work.
As designed in the 1930s, disclosure under the FDR Framework was based on the idea of providing the investor with access to all the useful, relevant information they needed at the time of their investment to make a fully informed investment decision. Of equal importance, no burden was placed on an investor to use this disclosure!
"Disclosure has come to be a dirty word. Disclosure has become like shrubbery, a dense thicket of words that are a good place to hide tricks and traps. Clarity is about emphasizing the key pieces of information that someone needs to know... I have great faith in the capacity of people to make good financial decisions — when they have good information. No one makes great decisions — consumers or businesses — if the relevant information is hidden from view" Elizabeth Warren