Abstract

http://ssrn.com/abstract=1894105
 
 

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Fragmentation Nodes: A Study in Financial Innovation, Complexity and Systemic Risk


Kathryn Judge


Columbia Law School

January 24, 2012

Stanford Law Review, Forthcoming
Columbia Law and Economics Working Paper No. 406

Abstract:     
This Article presents a case study in how complexity arising from the evolu- tion and proliferation of a financial innovation can increase systemic risk. The subject of the case study is the securitization of home loans, an innovation which played a critical and still not fully understood-role in the 2007-2009 financial crisis. The Article introduces the term ― fragmentation node‖ for these transaction structures, and it shows how specific sources of complexity inherent in fragmentation nodes limited transparency and flexibility in ways that undermined the stability of the financial system. In addition to shedding new light on the processes through which financial innovations become so complex and how that complexity contributes to new sources of systemic risk, the Article considers the tools regulators will need to tackle these sources of systemic risk. The policy analysis shows that disclosure, a tool commonly used in financial regulation, will not suffice. At times, regulators should target these new sources of systemic risk directly by seeking to reduce the length and complexity of the chain connecting investor and investment. The Article suggests some modest steps regulators could have taken prior to the 2007-2009 financial crisis, such as a transaction tax targeting serial fragmentation nodes, to illustrate how such reforms might work in practice. It also explains why the dynamics revealed in this case study are almost certain to arise again, even if in slightly different form.

Number of Pages in PDF File: 69

Keywords: MBS, CDO, financial regulation, securitization, systemic risk, complexity, innovation, fragmentation, foreclosure, disclosure

JEL Classification: D70, D74, D81, D83, E44, G12, G14, G38, K22, L22

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Date posted: July 29, 2011 ; Last revised: January 25, 2012

Suggested Citation

Judge, Kathryn, Fragmentation Nodes: A Study in Financial Innovation, Complexity and Systemic Risk (January 24, 2012). Stanford Law Review, Forthcoming; Columbia Law and Economics Working Paper No. 406. Available at SSRN: http://ssrn.com/abstract=1894105

Contact Information

Kathryn Judge (Contact Author)
Columbia Law School ( email )
435 West 116th Street
New York, NY 10025
United States
HOME PAGE: http://www.law.columbia.edu/fac/Kathryn_Judge
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