During the financial crisis of 2007–09 very liquid, highly rated financial assets all of a sudden became ‘toxic assets’; ratings for structured products had to be continuously downgraded; several markets broke down, eg, the interbank market; and banks faced severe liquidity and funding problems (see for instance Wyplosz 2007 on this site). The opacity of structured products, which was no issue in the boom, turned into a major drawback in the crisis; credit ratings were no longer trusted as providing reliable information about default risks; banks’ reported losses were viewed with suspicion by investors. The decision to relax accounting rules in response to public and political pressure was welcomed by the banks but added to the mistrust of many investors that viewed it as an attempt to restrict the quality of information.
The crisis experience has changed practitioners’, academics’, and regulators’ view of information transmission, transparency, and market discipline and raised a number of important questions both at the academic and at the policy level on how to improve transparency.
The immediate reaction from the G20 general recommendations to regulatory authorities has been to require that market participants have access to better information. While this requirement seems a natural implication of basic microeconomic theory on efficient resource allocation, the transmission of information is a more involved process, related to asymmetric information, moral hazard, and incentives. In recent research (Freixas and Laux 2012), we discuss the implications for two main sources of information, financial reports and credit rating agencies.
One of the points we emphasise is that it is important to distinguish between disclosure and transparency. We interpret disclosure as providing information, while transparency arises when the information is effective in reaching the market, being adequately interpreted and used. Both parts of the communication process are ultimately linked. Nevertheless, it is useful to distinguish them when discussing possible regulatory measures as regulators often seem to believe that disclosure is sufficient for transparency. However, there are several obstacles to a simple mapping of the former to the latter that are important.
Understanding the interrelation between disclosure and transparency helps to understand the role of information transmission when market discipline plays a limited role – as happened during the crisis of 2007–09. This is all the more important because regulatory authorities seem to promote disclosure as a way of ensuring market discipline (see recent proposals by the Bank of England). Moreover, as is well known, market discipline is supposed to be, as the third pillar of Basel II, an essential ingredient of banking stability. Yet, regulators are often silent about how market discipline should work.
The faith in market discipline has been hit hard during the financial crisis. With hindsight, one is compelled to acknowledge that market discipline was lacking during the boom and took place as an undiscriminating panic during the crisis. The origin of the failure of market discipline has different roots in the boom and in the crisis. In the boom it is quite likely that the major problem was a lack of market participants’ incentives to use or demand information. In contrast, in the bust, the dominant problem seems to be that transparency is most difficult to achieve when it is needed most.
In order to improve transparency and efficiency it is not sufficient to merely increase the provision and disclosure of information. Instead, transparency depends on how the information is interpreted and used. Two obstacles seem to hinder market participants’ use of better information.
The first obstacle is government intervention and regulation itself. For example, because of government bailouts and regulation based on ratings, investors’ incentives to use, scrutinise, and demand certain information are limited. To improve transparency, this issue has to be understood and taken into account. Regulation has to tackle the problems where markets fail, potentially because of intervention and regulation.
The second obstacle is the cost of processing information, and in particular of providing reliable information on the part of the issuer as well as collecting and understanding information on the part of the investor. There are several issues involved: What type of information should be disclosed? How do investors react to the information. And what are the consequences for market efficiency? These questions provide a challenge to regulators as they involve complex tradeoffs. An example is the classical ‘winner’s curse’ problem, in which better information can only be understood and processed by sophisticated market participants. When this is the case, it is no longer clear that better information increases market efficiency, as it may come at the cost of lower liquidity, since the existence of informed insiders will tax uninformed agents on every trade they engage in. Another example is the potential overreaction of market participants. Should information be hidden to avoid overreaction or would this cause even greater overreaction in a crisis? While regulators might demand the disclosure of additional information, it is impossible to limit access to different sources of information that investors might use.
Freixas, X and C Laux (2012), “Disclosure, transparency, and market discipline” in Dewatripont, M and X Freixas (eds), The crisis aftermath: New regulatory paradigms, London: Centre for Economic Policy Research, 69–104.
Wyplosz, C (2007), “Subprime 'crisis': observations on the emerging debate”, VoxEU.org, 16 August.