Is opacity an excuse?

I’ve been getting a lot of concerned feedback from people I respect on my claim that status quo finance requires opacity and some degree of trickery in order to function. (See previous posts.) If prosperity is connected to “opaque, faintly fraudulent, financial systems”, is that an excuse for looting and predation by financial intermediaries? Won’t it be used as one?

Though it may be counterintuitive, rather than excusing misbehavior, opacity in finance implies that misbehavior of intermediaries must be policed more vigorously and punished more punitively than in a world that could be made transparent. If finance were as transparent as baseline neoclassical models suggest, there would have been no “flaw” in Alan Greenspan’s ideology, and no need to regulate markets or root out fraud. Creditors would themselves vet and monitor their financial arrangements, would assume risks in full knowledge of all potential mishaps ex ante, and could therefore be required to accept responsibility for losses ex post. There would be no need for any heavy-handed meddling by the state or vitriolic second-guessing by nasty bloggers. The harms of malinvestment would be internalized by investors who were capable of bearing the risks. When things go wrong, it would be none of the rest of our business.

It is when the relationship between capital provision and investment choice becomes intermediated and opaque that we must impose institutions of accountability. If we permit you to invest other people’s money behind closed doors, if, even worse, we institute society-wide cons (deposit insurance, rating agencies) to trick people into bearing the risk of your schemes, then it is absolutely essential that you perform your duties to a very high ethical standard, and that you have strong incentives to deploy the pilfered capital well rather than to squander or expropriate it.

Opacity creates a very serious technical problem: as we allow finance to be opaque and complex, it may become difficult to police and impose good incentives. So we may, as a society, face an unpleasant tradeoff. Tolerating more opacity may help mobilize capital for useful purposes, but any benefit may be offset by a diminishment of our capacity to regulate and police. At one extreme of opacity, financial intermediaries simply steal everybody else’s wealth. That’s no good. At the other extreme, if we insist on perfect transparency (without big changes in how we organize our affairs), the result will be extreme underinvestment. Which is no good either.

There are some issues that we’ll need to unpack. When we talk about “transparency”, a core question is transparent to whom? My thesis is that status quo finance must be opaque to beneficial investors, that is to the innumerable people who must be persuaded to bear some portion of the risk of aggregate investment when their informed preference would be to defensively hoard. That does not mean that finance must be opaque to, say, regulators, who themselves participate in the con by assuring people it is “safe to get in the water”. (Ultimately it cannot be made safe.) In theory, we could design a system that is opaque to the broad public, but transparent to regulators who police the intermediaries. That is the architecture that our present system strives for. But the many practical problems of this architecture are widely known: the capital allocators are more numerous than the regulators, and as a matter of practice, they tend to be much better remunerated (a fact which itself is a kind of regulatory failure). If bankers wish to invest recklessly (or simply to loot) and it boils down to a cat-and-mouse competition, the bankers are likely to win. The potential spoils from looting are very large, large enough that bankers can offer to share the spoils with regulators or the politicians who control them, leading to revolving doors and see-no-evil regulation. Regulators are supposed to stand in as agents of people who’ve ceded control of capital to opaque intermediaries, ultimately the broad public. But it is difficult to prevent them from being “captured” — socially, ideologically, and financially — by the groups that they are supposed to regulate. Regulators themselves often prefer opacity and complexity for reasons analogous to those that sucker end-investors. Regulators don’t like to fight with their friends and future benefactors, and they fear the operational and political headaches that would come with reorganizing large banks. But they don’t like to be put in a position where misbehavior is plainly before them, so inaction would be unmistakably corrupt. They find it a great relief to be persuaded that “sophisticated risk management” models, rating agencies, and “market discipline” mean they don’t have to look very hard or see very much. It seems better for everyone. Everyone gets along and feels fine. Until, oops.

All that said, to the degree that we can maintain high quality supervision, regulators who pierce the veil of opacity, prevent looting, and ensure high quality capital allocation are a clear positive. If we posit very good regulators, there is no tradeoff at all between supervision and effective capital mobilization. On the contrary, opaque finance is unlikely to deploy capital effectively without it, since, with actual capital providers blind, there is no one else to provide intermediaries with incentives to invest carefully rather than steal. An opaque financial system is an argument for vigilant regulation, not deregulation. If regulators allow themselves to be blinded by complexity and opacity, if financial intermediaries are permitted to arrange themselves so that legitimate practices and looting are difficult for regulators to distinguish, that becomes an argument for very punitive regulation whenever plain misbehavior is discovered, because as the probability of detection diminishes the cost must increase to maintain any hope of effective deterrence.

I am pretty pessimistic about this architecture. I think that high quality financial regulation is very, very difficult to provide and maintain. But for as long as we are stuck with opaque finance, we have to work at it. There are some pretty obvious things we should be doing. It is much easier for regulators to supervise and hold to account smaller, simpler banks than huge, interconnected behemoths. Banks should not be permitted to arrange themselves in ways that are opaque to regulators, and where the boundary between legitimate and illegitimate behavior is fuzzy, regulators should err on the side of conservatism. “Shadow banking” must either be made regulable, or else prohibited. Outright fraud should be aggressively sought, and when found aggressively pursued. Opaque finance is by its nature “criminogenic”, to use Bill Black’s appropriate term. We need some disinfectant to stand-in for the missing sunlight. But it’s hard to get right. If regulation will be very intensive, we need regulators who are themselves good capital allocators, who are capable of designing incentives that discriminate between high-quality investment and cost-shifting gambles. If all we get is “tough” regulation that makes it frightening for intermediaries to accept even productive risks, the whole purpose of opaque finance will be thwarted. Capital mobilized in bulk from the general public will be stalled one level up, and we won’t get the continuous investment-at-scale that opaque finance is supposed to engender. “Good” opaque finance is fragile and difficult to maintain, but we haven’t invented an alternative.

I think we need to pay a great deal more attention to culture and ideology. Part of what has made opaque finance particularly destructive is a culture, in banking and other elite professions, that conflates self-interest and virtue. “What the market will bear” is not a sufficient statistic for ones social contribution. Sometimes virtue and pay are inversely correlated. Really! People have always been greedy, but bankers have sometimes understood that they are entrusted with other people’s wealth, and that this fact imposes obligations as well as opportunities. That this wealth is coaxed deceptively into their care ought increase the standard to which they hold themselves. If stolen resources are placed into your hands, you have a duty to steward those resources carefully until they can be returned to their owners, even if there are other uses you would find more remunerative. Bankers’ adversarial view of regulation, their clear delight in treating legal constraint as an obstacle to overcome rather than a standard to aspire to, is perverse. Yes, bankers are in the business of mobilizing capital, but they are also in the business of regulating the allocation of capital. That’s right: bankers themselves are regulators, it is a core part of their job that should be central to their culture. Obviously, one cannot create culture by fiat. The big meanie in me can’t help but point out that what you can do by fiat is dismember organizations with clearly deficient cultures.

But don’t my paeans to the role of opacity in finance place arrows in the quiver of those seeking to preserve and justify financial predation? Perhaps. People who benefit from corrupt arrangements will make every possible argument to rationalize and preserve their positions. But the fact that ones views might be misused doesn’t mean we should self-censor. I was rude, in the previous post, to assert categorically that my argument “is true”, but I do think that it is. My tone was sardonic and bleak, and perhaps it ought not to have been, but these ideas have always been “out there”, and it’s best we acknowledge and deal with them. Nearly every proposed financial regulation is greeted with stern warnings that it will cause “credit to contract”. It is worth trying to understand the mechanics of real-world capital mobilization, and its role in underwriting prosperity (or perhaps militarism). I don’t think we have to fear talking about this stuff. The proposition that looting and misdeployment of capital serve the public good is easy to debunk. The proposition that there are arrangements which serve useful purposes but also create space for corruption is not controversial. We need to understand how institutions actually function and how they are abused if we are to have any hope of minimizing their pathologies while preserving their benefits. And we have to understand the purposes our institutions actually serve if we are to have any hope of replacing very problematic arrangements with something better.

P.S. I should define what I mean by “transparent” and “opaque” investment. An investment is transparent if the investor is well informed ex ante of the potential risks of the use to which her capital will be deployed, and fully assents to bear those risks, such that there is little question or controversy ex post over who must bear losses should the investment not work out. An investment is “opaque” if the apportionment of potential losses is not well specified and clearly assumed by capable parties ex ante, so that in a bad outcome, allocation of losses would foreseeably become a subject of conflict and controversy ex post. Investments in which losses will “clearly” be borne by the state are opaque, because the actual incidence of those losses (in terms of taxation, inflation, or foregone government spending elsewhere) are unknowable ex ante and a matter of political conflict ex post. Transparency is ultimately about the quality of loss allocation.

Opacity and transparency are matters of degree, not binary categories. Questions of transparency cannot be resolved by legal formalism, but are matters of practice and expectation. Fannie Mae securities may have specified in big, bold text that they were not obligations of the United States government, but expectations of purchasers of those securities were not consistent with the formal disavowal, and those investors did not fully assent to bear the credit risk. The allocation of losses from Fannie Mae securities was determined ex post by a political process, not ex ante by informed acceptance of risk. So Fannie Mae securities were opaque investments. The degree to which an investment is transparent is contestable, a matter of judgment not a matter of fact. In the previous piece I argue that index funds are now opaque investments in the United States. I’m sure there are others who would dispute the point.

I think the degree to which investment in aggregate is mediated transparently vs opaquely is an important characteristic of a society.

P.P.S. It’s worth noting that, for now, in the US, savers are enthusiastically entrusting their resources to the state and opaque intermediaries. Deposit insurance and modest inflation expectations have been sufficient to prevent commodity hoarding and other nonintermediated, low return means of preserving wealth. For the moment, the bottlenecks to capital mobilization are at the interface of bankers, borrowers, and entrepreneurs, and in the reluctance of government to invest directly. (More fundamentally, perhaps the bottleneck is an absence of the security and demand that might inspire borrowers and entrepreneurs.)


20 Responses to “Is opacity an excuse?”

  1. Foppe writes:

    This is an interesting set of posts, and I appreciate how you’re trying to clarify things that some people (ED) are deliberately trying to obscure. (A shame, that.)

  2. Really, @Foppe, you should do a little more reading before you accuse me of trying to obscure the important issue which Steve has addressed. For one thing, I do not disagree with most of what Steve has said, and I have said so, in print.

    For another, I agree completely with his assertion that An opaque financial system is an argument for vigilant regulation, not deregulation.
    I have said so many times.

    When evaluating an argument, it is always important not to read into it what you expect (and hope?) to find. I suggest you try harder the next time, if you expect to be taken seriously yourself.

  3. Foppe writes:

    ED: As I understand your post linked to above, there are a few things I would classify as (un)intentional cases of obfuscation. :
    1. “Why do we tolerate opacity in our collective social institutions and rent-seeking (if not outright corruption) in the people who work there? Because, I must believe, after thousands of years of experimenting, we have not come up with any better way.”
    2. “we developed these systems together”.

    I’m sure you are quite aware of the fact that over the past century or so we have been making lots of progress wrt democratizing bits of the world. Yes, neoliberals have been enthusiastically trying to roll back/undo a whole bunch of these improvements, and especially over the past 30 years they have succeeded quite well, by moving decision-making power to either non-democratic sites, or supranational bodies (wto,bis, basel committee come to mind), but they have not yet been able to undo the ‘expectation’ of democracy. So why argue that no further progress is possible?

    Furthermore, it in no way follows from the qualitative argument that some degree of rent-seeking is unavoidable that we should leave it as opaque as its rent-seekers deem appropriate. With regard to this point (and counter to “I find it hard to imagine any meaningful function performed by the financial system which can be purified into a transparent, corruption-free zone.”) it also seems worth mentioning that there are quite a few people who are willing to argue that “financial innovation” is a rather overrated activity; so why not create a white-list of allowed kinds of behaviors, while banning the rest? Seems a fairly easy way to manage opacity.

    Lastly, there is the fact that you, in your conclusion, conflate all of the functions performed by “finance” when you say that “we should not throw out “our” baby”. (This might be rhetorical, but it sort of bugs me anyway, especially because of the gratuitous ‘our’; nobody voted on it, and cooperatively run banks behave a lot better while offering most of the important useful functions that other banks do; see contemporary South-American experiments for more.)

    My main objection, however, concerns your tendency to paint the issue in such a black & white fashion (the alternative you reject being ‘total transparency’, and the one you reluctantly adopt being ‘as opaque as its users make it, with the caveat that it must be strictly regulated’). For the reasons given above, I find this extremely unhelpful.

  4. Max writes:

    Steve, would you say that opacity and safety generally go hand in hand? That is, the safest investments are the most opaque, and the riskiest investments the most transparent?

  5. tales writes:

    Most beneficial investors lack the time, knowledge and skills necessary to become reasonably informed of investment risks. In fact, it would be impossible or impractical to “fully inform” them about these risks or to know whether they would hoard if they could be informed. Investors are well aware of this and often employ fiduciary agents. Are these investors are being “conned” when they assume risks unknown and unknowable to themselves but known to the agents? There will always be a grey area here, but the line has clearly been crossed when the agent deceives the investor knowing the investor will suffer as a result.

    Because of the intermediation required, financial services require trust. Without credible agents taking fiduciary responsibilities seriously, society will suffer on many dimensions. Steve seems resigned to a financial world filled with “con” men skilled in getting folks to do what they otherwise wouldn’t whose conduct is somehow restrained by a better form of regulation than we have now. I’m not ready to give up on a financial services edifice where fiduciary responsibilities are at the core of the incentive structures and investors trust agents knowing they’ve been recruited, trained and incentivized to have the best interests of investors and society at heart.

  6. Philip writes:

    I’d just like to congratulate and thank Steve for these posts. They are extremely thought-provoking.

    Two brief thoughts. First, how does all of this relate to Tyler Cowen’s refrain, “We are not as rich as we thought we were”? Does the opacity-creation system have to go into overdrive to compensate for this? Are “collective self-awareness about likely investment returns” and opacity substitutes?

    Second, I hope that at some point Steve will share his thoughts about how (and when and why) the culture within financial institutions evolved as it has. Was it really just a matter of repeating the “greed is good” mantra until it seemed unproblematic, or is it something subtler and easier to self-deceive about? In other words, I for one would be very happy to consume some armchair sociology of the financial industry if it came from Steve (as opposed to many other commentators who strike me as far less credible).

  7. Tom Hickey writes:

    There are good reasons to think that the financial system cannot be adequately regulated. This is not meant to suggest that legislation, regulation, oversight, and legal accountability are entirely worthless. Rather, it simply notices that there are several factors that stand in the way of imposing a solution exogenously, including, cost, the potential for corruption, difficulty of prosecution, and so forth, that experts have listed.

    An adequate solution has be have an exogenous component that exacts a price for bad behavior. It used to be that people in positions of responsibility had a sense of honor as well as of shame and were sensitive to ridicule and shaming for ethical transgression even if they were not illegal. There was also shunning by peers and exile from the profession that were swiftly experienced by those who broke their word, which at one time was one’s bond. Moreover, there was a fiduciary responsibility that management could not avoid in the days of the owner-manager and financial partnerships.

    Now what we hear is not even, “I did nothing wrong,” when someone is found to be either acting unethically or even skirting the law. Rather, it is, “I did nothing illegal,” daring prosecutors to prove something that is very difficult owing to the complexity and cost, as well as the political clout of the accused.

    The problem is an institutional one, having to do with the informal institutional culture and the formal institutional arrangements, as well as the cozy relationship of government and corporations that leads to moral hazard and cronyism.

    What we are dealing with here is perverse incentives that create a selection process that favors the unethical arriving at power and perverse incentives that make it almost guaranteed that this power will be abused for personal gain and for the advantage of cronies (“I’ll scratch your back if you scratch mine”) and minions that are also incentivized perversely (“wink, wink”).

    Unless the perverse incentives are eliminated or at least greatly reduced, no amount of imposed control with be sufficient to prevent wrong-doing. There’s just too much money involved.

  8. zach writes:


    I think your paragraph on culture really gets at the heart of a lot of modern problems. I think it extends beyond just finance. All government supported rent seekers are suffering from it. The ‘music’ industry is fighting for the right to maintain their business model. The MPAA is fighting for the right to destroy the internet. Both these groups are fighting to prevent the public from realizing that they have the ‘Big Meanie’ ability to decide that the ‘rights’ they aren’t in fact rights at all, but gifts the public has agreed should be available to reward content creators. By constantly forcing the action they are preventing people from understanding that the original intent of these gifts was to reward content creators exactly enough so that they would be encouraged to create more for the good of the general public. This extends even further, to the idea that anyone can ‘own’ anything. Not from a marxist view, but from a naturalist view. Ownership is a creation of society, and necessary for governments – including marxism. But it is not a ‘right’ outside of social constructs and governments. As such, social constructs and governments have the ability to modify that right.

  9. Joe Smith writes:

    I disagree with your premise that opacity is necessary so strongly it makes me want to shout rude things at you. Investors are not children to be told comforting lies. Opacity drives sophisticated investors (who are the ones with more money) to the financial sidelines of treasuries.

    No one can fully disclose the risk because no one knows what all the risks are but investment vehicles can still make full disclosure of the objective facts of what they are doing and let the investors decide for themselves. Instead we have a financial system where a major bank conspired with a national government to falsely present national accounts with a result that threatens the political stability of nations and finacial collapse of a continent – and no one is in prison.

    The fact is that sociopaths are drawn to senior management. They have no sense of right and wrong or moral responsibility and cannot be taught it. They cannot regulate their own personal behaviors, never mind their industries. Culture and ideology are no substitute for full and fair disclosure and long LONG prison sentences for those who fail to make full and fair disclosure.

  10. […] Is opacity an excuse? – interfluidity […]

  11. […] “At one extreme of opacity, financial intermediaries simply steal everybody else’s wealth. T… Steve Waldman. No, it isn’t. […]

  12. Peter Kurze writes:


    I agree with you about the value of opacity. If our minds were capable of grasping and quantifying the risks to which we are exposed, most of us could not get out of bed in the morning. We are conditioned by biology or whatever to tune out hypothetical catastrophes and seek positive outcomes.

    But I don’t think the regulatory problem is as hard to solve as you make out if we are willing to entertain obvious but verboten solutions. Okay, so greed is good and drives us forward, but outside certain limits it has the potential to become destructive. It seems like everybody is trying to figure out how to let it run outside the limits where it becomes potentially destructive and find some magic way of preventing the destruction. I don’t understand why people find the idea of limiting income and accumulation through some sort of geometrically progressive tax structure so odious. The idea that it limits any socially useful motivation or activity is just wrong. I don’t care about the redistributive aspect of this nearly so much as I care about incentive structures. A person with a passion to create, who wakes up in the morning with $5M in the bank and income stream of $500K, is still going to pursue whatever it is that makes them tick, even if they know that they can’t earn another nickel. If the thing that makes them tick is just piling up more money, maybe they’ll go do something else. I hope so. The more counter-incentives we throw at greedy sociopaths they fewer of them we’ll have.

  13. Zach writes:

    @Peter Kurze

    In theory I agree with you, the regulation should be easy. In practice, the party that controls the House of Representatives has made opposition to the tax code you recommend part of its foundation.

  14. Peter Kurze writes:


    I don’t disagree. I was not trying to imply that it was politically easy or even remotely feasible in the short run. The main practical problem is that too few people are in favor of it.:) Wayne Gretzky said that a good hockey player skates to where the puck is, but a great player skates to where the puck is going to be. I’m just trying to point out that the current approach to regulatory regimes is an effort to get to where the puck is. In the context of all of the challenges that Steve points out, regulatory capture and all the rest, they’ll never be able to develop a system of rules that will be effective for long. The puck will get moved up the ice. We know what these people are after. We need to get up ice ahead of them and deny them access no matter how they got there.

    It’s no accident that whenever the subject comes up, the ‘free market’ types try to cast it as some Soviet style redistribution from the worthy hard-working go-getters to loafers and worse. What was Rick Santelli’s battle cry: “Who wants to pay off the mortgages of the losers?” Of course I think that argument is bullshit, but there are legitimate questions that need to be asked about the ‘harm’ done to individuals who by luck or accident make huge contributions to common good in a way that would, according to the normal order, result in accumulation of a huge fortune. My contention is that there is some tipping point on the marginal utility of additional wealth beyond which the harm done by restricting income is, in real-life terms, small no matter what the balance sheet says. In the final analysis the purpose of any form of government is to increase the sense of social cohesion among the governed.

  15. […] of feedback and correspondence following my recent posts on “opaque finance” (1, 2, 3). Much of that has been positive, though certainly many readers disagree and dispute my points. […]

  16. mathbabe writes:

    […] then Steve wrote a follow-up post which I really enjoy and has a lot of interesting ideas, and I want to address some of them today. […]

  17. […] is a response to three posts at Interfluidity that argue that banking is essentially a con job.   The quotes here are from […]

  18. […] interfluidity » Is opacity an excuse? […]

  19. Nichol writes:

    Maybe it is more reasonable to say that a large fraction of investors are too ‘lazy’ or ‘uninterested’, or just not expert enough, to do the due diligence job that needed, if banking were organized fully transparently, and not opaque. These people, ie. most people, want somebody that they can trust with their money, to a certain extent. For that service, they’re willing to forego a bit of the advantages of an expert investor in a fully transparent environment, so they don’t have to do the work themselves.

    So opacity isn’t just an excuse, it is also what the customers really want. It is like a doctor-patient relationship: you want the doctor to tell you as much as you can handle, and make the choices relevant to you personally, without having to do all the expert judgment of the situation. There is an inherent inconsistency in such a demand. And in the wrong environment doctors will be allowed, or even encouraged, to make more money by doing many expensive tests and treatments that are not strictly necessary. And patients don’t have the information to say ‘no’.

    So it may be that bankers are con-men that make use of opacity, but their clients are willing to go along with the con, so as not to have to bother about all the gory details.

  20. Elvin writes:

    Isn’t opacity true in a lot of transactions, not just finance. Take buying a car. There are dozens of models to choose from and all sort of variety. The ads on TV and the salesmen tell me how great a particular car is. But as to specific little things, the dealer is deliberately “obscure”: how much is the actual price, what is the service record of prior years, is the car good in the snow, etc. One dealer even winked at me and said that I didn’t really need to put in that high octane gas that was clearly specified on on the gas cap. Ultimately, even after weeks of research and test-driving five or six different models, I’m trusting the dealer and manufacturer that I’m not buying a lemon and will regret the car.

    I can think of lots of goods and services that are opaque and non-transparent. Some of the bigger ones are buying a house, finding a day care center for my kid, picking an insurance policy, deciding which job offer to take, and deciding which employee to hire. Smaller ones are: deciding which dentist to use, which cell phone plan to get, which hotel to book. In all these cases, the seller will deliberately over-promise. I’m an idiot for not being cautious in each case and doing some research to reduce my risks, but I can’t complete eliminate the risk that I’ve been taken or get less than I bargained for.

    So, what is the difference between a broker and a used-car salesman or realtor? Don’t they all have complex, opaque, and non-transparent contracts?