It is now believed that in the years preceding the recent financial turmoil, banks took excessive risks that weren’t disclosed, and regulators were only able to intervene after widespread panic had brought the system to its knees.

More transparency, it is argued, could have allowed the market to discipline such excessive risk-taking behavior. Yet there is evidence that, in many situations, greater disclosure may not be good corporate governance or even desirable.

In the post-crisis regulatory environment, companies are under pressure to disclose more. The Financial Accounting Standards Board and the International Accounting Standards Board have been trying to improve both U.S. Generally Accepted Accounting Principles and the International Financial Reporting Standards, and make the two sets of accounting rules fully compatible. The goal is to produce a single set of international conventions that achieve a high degree of reporting transparency.

The benefits of more transparent reporting seem obvious: Companies with a high degree of disclosure would allow outsiders to exercise better market discipline, which, in turn, would improve resource allocation in the economy.

However, the view that greater transparency enhances market discipline and therefore economic efficiency holds true only in a “Robinson Crusoe” economy, that is to say one in which a single decision maker is learning about a company whose decisions are taken as given and whose future cash flows or economic fundamentals are therefore fixed.

Complex Economies

In such an environment, more information is desirable as it leads to more precise beliefs about fundamentals. Most companies don’t operate in such an economy. Instead, they function in environments in which information has strategic consequences. These are economies where there are limitations to market discipline that need to be understood by those who are setting reporting standards.

I will draw upon two insights from economic theory to illustrate why greater transparency isn’t necessarily a panacea:

-- In a second-best environment -- one plagued with multiple imperfections -- simply removing one flaw without addressing the others won’t necessarily improve the system as a whole. In fact, it is possible that removing an imperfection -- for example, information asymmetry, or the informational advantage held by insiders -- could magnify the negative effects of the remaining imperfections to the detriment of overall welfare.

-- Companies aren’t passive technologies, but are managed by insiders who respond to changes in the disclosure environment.

Market Price

Here is an example of how these two insights apply: Fair-value accounting is one of the ways in which standard setters are striving to achieve reporting transparency. This method uses market inputs or prices to value balance sheets every reporting period as opposed to using a historical-cost system where balance-sheet claims are kept at their acquisition values but not marked to market.

Standard setters have argued that fair-value accounting would alleviate information asymmetry between insiders and outsiders. Yet insiders of many financial institutions have complained that rather than enhancing market discipline, fair-value accounting would introduce volatility into their reported numbers, thereby inducing suboptimal decisions.

Illiquid Trades

These insiders argue that a large proportion of the assets of financial institutions consist of claims that aren’t standardized and as a result don’t trade in deep and liquid markets. Rather, they trade in illiquid and incomplete venues such as over-the-counter markets, where prices are determined via a bilateral trading and matching process.

Given that the assets of financial institutions trade in markets with multiple frictions, our first insight tells us that it isn’t obvious that reducing information asymmetry via fair-value accounting is desirable.

The attached figure illustrates the dual role of prices in the economy: Prices not only reflect the underlying fundamentals, but also influence the actions of companies, which, in turn, affect prices.

Our second insight tells us that, in relying on market prices, there is the possibility of the emergence of a feedback loop in which the anticipation of short-term price movements may induce insiders of financial institutions to respond in ways that amplify these price movements.

Feedback Effect

The more sensitive financial institutions are to short-term price changes -- perhaps because of illiquid and incomplete markets -- the stronger the feedback effect. When such effects are strong, the decisions of financial institutions are more likely to be based on second-guessing of their competitors than on perceived fundamentals. Thus, the accounting norm itself may become the source of additional, internally produced volatility, as opposed to volatility that reflects the underlying fundamentals.

Put differently, in trying to enhance market discipline, reliance on market prices via fair-value accounting weakens market discipline.

The recent financial crisis is a case in point. When liquidity started drying up, some banks began to sell their illiquid loans, putting downward pressure on prices. Anticipating the fall in prices, other banks started selling their loans and prices declined further, leading more banks to sell their loans. The effects were so severe that prices no longer reflected fundamentals but rather the amount of cash or liquidity available to buyers in the market.

Information Asymmetry

If information asymmetry were the only friction between insiders and outsiders, the feedback effect would be weak or even nonexistent and prices would play their proper role of providing market discipline. But in strategic environments with multiple imperfections, market participants who try to extract the informational content of current prices distort this very content by adding an extra, nonfundamental component to price fluctuations.

As a result, the choice of an appropriate measurement regime amounts to a dilemma between ignoring price signals -- as one would in a historical-cost regime -- and relying on their degraded versions, as would be done in a fair-value regime.

In their quest for greater transparency, standard setters should be mindful of the limitations of market discipline. When there are multiple imperfections in an economy, removing just one need not always improve welfare.

Accounting measurement rules can have substantial real effects, and understanding these real effects would go a long way toward addressing the policy implications of increasing financial reporting transparency.

(Haresh Sapra is professor of accounting at the University of Chicago Booth School of Business, and a contributor to Business Class. The opinions expressed are his own.)

To contact the writer of this article: Haresh Sapra at Haresh.Sapra@chicagobooth.edu

To contact the editor responsible for this article: Max Berley at mberley@bloomberg.net.