Is Transparency the Answer?
By Arnold Kling
The credit system — not surprisingly, given its name — operates on trust. The government’s bizarre position has been that this trust rests more securely on blind faith that government will protect the banks than it would on the informed judgment of investors that the banks were being managed soundly. Government has been asking us to trust but refusing to let us verify.
…the one and only new law we need — and it needs to be a law, not a “flexible” rule — is a requirement that the banks fully disclose, at the finest level of detail, every investment they hold on or off their balance sheets.
Some points in response.
1. I do not propose breaking up large banks as a solution for risk cycles in banking. I have a pessimistic view, in which I think that risk cycles are inevitable. I see breaking up large banks as making it easier to disentangle banks from government. That is a good thing by itself, even if it does nothing to change the amplitude of the risk cycle. However, it is quite possible that the amplitude of risk cycles would be reduced if government were less involved. The presumption among those on the left who favor regulation is always that regulators will somehow be smarter than banks over the course of the risk cycle, when the evidence strikes me as showing the reverse to be the case.
2. Anyway, Redleaf and Vigilante are not on the left, but they seek to reduce the amplitude of the bank risk cycle through legislation. In this case, legislation mandating transparency. I do not think this would work as they intend, as I will explain below.If banks were perfectly transparent, risk cycles in banking might very well disappear. However, if banks were perfectly transparent, they would not exist. See Banks and Modigliani-Miller.
My view of banking stems in part from Douglas Diamond’s paper, Financial Intermediation and Delegated Monitoring. I don’t see a non-gated version, and I don’t have a copy of the paper. As I remember it, and as you can tell from the title, the idea is that when people save through banks they are delegating important risk-management functions to the banks. You do not want to know as much as the bank about what is in its portfolio. If you knew the investment portfolio like the back of your hand, you would do your own investing and eliminate the bank as middle-man.
Assume for the moment that we had free-market banking. In that case, my guess is that the market would arrive at a degree of transparency that is perhaps greater than it is now but certainly less than 100 percent. No law would be required. Bank shareholders would want to know something about the bank’s portfolio. Senior unsecured creditors would also have a lot of reason to be curious. Those classes of investors would drive the disclosure policies of banks.
If I am lending to an institution that could go bankrupt with no government safety net, I will demand some assurance that I will be paid back. Disclosure will be part of that assurance.
What messes this up are government policies that protect unsecured creditors, particularly if a bank is deemed “too big to fail.” If I believe that it is government’s policy to bail out unsecured creditors, then I will invest in debt from Citicorp or Freddie Mac with hardly a care in the world about what’s on their balance sheet or how they manage their business. I know they’ve got Uncle Sugar behind them. They could be transparently bankrupt, and if I think they will get bailed out I have no reason not to invest. In fact, Reserve Primary, the famous money market fund that “broke the buck” when Lehman failed, had deliberately loaded up on Lehman paper during the months prior to its bankruptcy. The problem was not that Reserve Primary’s managers could not see inside Lehman’s portfolio–everybody could see enough to know that Lehman was on the ropes. Presumably, what Reserve Primary’s managers were thinking was that government would find a way to ensure that Lehman’s short-term creditors were bailed out.
In short, a “transparency” law is neither necessary nor sufficient to reform banking. It is not necessary, because the market could arrive at the right amount of transparency, which is almost certainly going to be less than 100 percent transparency. It is not sufficient, because even with transparency, creditors will lend excessive amounts to risky banks as long as they expect to be bailed out. To reduce the probability of bailouts, and hence to keep institutions that lend to banks on their toes, I think it is necessary (although not sufficient) to break up big banks, so that they have less political leverage.