Arnold Kling  

Is Transparency the Answer?

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Responding to my break up the banks piece, Andrew Redleaf and Richard Vigilante write,

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.

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COMMENTS (12 to date)
Hume writes:

Somewhere, Bryan Caplan is depressed:

The PhilPapers study, by David Chalmers of the Australian National University and David Bourget of London University, surveyed academics at 99 leading philosophy departments around the globe, over 90% of them in the English-speaking world and nearly two-thirds in America. Some 91% of the respondents thought they belonged to the analytic tradition and 4% the “Continental” one. When asked which dead philosopher they most identified with, a clear winner emerged, with 21% of the votes: David Hume.

Will writes:

Non-existence of banks and eliminating the middle man sounds like a good idea. For some reason you didn't continue down that line of thinking.

Nick writes:

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.

Dr. Kling, Would you really have me believe that banks do not benefit from an economy of scale?

Additionally, did we not have a significant number of banking panics prior to the federal reserve era? Canada has less bank panics then the USA (something which you have noted on this blog) do they have less government intervention in their banking system?

David Merkel writes:

The insurance industry already lives under such a regime, and they came through the crisis well. Few failures, aside from AIG, which cheated the regulations in a number of ways. Let the banks rise to the disclosure levels of the insurers, which are much better regulated by dumber regulators.

Doc Merlin writes:

Imo Smith was right and Hume was wrong... but hey, being right doesn't always mean you win.

guthrie writes:


It might sound like a good idea, but I don't have the time, energy, discipline, or the ‘care’ enough to do my own investing. That’s what the ‘Delegated Monitoring’ paper is likely about. If I did everything a bank does on a daily basis, I'd have no time during the day to do much else.

Those who love investing and get involved in doing it themselves don’t rely on the banks, because they don’t have to, and they likely have a career in finance.

The rest of us use banks to optimize our time and talents doing whatever it is we would do if not deeply invested in investing. I rely on farmers, truckers, and grocery stores in the same way to feed myself. And I don't need to know where each farm, transportation company, or grocery store spends its money in order to get my breakfast cereal.

I think Arnold has a post here about such things, but I can’t seem to locate it.

Justin writes:

I found this line funny:

"...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."

Yeah, because bank balance sheets aren't so hideously complex that a couple of analysts spending a few days on loan/security level detail can accurately understand at a high level how much risk a bank is taking on. I think I hear Hayek laughing in his grave.

Even banks which aren't TBTF probably have several million asset and liability records on several different databases and occasionally spotty record level detail. These banks employ quite a few full-time analysts to get a very approximate sense of balance sheet valuation and risk - clearly that didn't seem to provide a crystal clear picture in advance of the last downturn.

Limit size (end TBTF), and require contigent debt which converts to equity if the bank would otherwise fail (have a private recap plan baked into each bank's balance sheet, use market discipline rather than regulators to discipline risk taking).

Joshua Lyle writes:

you imply that Dr. Kling's position requires you to believe that banks do not benefit from economies of scale. This is not so; he can merely believe that the economy of scale lies in aggregating the knowledge needed to build the portfolio, meaning that you would still be able to do your own investing if they were transparent enough for you to simply appropriate that knowledge.

Chris Bolts Sr. writes:

One of the inferred answers I got from reading the piece from Redleaf and Vigilante is that they actually blame the banks for being too intertwined with the government:

"The market unassisted can’t regulate banks because the banks, as the foundation of the credit system that supports the dollar, are inextricably intertwined with government. Our failure to grapple with this has left conservatives speechless on financial reform. Our admirable instinct to “just let the market do it” has put us in a box. Kling shows us the box."

I partially agree with this, which is why Dr. Kling's response is appropriate. Our problem with our banking system, as it is with so much of our economy, is that we are forcing companies to serve two masters: the government and their consumers. Unfortunately, they cannot serve both because each one has differing objectives (not to mention those of the companies themselves are profit-maximizing firms). The solution is to eliminate one of these masters and go with the one the provides the most optimal benefit for society as a whole.

On its face that tells us which master has to go: the government. Politicizing banking or socializing loss while privatizing reward is what put us in this situation that we are currently in and the government's solution is to give us more politicized banking and socialization of loss.

As Dr. Kling pointed out, there is no reasonable expectation that the banks would want to disclose all of their information and, if they did, what could any of us do with that information? There is a such a thing as too much information. We as consumers of banking services just need to know the answer to one simple question: will my money be safe at this bank? Any other information that we receive will just complicate that question. All of the government programs that we have put in place: FDIC insurance, loan guarantees, bailouts of banks, reserve requirements, etc., make it less likely that we can get a satisfactory answer to that question because the banks themselves have removed a lot of their own risk assessing tools because they know they have the government as a backdrop. (just an aside, this is also the government's solution to healthcare. If we don't like this for our banks, do we really think that we will like it when it comes to our healthcare?)

To sum up, Redleaf and Vigilante essentially are not "checking their premises" because they don't recognize the inherent contradiction between having the bank serve their consumers and the bank follow the wishes of the government. After all of the regulations we have passed over the years we have not made banking more stable, but are making it more destable and more volatile. Eliminate the government from banking and then allow the market to figure things out as it goes along. "Progress" can wait.

Miller-Modigliani, like Coase, is a useful guide in identifying the key dependent variables. It is not an accurate model of how actual credit and equity markets work. Please.

Anybody who wants to keep their financial freedom ought to demand more transparency in financial statements from large companies. The central planners who rule our economy today are not simply the bureaucrats in D.C., but the oligopoly of professional managers on Wall Street. You trust them more because they have to make money to keep their jobs. Fine. That doesn't mean they're looking after your interests.

steve writes:

"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."

Then 1929 did not happen? There were no bank failures in the 1800s?


Deanna (WCU) writes:

Part of the transparency debate here hinges on whether one has more faith in the market system or government regulation. Smaller banks obviously tend to be more geared towards the market system by allowing investors and bankers to communicate in a more market-style setting, in which each party has more control over what they bring to the table. When bigger banks are involved there are many systems and policies that are put in place by the hierarchies running these banks, while with smaller banks, there are fewer levels to have to go through in order to tweak these systems if necessary. I feel as though there is simply more opportunity for disclosure in situations where smaller banks are involved, without the need for legislation to be put in place to force it to occur. When government legislation is put in place it does not always affect large and small banks the same way, but if it does, smaller banks are still in a better position to work with their investors on a more personal level, where “transparency” comes more naturally as a result of the necessity for both parties to know as much about the market and their arrangements within it as possible. As I said before, it all depends on whether you place more faith in the market itself or the regulations the government puts on the market.

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