Nowadays there is ample evidence that financial systems, whether in Asia in the 1990s or a decade later in the United States and Europe, are vulnerable to breakdowns. The cost in interrupted growth and unemployment has been intolerably large.
But, in the absence of international consensus on some key points, reform will be greatly weakened, if not aborted. The freedom of money, financial markets and people to move – and thus to escape regulation and taxation – might be an acceptable, even constructive, brake on excessive official intervention, but not if a deregulatory race to the bottom prevents adoption of needed ethical and prudential standards.
Perhaps most important is a coherent, consistent approach to dealing with the imminent failure of "systemically important" institutions. Taxpayers and governments alike are tired of bailing out creditors for fear of the destructive contagious effects of failure – even as bailouts encourage excessive risk-taking.Regular readers know that requiring financial institutions to provide ultra transparency is the only financial reform that can and needs to be adopted globally.
Requiring financial institutions to disclose on an on-going basis all of their current asset, liability and off-balance sheet exposure details is a regulation not prone to a race to the bottom.
Market participants will reward financial institutions that disclose and punish with higher cost of funds (including a lower earnings multiple on their stock price) those that do not. The assumption being those financial institutions that will not disclose must have something to hide.
In addition, ultra transparency is a regulation designed to prevent the failure of systemically important institutions as well as to eliminate concern over contagion if the institution does fail.
With ultra transparency, market participants can independently assess the risk of each bank and adjust the amount and price of their exposure accordingly. As the amount of risk at a bank increases, so will its cost of funds. This adjustment in a bank's cost of funds is market discipline which should restrain a bank from taking so much risk it fails.
However, there are some managements that are determined to fail. Fortunately, the contagion effects of this failure should be minimized in the presence of ultra transparency. In the same way that market participants adjust the price of their exposure based on their assessment of risk, as the bank gets riskier, market participants will cut back on the amount their exposure to what they can afford to lose.