Sunshine or a Tight Leash, which works better?

Gordon Crovitz has an interesting article on the Wall Street Journal discussing the regulation of securities markets in the light of the recent economic failures.  In the article, Covitz argues that even the most liberal minds of the , Brandeis and Franklin Roosevelt specifically, advocated transparency over regulation in response to beginning of the Great Depression.

Supreme Court Justice Louis Brandeis had made the point that “sunlight is the best disinfectant,” and the Securities Act of 1933 mandated the information that public companies would have to share. One indicator that disclosure was more important than regulatory power is that it wasn’t until the following year that the Securities and Exchange Commission (SEC) was created.

What worked to restore confidence in the equity markets then can help to restore confidence in the debt markets now: more disclosure, aimed at making the terms of debt such as mortgages more transparent. Unlike the case of stocks, under current law no one in the chain of making, insuring and rating debt is required to disclose full terms to regulators or to the market. Instead, debt markets function based on best estimates, with mathematical models determining probabilities of cash flows and defaults.

Ever since the models failed due to an unpredicted bubble, the market has been paralyzed with uncertainty. There is still a wide gap between what banks think their bad debt might be worth and what the Treasury or private investors are willing to pay.

In passing the Securities Act of 1933 and the creation of the Securities Exchange Commission the following year, Congress and the Roosevelt Administration showed a preference of transparency over regulation. While both acts created large regulatory provisions to be enforced by a powerful government body, the focus was largely on transparency because those regulatory provisions focused on report requirements by publicly traded companies to the SEC.

Today, advisors to the Obama administration have largely advocated greater regulation and oversight over the trade in securities.  Conservatives argue against this opinion over largely philosophical grounds, rooted in the economic philosophy of the likes of Milton Freidman.  Advocates of free trade have frequently railed over how excessive regulation restricts free trade and inhibits economic growth.  Transparency is viewed as a much better option in that it should accomplish the goals of regulation, while not inhibiting the free market.  As Corvitz stated, modern technology makes transparency an even more viable option.

“Today’s financial crisis was driven in part by a lack of accurate, easily usable information to give investors what they need to make informed, responsible decisions,” testified Mark Bolgiano, chief executive of a nonprofit technology and accounting consortium called XBRL US. “The value of toxic asset-backed securities remains a mystery because information on the underlying loans and ongoing viability of those loans and the securities themselves was not collected consistently and even if it had been, it would not have been in a usable, portable form.”

XBRL sounds complicated, but eXtensible Business Reporting Language is simply a new technology language that allows data to be easily extracted, searched and analyzed. XBRL is already being used for some equity disclosures, tagging financial information into a globally consistent, computer-readable format.

Along with Edgar, the XBRL system could be the most valuable tool to prevent securities fraud.  Let us hope that cooler minds prevail, and that the Obama administration chooses transparency over regulation.