The gut reaction to the current financial crisis is that we need more and better regulation. Few understand that regulation is part of the problem and not its solution. The solution lies in identifying its fundamental causes, which may be found in the traditional policy of organised obscurity in the provision of information on financial institutions.
Because financial institutions report to their regulators instead of the public, investors are left in the dark and cannot make informed judgments of market value. Therefore, when one bank gets into trouble the public does not know whether the problem concerns that bank alone or the banking system as a whole.
To play safe, the public begins to withdraw money from the banking system. In this way a solvency crisis turns into a liquidity crisis and a relatively minor drama in the US housing market turned into a major international financial crisis.
Suppose banks and other financial corporations reported directly to the public instead of to their regulators. The public including the banks themselves would then be able to distinguish between good and bad banks. Moreover, the onus of transparency would induce managements of financial corporations to behave more cautiously.
Currently, these managements take bad risks precisely because they know that the public will not find out. They have to inform their regulators, but regulators have a vested interest in allowing matters to degenerate into crises.
Regulation gives regulators power and importance. During a crisis they occupy centre-stage and become the would-be saviours of the world. The banks and other financial corporations understand this. They know that their regulators will bail them out, so they take risks which they would never have taken in the absence of state regulation.
It is no coincidence that regulated banks have been failing while unregulated off-shore banks have been safe. Unregulated banks have to fend for themselves by not skimping on capital and by avoiding financial adventures. They play safe precisely because they are regulated by markets rather than by regulators. The regulatory paradigm has failed. The time has come to replace it with an information paradigm that emphasises transparency, acknowledges the human weakness of regulators, and recognises the ability of markets to regulate themselves.