How to stop the next financial crisis

In his column in the Atlantic, Glenn Hubbard examines what your humble blogger refers to as technocratic financial regulation and finds that it is insufficient to prevent the next financial crisis.  He then calls for bringing in the big gun.

In Mr. Hubbard's case, the big gun is the Fed.  In your humble blogger's case, the big gun is the market.

Which is more likely to prevent the next financial crisis?

The Fed which failed to prevent the current financial crisis and is pursuing a policy of re-inflating the real estate and stock market bubbles or the market which because of opacity was unable to exert discipline in the run-up to our current financial crisis?

I agree with Mr. Hubbard's assessment of why technocratic financial regulation will not prevent the next financial crisis.  I also agree with his calling for an end to small fixes and bringing in the big gun.

What is needed is transparency into all the opaque corners of the financial system, including banks and structured finance, so market participants can once again exert restraint on risk taking and bad behavior.

As regular readers know, our financial system is based on the FDR Framework.  It combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all useful, relevant information is accessible in an appropriate, timely manner.  Market participants are responsible for all losses on their exposures so they have an incentive to use the information disclosed.

Market participants use this information to independently assess the risk and value each of their exposures.  Based on the assessment of risk, market participants then limit their exposure to what they can afford to lose (the basis for market discipline).

Our current financial crisis showed that the FDR Framework works.  Markets, like the equity markets, where there was and still is transparency continued functioning.  It was the markets, like the interbank lending market, where there is opacity that froze and effectively still remain frozen.

Our current crisis is the direct result of the government's failure in its responsibility to ensure transparency.  As a result, we ended up with opaque, toxic sub-prime mortgaged-backed securities and banks that are 'black boxes'.

It time to rollout the big gun and let the market, using the information disclosed as a result of transparency, end our current financial crisis and prevent the next financial crisis.

This worked for 7+ decades before government forgot that it was suppose to error on the side of too much transparency and allowed Wall Street to create opacity in large areas of the financial system.

One key reason for skepticism that policy has put us on a course toward financial stability is that we have treated the loose ends of the financial crisis as technical problems to be solved …

• If proprietary trading by financial institutions is risky – though such risk-taking paled alongside old-fashioned bad lending before the crisis – ban it. 

• If taxpayers and investors lost money in the crisis, force institutions to hold much larger amounts of capital to mitigate future losses. 

• If securitization led to losses, force mortgage originators to hold more “skin in the game.” 

… and so on. 

Each technical problem has been solved using complex rules and regulatory oversight rather than transparency and market discipline.