Lost in Disclosure: The Limits of Disclosure as a Regulatory Technique in Financial Markets

Disclosure has been the centerpiece of the regulatory armoury since the early 1930s. In an attempt to clean up US markets from abuse, the Roosevelt administration created widespread disclosure regimes for securities issuers and traders by means of the so-called New Deal Statutes: mainly Securities Act 1933 and Securities and Exchange Act 1934. Yet disclosure completed its ascent to the ‘regulatory Olympus’ in the past twenty five years for reasons that had little to do with the battle against fraud and market abuse. 

With the advent of financial liberalization and with the aid of modern finance theory, -- but not with its full endorsement -- policy-makers and regulators came to view financial markets as an agglomeration of rational investors, who make optimal resource allocation and wealth maximization decisions when provided with sufficient information and appropriately structured economic incentives. So all regulators had to do to safeguard efficient markets and help investors was to ensure that a vast volume of pertinent information entered the public domain in any given area of financial market activity. Then, on the basis of all available information, market actors would adjust their investment decisions, trading positions, and strategies to information’s content and the market would essentially regulate itself. Thus, no further consideration was usually given to other very important issues, such as the question whether market actors used all of the disclosed information and if so what kind of decisions they took on the basis of abundant supplies of information. 

Disclosure’s Ascent and the Perceived Role of Disclosure

Disclosure has been regarded as one of the most potent tools of corporate and financial market regulation for six reasons:¹

1. By increasing publicly available information, it enables market actors to make informed investment decisions,
2. It improves market efficiency: increased availability of information leads to better pricing of securities and of other financial instruments enhancing allocative efficiency,
3. It reduces the cost of information searches, which, when excessive, is pure social waste in zero sum securities markets;
4. It fosters fair, ethical, and competitive markets, as it obliterates (along with prohibitions of insider dealing) the information advantage that insiders enjoy over outsiders in financial markets,
5.  It may help market stability by containing market volatility that is usually caused by limited information regarding the merits or risks of financial products, and
6.   It deters fraud; as the much celebrated US Supreme Court Justice Louis Brandeis observed almost nine decades ago, ample provision of information is the best ‘disinfectant’ of the markets driving out abuse, which may be easily identified under conditions of transparency. 

Arguably, some of the aforementioned benefits of disclosure regulation not only are undisputable but also have served multiple causes. For instance, mandatory (securities issuer) disclosure not only has helped to improve the integrity of securities markets, it has also advanced the cause of democratic capitalism by eradicating the information advantages of the established economic elites. However, the above benefits are not the sole reason that disclosure has become the cornerstone of modern financial regulation. And neither is it because it is an inexpensive or non-intrusive regulatory technique. It is both very costly and intrusive for the subject of relevant disclosure requirements, whether a securities issuer or a financial firm. Regardless of context, e.g., periodic issuer disclosure, offer prospectus etc., an army of auditors, lawyers, and compliance officers are assigned the task of processing and verifying disclosable information. Rather disclosure’s ascent is due to the pre-eminence of rational choice theory in modern financial regulation. 

As a result, based on the rational investor model, modern financial regulation stretched the disclosure paradigm and reliance on self-regulation way beyond its original realm of issuer disclosure and prevention of market abuse to financial services consumer (retail investor) protection and even prudential regulation with mixed results. For example, disclosure was utilized, in lieu of protective regulation (e.g., position limits), as a principal supervisory tool in banking regulation. Under the third pillar of Basle II (market discipline), timely informed rational actors are assumed to be capable to act as supervisors and enforcers of prudential regulation (capital adequacy) rules. This approach left to market self-regulation a crucial and strategic role in preventing institutional collapses and systemic crises. Yet this view was seriously flawed, and the way banking markets have behaved in the course of global financial markets also proved that it was dangerous. 

Disclosure’s Descent

Given the influence of the rational investor approach in policy-maker, analyst, and regulator thinking, it is not surprising that inadequate disclosure has been widely cited as almost the sole cause of the global financial crisis.² As this argument goes, investors had insufficient information regarding the risks involved in structured securities, such as asset backed securities (ABS), collateralized debt obligations (CDOs), and credit default swaps (CDS), the flaws and limitations of credit ratings, and the impact of excessive executive compensation. Had rational investors been given higher quality information they would have approached structured credit securities with caution and they would not have been overexposed to these markets. Also, well informed capital markets would have punished companies with executive and trader compensation schemes that fostered short-termism, in spite of bringing to them mega-profits. 

The inadequate disclosure critique has not, however, been fully endorsed by all analysts of the global financial crisis. A strong minority of commentators have argued that closer examination shows that investors had, in many cases, sufficient information about the risks of their investment strategies and of the financial products used to implement them. Yet market actors could not properly process available information in those cases and adjust their positions to the riskiness of structured credit securities for a variety of reasons. First, due to product complexity, boundedly rational investors failed to understand the mechanics and risks of shadow banking and structured credit securities.³ Second, because of market players’ tendency to herd, responding strategically to other market actors’ behaviour, investors did not have the capacity or the desire to use in a rational way the disclosed information and take contrarian positions. Third, the influence of other behavioural factors such as the use of heuristics⁴, and investor overconfidence in times of market euphoria because of abundance of easy credit and rising market prices, meant that investors chose to ignore the warning signals in the disclosed data in favour of over-reliance on credit ratings.⁵

Especially in the context of banking (prudential) regulation, disclosure based market discipline faces severe constraints, due to the very nature of the banking industry, which creates interconnectedness. The existence of the implicit government guarantee gives banking institutions a strong incentive to grow their asset book (loans) and become ‘too big to fail.’ Obviously, the larger the institution becomes and the more inter-connected, the more likely is that its failure will also drag down other inter-connected institutions necessitating a government bailout. The Geneva/Goodhart Report on Financial Regulation calls this risk the ‘interconnectedness spillover.'⁶ This, in turn, creates a powerful perverse incentive to expand a banking institution’s balance sheet, obliterating the restraining power of market discipline. 

However, even if it was possible to eliminate moral hazard and fashion appropriate incentives so that bank creditors became effective monitors of banks, in which case extensive market disclosure would have been very useful, market monitoring would still mean little in terms of preventing institutional failures and/or safeguarding systemic stability for two reasons. First, as Martin Hellwig observes in Systemic Risk in the Financial Sector: An Analysis of the Subprime-Mortgage Financial Crisis, published in November 2008:

_{Because of systemic interdependence, the individual bank’s risk exposure cannot be ascertained by just looking at the bank’s assets and liabilities, on balance sheet and off balance sheet. If the bank’s asset position involves a certain risk and the bank has hedged this risk by contracting with a third party, the effectiveness of the hedge depends on the third party’s ability to fulfil its obligations when needed.} 

In today’s globalized markets, there is no private institution that could possibly have the ability, resources, and access to information to be able to conduct a credit analysis of all other financial institutions, regulated and unregulated. Furthermore, even if such institution existed, the colossal costs of universal monitoring would far exceed the expected benefits. Second, even if a financial institution behaves individually in a prudent way, or even if all financial institutions behave in a prudent, but un-coordinated way, a systemic crisis may not be averted. Especially in the event of a liquidity crunch, even the prudent behaviour of financial institutions can create spillovers that may undermine the stability of the rest, leading to systemic instability. This problem is due to another risk-spillover externality: fire sales.⁷ 

It is not, therefore, surprising that more recently sceptical voices are raised at the highest level, with the recent March 2009 Turner Review, ‘A Regulatory Response to the Global Banking Crisis’  being the leading example.⁸ The above findings are not totally lost on global policy makers either. The G20 summit in London placed much more emphasis on protective regulation and the imposition on restrictions on market activities, which were highly implicated in the building up of the crisis, chiefly shadow banking, and focused much less on disclosure and market discipline. 

What Future for Disclosure? 

The old disclose and self-regulate paradigm in financial markets is dead, no less because of its role in bringing about the current global financial catastrophe. However, this does not diminish the value of disclosure as a regulatory technique, it simply calls for a substantial overhaul of its processes, volume, timing, and format, in order to make it more effective. 

Premising banking (prudential) regulation on disclosure and market discipline was a flawed approach that endangered the stability of the global financial system. Disclosure can have an effective role in prudential regulation only as a supplement to strict protective rules that limit the kind of activities an institution may undertake and restrain its risk-taking appetite. 

Disclosure still has a great role to play in capital market regulation. In fact, it should be used much more extensively in areas such as short sales regulation, where a comprehensive disclosure regime can be a very effective tool to combat market abuse, rendering unnecessary an autocratic prohibition of short selling. 

However, as regards the traditional disclosure paradigm in investor protection regulation, the disclosure conundrum will only be resolved if disclosure rules are subjected to extensive and rigorous empirical and experimental studies. It is possible that such studies will show that, in spite of the existence of extensive disclosure regimes, certain classes of individual investors need to be aided by the introduction of default choices. It follows that the selection of those default choices in financial contracts is a role that should be assigned to an independent public body that is not susceptible to regulatory capture. 

About the author:

Emilios Avgouleas, LLM (LSE), PhD (LSE), is Senior Associate Professor (Reader) in International Financial Law, at the School of Law, University of Manchester, in the UK. This past spring, Emilios was the Global Capital Markets Center Fellow, Law School, Duke University. Emilios has extensive practising experience with leading international law firms and has acted as an advisor to several regulatory policy organizations.

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End notes

¹For an overview of the many studies that provide an economic analysis of the merits and de-merits of disclosure regulation see Emilios Avgouleas, The Mechanics and Regulation of Market Abuse, A Legal and Economic Analysis (OUP, 2005), 173-183. The most convincing academic analysis in favour of disclosure regulation are J. Coffee, ‘Market Failure and the Economic Case for a Mandatory Disclosure System’, (1984) 70 Virginia Law Review 717.

²Policy Statement on Financial Market Developments (The President’s Working Group on Financial Markets, March 2008). Steven Schwarcz, ‘Protecting Financial Markets: Lessons from the Subprime Mortgage Meltdown’ (2008) 93 Minnesota L. Rev. 373.

³For the limitations that financial product complexity posed for investors’ understanding of what was disclosed and the catastrophic consequences of this limited understanding see Steven Schwarcz, ‘Regulating Complexity in Financial Markets’, Duke Public Law & Legal Theory Research Paper Series No. 217, revised February 26, 2009.

⁴Emilios Avgouleas, ‘The Global Financial Crisis, Behavioural Finance and Financial Regulation: In Search of a new Orthodoxy’ (2009) 9 Journal of Corporate Law Studies 121-157

⁵Markus Brunnermeier, Andrew Crockett, Charles Goodhart, Avinash D. Persaud, and Hyun Shin, ‘The Fundamental Principles of Financial Regulation’, Geneva Reports on the World Economy 11, January 2009, 20-21.

⁶This externality was first explained in a model in John Geanakoplos and Heracles Polemarchakis, ‘Existence, Regularity, and Constrained Suboptimality of Competitive Allocation When the Asset Market is Incomplete’ in Heller, Starr, Starrett (eds), Uncertainty, Information and Communication, Essays in Honor of Kenneth J. Arrow, Vol. 3, (CUP, 1986) .

⁷FSA, ‘The Turner Review, A Regulatory Response to the Global Banking Crisis’, March 2009.