The Case for Why Financial Regulators Must Give Up Their Information Monopoly - Updated

As this blog has discussed several times, see here, here, here and here for example, financial regulators are a major source of instability in the financial system.

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.

An Irish Times article on the Nyberg report highlights this systemic aspect,

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. 

“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.

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.

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.

As the Congressional Oversight Panel’s Special Report on Regulatory Reform (2009) states:

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.’

Why is disclosure important?

Because disclosure is what distinguishes investing from gambling.  Investing is buying the contents of a clear plastic bag after examining the contents and verifying there is something of value in the bag.  Gambling is buying the contents of a brown paper bag and hoping there is something of value in the bag.

Without disclosure of all the useful, relevant information on financial institutions, investors are gambling that the regulators are right when they say that there is something of value in the brown paper bag which represents a financial institution.

Why is this distinction important?

Because it supports a financial system where investors are responsible for bearing any losses that result from their investment activities without looking to the government for being bailed out.

Since investors bear the losses, they have an incentive to do their homework to avoid losses before investing on a buyer beware basis.  In order to do their homework, investors need the disclosure of all useful, relevant information in an appropriate, timely manner.

It is only with the ability to do their homework, that investors can adjust the pricing and amount of their exposure appropriately for the risk of the investment.

Currently, for financial institutions, the information required by investors to do their homework is not disclosed and regulators make representations as to their solvency.  Given these facts, it is not surprising and only fair that investors expect to be protected from losses if it turns out the financial institutions are insolvent.

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!

How does the market for an individual security (stock, bond, structured finance product) work if investors are not required to look at the information disclosed?

The fact that all investors are not required to look at the disclosed information does not mean that some investors will not look at the disclosed information.

It is the investors who look at the information who are likely to understand how to use it in the analytic and valuation models of their choice to independently value the security.  These investors are also likely to add liquidity and stability to the price of the security by being buyers when the price is below their valuation and sellers when the price is above their valuation.

In the absence of all the useful, relevant information itself, the investors who provide liquidity and stability to prices in the market are absent.  As a result, prices for securities make movements similar to what occurred for structured finance securities in 2008 - one day the price is par and the next it is 20% of par.  In the case of financial institutions, the interbank loan market freezes.

Deep, liquid markets require disclosure because it is the market participants who can analyze the information to independently value a security that create liquidity and stability in prices.

For purposes of full disclosure, your humble blogger was recognized in the main stream media well before the credit crisis began for identifying the problems with structured finance securities and advocating for providing loan-level disclosure on an observable event basis to solve these problems and minimize the cost of a crisis.

The bank/sell-side dominated lobby pushed back strongly against this type of disclosure.  One of their leading argument against providing loan-level disclosure on an observable event basis was that providing this much data would confuse investors.

Frankly, Joe Six-pack cannot analyze or value structured finance securities.  However, Joe Six-pack is not likely to buy these securities directly.  He is likely to invest through a mutual fund or hedge fund with a professional portfolio manager.  The portfolio manager can choose to use the loan-level disclosure to value structured finance securities or they can hire an independent pricing service that is capable of valuing the securities using loan-level disclosure.

Let me repeat that, Joe Six-pack cannot analyze or value structured finance securities.  Nor can he evaluate all the current asset and liability-level data at a financial institution.  So, he hires a professional portfolio manager.  That manager and his firm either have the ability to analyze and value the structured finance or financial institution securities using the asset and liability-level data or the firm hires an independent third party service to do so.

As Yves Smith points out on the NakedCapitalism blog, nobody was ever highly compensated on Wall Street for developing transparent, low margin products.

"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

The quote from Mrs. Warren appeared in an interview with the Chicago Tribune.  She was talking in reference to all the financial products offered to consumers.  These products exemplified Yves Smith's observation.

The fault lines along which the financial system fractured in the recent credit crisis match up exactly to the parts of the financial system, structured finance securities and financial institutions, characterized by a lack of disclosure of all the useful, relevant information in an appropriate, timely manner.

To paraphrase Ms. Warren, no one makes great decisions if the all the useful, relevant information is not available in an appropriate, timely manner.