In the 1930s, when the global financial system faced a similar solvency crisis, FDR observed that "we have nothing to fear, but fear itself." He then set about backing up these words. Specifically, he transformed the financial system from being based on the practice of caveat emptor to being based on the philosophy of disclosure.
The one area where he could not bring disclosure fully to was banking. The lack of 21st century information technology made it impossible to share with market participants all the useful, relevant information for each bank in an appropriate, timely manner.
Instead, FDR introduced deposit guarantees and enhanced regulation and supervision. With deposit guarantees, he shifted the risk of loss on deposit investments from the depositor to the government. With enhanced regulation and supervision, he put in place bank supervision that allowed for examiners to look at all of a bank's useful, relevant information 24/7/365 - to this day, bank examiners still sit full-time in the offices of the countries largest banks looking over everything a bank does from loans to investments and funding.
Given the lack of 21st century information technology, this was the best that FDR and his government could do. However, it is a solution that is fundamentally flawed. It creates a systemic point of failure in the financial system by making market participants dependent on the regulator.
This blog has documented a number of ways that failure could occur including:
- The Bank of England's Andrew Haldane provided one in his discussion of the ability of the examiners to transform the data they received from the banks into useful information.
- In Ireland, the Nyberg Report provided another in its observation that the financial regulatory bureaucracy itself is an obstacle because, even when the analysis is correct, the examiner must convince everyone above them in the bureaucracy before action can be taken.
- Investors are more confident when they know what they own.
- Financial institutions are subject to market discipline when investors can change the amount and pricing of their exposure in response to changes in the financial institution's risk profile.