Taming Wild Markets (Part II)

Two regulatory reforms require immediate attention.

One, we must recognize that the very process of financial innovation changes the way people conduct business and therefore, the probability of default.

The lesson for regulation in the future is that appraisal of the incentives, the "moral hazard," created by new products and new contractual arrangements must be a central part of the regulatory process.

Every new financial product should either be registered and publicly discussed for a period before it is released (with regulatory approval), or the inventors should be open to malpractice lawsuits if they choose to release the product without prior notification (for competitive reasons).

Offshore vendors of financial products should be treated similarly to domestic intermediaries.

Just as new construction projects require environmental impact statements, every time a new type of contracts in finance or insurance is introduced, it should first be evaluated through an "incentive impact statement."

Two, every financial product should come with a complete record of who created, sold and resold it.

A home builder can identify the main contractor, the subcontractor who poured the foundation, the plumbers who laid the pipes, the electrical company that did the wiring and the painters who completed the interior.

So too, regulatory authorities should insist that financial intermediaries track the people who produced and sold every loan and every derivative.

Every financial contract should have a transparent history, which would permit the public to discover patterns of failure.

Imagine a builder who put up an apartment block and after five years, the top two floors collapsed, or the electrical system produced chronic fires.

The agency that issued the building permit, the builder, the contractor and the electrical sub-contractor all would likely face intense scrutiny — and some would face lawsuits.

Now imagine a new financial product. It is released to the market with zero testing, is unvetted by public agencies — and has no record of who sold the product, what they told the buyers and where they are today.

The production and distribution of new financial services is as wide open to innovation as if they were spa products with only cosmetic effects.

As the world economy moves steadily away from production of goods in specific geographical locations, into production of services in the electronic ether, it moves away from products that historically have been held to standards by public law and toward activities where the unfettered market rules.

Unfortunately, it is quite clear that the part of the economy where regulation is minimal cannot pursue its activities without creating global problems, reaching businesses and people who never directly touch these new products.

What has become clear over the past few weeks is that financial innovation changes the probability of default.

When underwriters adapted to the fact that they could unload risk on others, through securitization, they shed inhibitions about making dubious loans.

For the issuers of debt, the money was in writing the contracts, not the contracts' long-term outcomes. More deals meant more money, and if a bank in Iceland ended up with the risk, that was not the concern of the person who originated the debt.

The lesson for regulation in the future is that appraisal of the incentives, the "moral hazard," created by new products and new contractual arrangements must be a central part of the regulatory process.

Moreover, the accountability of those who buy and sell financial products must be improved though greater transparency. If we fail to improve regulation, we will go down this path again.

Editor’s Note: Read Part I of this Globalist Paper — which explores more lessons to be learned from the financial crisis — here.