Public companies still follow disclosure rules set more than 70 years ago, in a world that didn’t have global corporations, credit default swaps or the Internet. Henry T.C. Hu, Allan Shivers Chair in the Law of Banking and Finance at the University of Texas School of Law, has caused a stir with proposals for bringing financial information into the information age. He knows the subject from the inside: Before coming to UT in 2011, he served the Securities and Exchange Commission, as its first director of the Division of Risk, Strategy, and Financial Innovation.
Last May, Hu authored a paper called “Too Complex to Depict? Innovation, ‘Pure Information,’ and the SEC Disclosure Paradigm,” in which he argued that financial information has grown too complex to capture under old rules. He looks at the worlds of asset-backed securities and banking – in which weak disclosure helped to bring on the crash of 2008 – and suggests using the Internet to give more accurate pictures to investors.
Hu recently sat down to discuss these issues with UT Law magazine. Below is a condensed version of the interview; the full text is available here.
Simple rules from simpler times
The SEC disclosure paradigm emerged in a simpler time, relied on a simple conception of information, and was directed at simple goals. The modern process of financial innovation has resulted in financial products, as well as major financial institutions, that are far more complex than in the past.
Since the Depression, the SEC’s totemic philosophy has been what I call an “intermediary depiction” model. An intermediary – such as a corporation issuing shares – stands between the investor and an objective reality. The intermediary observes that reality, crafts a depiction of the reality’s pertinent aspects, and transmits that depiction to investors. Securities rules direct that depictions are to be accurate and complete.
The longstanding “intermediary depiction” model is increasingly undermined by innovations in financial theory and practice. I show this largely by using two important contexts. First, I focus on “asset-backed securities” (ABS). Informational problems associated with ABS played major roles in causing the global financial crisis that began around 2007. Second, I focus on “too big to fail” banks deeply involved in swaps and other derivatives.
Today’s information: too complex to capture
Financial innovation poses two basic roadblocks to good depictions. The first roadblock is that financial 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 and other tools. The depictions may offer little more than shadowy outlines of the objective reality.
The second roadblock is more fundamental: Even a completely well-intentioned intermediary may not truly understand the reality he is charged with depicting. If the intermediary fails to understand the objective reality, how can it possibly provide a good depiction of reality?
With ABS transactions, crafting depictions faces really fundamental challenges. Even the “objective reality” is subject to multiple meanings. As a practical matter, it can be extremely difficult for the investor to map the intermediary’s depiction to the actual cash flows he would encounter over the life of his investment.
Depictions of major banks can suffer from both roadblocks, helping explain the severity of the bank disclosure problems that helped cause the financial crisis.
Using computers to skip the information middleman
[But] if the modern era’s revolution in financial innovation is creating problems for the SEC’s disclosure paradigm, I think that the modern era’s revolution in computer-related innovation offers a partial solution. With advances in computer and Internet technologies, it is no longer essential to rely exclusively on intermediary depictions of reality.
Figuratively, if the intermediary steps out of the way, the investor may now be able to see for himself, to download the objective reality in its full, gigabyte richness. Such “pure information” can be more granular and accurate. Moreover, investors will have information freed from possible intermediary biases and misunderstandings.
However, at the same time, [it] will also leave investors bereft of the benefits of an intermediary’s efforts to analyze and distill objective reality. The article thus suggests that a disclosure paradigm that relies on both models can help investors triangulate the truth. I offer some possible solutions involving the provision of “moderately pure” information, solutions that could actually be useful to investors and yet not be burdensome to the banks, or cause banks to lose proprietary information.
Big banks: too complex to exist?
Another alternative would be the “simplification” of reality. If reality itself is simpler, it would generally be easier to depict. In a physical sense, Kazimir Malevich’s painting, “White on White,” would be far easier to describe accurately, fully, and succinctly than Hieronymus Bosch’s triptych, “The Garden of Earthly Delights.”
There are [also] substantive implications of this article for the “too big to fail” issue, broadly defined. If, for instance, a major bank is too complex to depict, and pure- or moderately-pure information models are insufficient, the article argues that we should at least ask the question whether it may also be too complex to exist.
For more details on Hu’s proposals, read his May 2012 paper “Too Complex to Depict? Innovation, ‘Pure Information,’ and the SEC Disclosure Paradigm.”