The following post comes to us from Henry T. C. Hu, Professor at the University of Texas School of Law. It is based on his recent paper, “Disclosure Universes and Modes of Information: Banks, Innovation, and Divergent Regulatory Quests,” which is forthcoming in the Yale Journal on Regulation and is available here.

The mention of the word “disclosure” usually conjures up the Securities and Exchange Commission (SEC) system for mandatory public disclosure, that system’s classic goals of investor protection and market efficiency, and implementation by way of Form 10-Ks and other SEC-dictated documents. In fact, there is now an independent, bank regulator-developed, public disclosure system—a parallel system that has ends and means that depart in fundamental ways from the SEC system.

Disclosure Universes and Modes of Information: Banks, Innovation, and Divergent Regulatory Quests (here), forthcoming in the Yale Journal on Regulation, is the first article to systematically analyze this new morphology of mandatory public information, a morphology that spans two parallel regulatory universes with divergent ends and means. In addition, the new article shows that both the SEC and bank regulator systems largely rely on a single, longstanding approach to “information” that a June 2012 article—Too Complex to Depict? Innovation, “Pure Information,” and the SEC Paradigm (here)—suggested was insufficient in the face of the informational challenges posed by modern financial innovation.

In 2013, a new system for mandatory public disclosure came into effect, the first since the creation of the SEC in 1934. Today, major banks must make disclosures mandated not only by the SEC, but also by a new system developed by the Federal Reserve and other bank regulators in the shadow of the Basel Committee on Banking Supervision and the Dodd-Frank Act. Already, this new bank regulator system, which stemmed in large part from a belief that disclosures on the complex risks flowing from modern financial innovation were manifestly inadequate, dwarfs the SEC system in sophistication as to the quantitative aspects of market risk and the impact of economic stress.

Unlike the SEC system, the bank regulator public disclosure system is directed not at the interests of investors and market efficiency, but instead at the well-being of the bank entities themselves and the reduction of systemic risk. The regulatory means diverge as well, not only as to specific risk-related disclosures, but even as to overarching concepts like “materiality” and the availability of private enforcement.

However, both of the disclosure systems substantially rely on a longstanding approach to information that Too Complex To Depict? showed to be insufficient in an era of complex financial innovations (including certain asset-backed securities and derivatives) and of entities heavily exposed to such innovations or strategies involving those innovations. The new article refines the conceptual framework of “information” introduced in Too Complex to Depict?. I set out three approaches to information. First, the longstanding approach is termed the “descriptive mode,” one that relies on “intermediary depictions” of objective reality. An intermediary—such as a corporation issuing shares—stands between objective reality and the investor. The corporation observes and analyzes the objective reality, crafts a depiction of the pertinent aspects, and transmits its depiction to investors. Modern financial innovation poses two basic roadblocks to the descriptive mode. First, such innovation has resulted in objective realities that are far more complex than in the past, often beyond the capacity of the English language, accounting terminology, visual display, risk measurement, and other tools on which all depictions must primarily rely. Sometimes, even “objective reality” is subject to multiple meanings (as can occur in certain asset-backed securities situations). Second, even a well-intentioned and sophisticated intermediary either may not truly understand—or may not function as if it understands—the reality it is charged with depicting. If the intermediary itself suffers from such “true” or “functional” misunderstandings, any depiction it offers will necessarily be flawed. (The preliminary analysis of the 2012 JPMorgan Chase “London whale” credit derivatives debacle offered in the 2012 article has been updated in the new article in light of fresh evidence.)

With revolutionary advances in computer- and web-related technologies, investors need no longer rely exclusively on the descriptive mode and its intermediary depictions. The “transfer mode” allows “pure information” about the objective reality to be transmitted directly to investors. The “hybrid mode” draws on elements of both of the other modes, and investors rely on “moderately pure information.”

The new article also offers pathways for reform, falling in two categories. One category is at the level of modes of information. Here, the most incremental step would be to improve implementation of the descriptive mode, especially at the SEC. The key SEC disclosure requirements have been substantially frozen even as banking and financial innovation have undergone epochal changes. More fundamentally, regulators have invested almost entirely in the descriptive mode. Giving full consideration to all three modes—modal “information neutrality”—would lead to a more diversified portfolio of informational strategies, one better suited to the informational challenges of financial innovation. The article outlines examples of transfer and hybrid mode strategies and the need to address longstanding issues associated with confidential treatment requests and the Freedom of Information Act.

The other category of reforms is at the level of the overall morphology. In the long run, the existence of parallel universes with divergent regulatory quests is unsustainable. Among other things, the regulatory objectives of the two systems not only diverge, but sometimes conflict. A disclosure the SEC deems essential for investor protection and market efficiency can be contrary to the bank well-being and financial system stability goals of the bank regulator system (and of the Financial Stability Oversight Council). In the short-run, boundary-setting and a modest form of “informational neutrality” across regulatory systems (including as to judicial review of rule-making) can promote coordination.