What Future for Disclosure as a Regulatory Technique? Lessons from the Global Financial Crisis and Beyond

Inadequate disclosure has been at the heart of most policy analysis of the global financial crisis. According to the inadequate disclosure critique, investors had insufficient information regarding the risks involved in structured securities, the flaws of credit ratings, and the impact of excessive executive compensation, all among the main causes of the recent financial market collapse. However, the global financial crisis has also exposed the many limits of disclosure as an effective regulatory tool in the context of financial markets. For instance, many of the risks that led to the creation of the 2008 catastrophe were often fully disclosed but the markets failed to understand what was disclosed and appreciate the implications. The reasons for this failure were product complexity and the impact of socio-psychological factors such as bounded rationality, strategic trade behaviour (herding), and cognitive biases. These findings pose a great challenge to the prevailing rational choice view of disclosure as a regulatory remedy of most market failures. At the same time, the issue of transparent financial markets dominates the global regulatory reform agenda. Accordingly, there is a clear need to devise strategies that make disclosure work under actual (not hypothetical) market conditions and redress the adverse impact of socio-psychological factors. The chapter argues that in specific contexts, such as the field of prudential regulation of banks, disclosure will only work if it is supplemented by protective regulation, e.g., business activity barriers and position limits. It also argues that only through the use of experiments, as a complement to empirical studies, policy-makers and regulators will be able to measure the actual contribution of disclosure to investor protection and devise effective disclosure strategies