Absent ultra transparency, China discovers disclosure system no guarantee of protection

Reuters ran an interesting article on how China is looking at how to improve legislation governing its developing disclosure-based securities regulatory framework.

The goal is to increase transparency and improve investor protection.

Regular readers know that disclosure-based financial systems are stable only if investors have access to all the useful, relevant information in an appropriate, timely manner so they can make fully informed investment decisions.

For all financial firms, all the useful, relevant information takes the form of ultra transparency.  Under ultra transparency, financial firms disclose on an ongoing basis their current asset, liability and off-balance sheet exposure details.

Market participants need these details in order to assess the risk of each financial firm.  Then, based on this risk assessment, market participants adjust their exposure to what they can afford to lose given the risk of the financial firm.

Regular readers know that the FDR Framework is the fundamental building block for the stable disclosure-based financial system that China is looking to build.

China’s bourse regulators and the nation’s IPO watchdog, the China Securities Regulatory Commission, have been busy brainstorming improvements to legislation governing the disclosure requirements of listed companies in the PRC. 

Aiming to bring increased transparency and other investor protection merits often associated with a disclosure-based securities regulatory framework, the CSRC is contemplating models from Hong Kong, the United States and other jurisdictions where listed companies are required to publicly disclose corporate and financial statements in a timely manner.

It is ironic that China is studying US disclosure requirements in light of the recently passed JOBS Act that repealed these requirements for firms with less than $1 billion in revenue.

Previously, since the 1930s, the US had been the model for disclosure-based capital markets.

Now, consistent with the financial regulators allowing banks to hide losses on and off their balance sheet as part of implementing the Japanese model for handling a bank solvency led financial crisis, the US is adopting the idea that capital markets work better when investors do not have access to the information they need to make a fully informed investment decision.

Recent fraud allegations involving U.S.-listed Chinese companies have highlighted shortcomings in a disclosure based system, particularly where securities regulators primarily rely on companies and their professional advisors to truthfully and accurately disclose information in filings. 

Although many of the accused companies appeared to comply with disclosure obligations, subsequent investigations produced allegations of material misstatements, omissions and even forgery of regulatory filings....

This is why your humble blogger has urged China to make its financial institutions the global model for disclosure by requiring them to provide ultra transparency.

Disclosing the data from which the financial statements are constructed materially reduces disclosure errors.

Disclosure alone, without regulatory authority to verify the authenticity of documents and hold listed companies responsible for violations of disclosure rules, may therefore be insufficient to protect investors. 

As the guardians of China’s capital markets move towards a disclosure-based system in securities regulation, they may well be looking to such enforcement gaps and considering efficient alternatives to protect investors when companies are accused of lying in disclosure documents.

By requiring disclosure of each financial institution's exposure details, China can instill market discipline in bank financial reporting while efficiently eliminating lying in disclosure documents.