Sapra: Increased Transparency May Not Be the Best Fix For Crisis

In a Bloomberg editorial, University of Chicago Booth School of Business professor Haresh Sapra says that conventional thinking on financial regulation may not be entirely beneficial. “The view that greater transparency enhances market discipline and therefore economic efficiency holds true only in a ‘Robinson Crusoe’ economy, that is to say one in which a single decision maker is learning about a company whose decisions are taken as given and whose future cash flows or economic fundamentals are therefore fixed,” says Sapra.

Fair value accounting is one method that regulators have undertaken to improve transparency, requiring that assets be accounted for at market price (rather than purchase price) to give a more accurate view of a holding’s value to both insiders and outsiders of a company. But financial insiders point to increased volatility in financial statements, leading to unnecessary and unintended instability.

The more that a financial institution relies on short-term pricing and value changes, the more at-risk it is for a “feedback loop,” as “decisions of financial institutions are more likely to be based on second-guessing of their competitors than on perceived fundamentals,” says Sapra. “Put differently, in trying to enhance market discipline, reliance on market prices via fair-value accounting weakens market discipline,” he concludes.

Amen to that, Professor! Let’s do both–print holdings at purchase price and then footnote the exact mark-to-market effect. This attains both goals–it gives long-term decision-making room to think and operate and fully discloses the market value effects on the institution. Why isn’t this a perfect solution? It provides more disclosure and less volatility–win-win!