Finance and the risk of knowing too much

The Guardian ran an interesting column looking at the Bank of England's Andrew Haldane's call for simplicity in regulation of finance.

Mr. Haldane's call is timely because the UK is about to pass legislation for how to reform its financial system in the wake of the financial crisis that began on August 9, 2007.

Regular readers know that your humble blogger has been calling for simplicity.  Specifically, I have been calling for and Mr. Haldane's speech supports bringing transparency to all the opaque corners of the financial system.

There are two types of transparency:  valuation and price.  The important type of transparency is valuation transparency.  With valuation transparency, market participants have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess the risk of any investment.

Valuation transparency is radically different than Wall Street's preferred price transparency.  With price transparency, all that market participants know is either the last price a security traded at or the price that several Wall Street firms would sell the security to a buyer or the price they would buy the security from a seller.

Price transparency is worthless from an investor's viewpoint if the investor does not have the information the investor needs to value the security first.

It is only by independently valuing the security that investors can meaningfully interpret either the last price a security traded at or the price Wall Street is offering.  It is only with the independent valuation that investors know if the last buyer or seller was the bigger fool.

It is only with valuation transparency that financial markets remain liquid.  Just look at how interbank lending markets have frozen as a result of the lack of valuation transparency.

If Parliament really wanted to adopt Mr. Haldane's simplicity, it would pass legislation calling for valuation transparency.

Two obvious conclusions flow from this. 

The first is that financial economics is heading back towards the world as Keynes and Hayek knew it: where economic uncertainty was recognised as such, rather than mathematised and missold as controllable risks. 

Second, that regulators really ought to deal with bankers using a regime of brutal simplicity that errs of the side of caution. If a bank looks like it's borrowed too much, it probably has – no matter what the risk models say – and should be stopped.

The best way to stop a bank is by requiring banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, market participants can exert discipline on the banks to restrain their risk taking.

Mr Haldane's view makes far more sense than that described in the Basel agreements or Vickers commission: and in its simplicity, it is pleasingly radical.