New financial instruments played a role in the financial crisis. However, attempting to regulate such innovation is not the most promising approach for preventing crises in the future.
In the housing market in the United States (and in many other countries as well), the period from roughly 2000 through 2006 was one of financial euphoria. As John Kenneth Galbraith pointed out in 1990 in his book, A Short History of Financial Euphoria, such periods tend to foster innovations that at the time seem more magical than is in fact the case.
Rather than acting as a brake, regulators were swept up in the latest euphoria. In a speech that he gave in June 2006, Federal Reserve Chairman Ben Bernanke said:
Banks and other market participants have made many of the key innovations in risk measurement and risk management, but supervisors have often helped to adapt and disseminate best practices to a broader array of financial institutions.
As it turns out, much of the financial innovation of recent years was designed to minimize the effect of regulatory requirements on bank capital. This "regulatory capital arbitrage," as it was termed by both regulators and market participants, drove much of Wall Street's innovations of the past 10 years.
Under the international capital standards known as the Basel Accords, particularly rules implemented in 2001, AAA-rated securities were granted exalted status, stimulating the creation of AAA-rated securities out of lower-quality assets, such as sub-prime mortgages.
Usually, markets perform well at sorting out innovation. Innovations that are socially beneficial earn sustainable profits, while innovations that provide no social benefit fall by the wayside.
However, markets did not perform well during the recent euphoria. First, many of the innovations were profitable not because they added social value but because they exploited regulatory anomalies. Second, the companies that lost money on these innovations were not allowed to fall by the wayside — instead, they were bailed out.
Many pundits claim that we allowed the financial system to be self-regulating during the euphoria. This is emphatically not the case. Without the anomalies created by the Basel capital regulations, the financial system would not have rewarded these innovations.
In a self-regulating system, investors who held debt in Freddie Mac, Fannie Mae, or large banks would have put pressure on those companies to rein in their risk-taking, rather than counting on bailouts.
Some day, we are bound to experience another episode of financial euphoria with its own innovations, and in that environment regulators are likely to be just as unable to foresee the consequences. Instead of putting our faith in regulation to provide a fool-proof financial system, we should be focusing on two things.
One is to phase out Fannie Mae, Freddie Mac, FHA, and other agencies and policies that promote excessive debt finance for housing.
The other is to put more burden on the private sector to bear the cost of the failure of financial institutions. I recommend breaking the 10 largest financial institutions into about 40, and I also recommend trying to clarify the order in which creditors will be paid off in the event of a bank failure.