An international group of researchers, including Prof. Robert Stoumbos, Chair of Excellence in Financial Reporting at ESSEC Business School, explore the critical subject of financial transparency in the context of the unregulated 1890s streetcar industry to challenge the theory of immediate disclosure from a bounded rationality and learning perspective.

A Streetcar Named Disclosure by CoBS Editor Antonin Delobre and Robert Stoumbos. Related research: Bourveau, T., Breuer, M., & Stoumbos, R. (2025). Learning to disclose: Disclosure dynamics in the 1890s streetcar industry. The Review of Financial Studies, 38(9), 2602. https://doi.org/10.1093/rfs/hhaf033.

If Homo Economicus, that perfectly rational agent of classical economics, truly existed, financial transparency would be instantaneous. Information would flow freely, driven by the sheer logic of market forces. However, as Herbert Simon famously theorized with the concept of “bounded rationality,” human agents are not optimizing machines; they are limited by their cognitive resources.

The electric streetcar industry of the 1890s offers a fascinating historical laboratory to test this friction between theoretical rationality and human reality. In this analysis, Prof. Robert Stoumbos et al look at how companies learned to be transparent in an era before the Securities and Exchange Commission, and why the “invisible hand” sometimes needs a helping brain to ensure the flow of information.

The spark of a new industry and the birth of disclosure

In the late 19th century, the transition from horse-drawn carriages to electric tramways transformed urban transport into a capital-intensive industry. This massive electrification required colossal investments, drawn from a dispersed pool of investors across the United States and Europe. Yet, prior to 1900, the regulatory landscape was a blank slate. There were no federal or state laws mandating the publication of earnings, and the New York Stock Exchange would not impose such rules until the turn of the century.

To bridge this abyss of information, the financial press—specifically the Commercial & Financial Chronicle—stepped in, publishing voluntary supplements. In this environment, the ratio of earnings to invested capital became the “North Star” for valuation and they rely on three institutional pillars: companies knew their own profitability, they cared about their valuation to raise funds, and disclosing via newspapers was essentially free.

The theory of unravelling

According to the classical “unravelling theory” (popularized by Grossman and Milgrom in 1981), total transparency should be the default equilibrium. The logic is ruthless: investors are naturally skeptical. If a company remains silent, the market assumes the worst—that its profitability is average at best.

Therefore, high-performing firms have a strong incentive to disclose to distinguish themselves. Once the best firms disclose, the “average” of the remaining silent pool drops. The “best of the silent ones” then feel the pressure to disclose to avoid being lumped in with the worst. Iteratively, this unravels the silence until everyone discloses, except perhaps the absolute worst performer.

However, history defies this neat mathematical model. The data from 1894–1896 reveals an initial failure of this theory. When the first specialized supplement was published in 1894, only 72% of companies disclosed their earnings. A third of the industry remained silent despite needing capital.

The four levels of thought or the incentives to disclose

Why did companies act against their own interests? The answer lies in bounded rationality, modelled by what the researchers call “level-k thinking.” This framework categorizes strategic sophistication into levels:

• Level 0 (The Non-Strategic): These firms act randomly. They disclose or withhold information without regarding their actual profitability.
• Level 1 (The Basic Strategist): These firms assume everyone else is Level 0. They only disclose if their profitability is above the global average.
• Level 2 (The Anticipator): These firms anticipate that Level 1 firms will disclose. They realize that silence signals weakness, so they disclose even if they are below the global average, provided they are better than the remaining silent pool.
• Level 3 (The Rational Agent): This is the domain of total rationality, where the unravelling theory holds true.

The analysis shows that in 1894, nearly 50% of companies were operating at Level 0—essentially making random decisions. Only 25% possessed the full strategic sophistication of Level 3. The most profitable firms disclosed early, but cognitive limitations held back the less sophisticated ones who would have actually benefited from speaking up.

Learning by doing

The market, however, is a harsh but effective teacher. While the initial disclosure rate was 72%, it surged to 95% in less than two years. This convergence suggests a rapid learning process. Companies observed the market’s reaction—specifically that capital investment increased significantly around the time of disclosure—and updated their beliefs.

The data indicates that a firm operating at Level 0 in one period had a 68% chance of advancing to Level 1 in the next. The Chronicle itself chided silent firms, labelling their secrecy as “short-sighted” and a betrayal of their own interests. Ultimately, the mechanism driving transparency was not a reduction in the cost of reporting, but a collective upgrade in “strategic intelligence.”

To regulate or not to regulate disclosure?

Prof. Stoumbos et al’s research shows that disclosure mandates make little difference in the medium to long run, after firms and investors have learned the unravelling equilibrium. The mandate only bites for the few remaining firms that stay silent. And for these few silent firms, the costs of the mandate may outweigh the benefits.

Indeed, the silence of these firms will not trick investors who understand the unravelling equilibrium, since they will simply give the silent firms low valuations. Moreover, the fact that the silent firms continue to stay silent in the face of these low valuations suggests that their costs of disclosure outweigh the benefits (e.g., Verrecchia, 1983; Wagenhofer, 1990). On the other hand, a disclosure mandate will force the silent firms to incur these costs, making them worse off. For the mandate to be justified, there must be benefits to others—positive externalities—that outweigh these costs. 

It is unlikely that the silent firms’ own investors receive positive externalities from a disclosure mandate. Indeed, they are likely to be worse off.

Under the equilibrium, these investors already give the firms a low valuation, meaning that they are not being fooled by the lack of disclosure. Forced disclosure will likely just confirm this low valuation, and in addition will compel the firms to incur costs. As such, these costs will lower the value of the firms for the investors, making the investors worse off. Thus, any positive externalities to justify the disclosure mandate will likely need to be found elsewhere.

Useful links:

• Link up with Prof. Robert Stoumbos on LinkedIn
• Read a related article: Exploring the willingness of shareholders to pay for disclosure
• Discover ESSEC Business School France-Singapore-Morocco
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