Regulating for Financial System Development, Financial Institutions Stability, and Financial Innovation

Abstract

Financial innovation is inextricably tied to asymmetric information and therefore sets the stage for financial crises. Over history, every truly meaningful crisis has had elements of asymmetric information, particularly affecting innovative financial instruments that are primary market liabilities. But financial innovation, by definition, occurs outside the regulated financial sector. Indeed, that is often the point of financial innovation! Hence, limiting regulators' scope of supervision to one narrow legally-defined sector of institutions sets a natural stage for regulatory arbitrage and crises. In such a system, crisis will always "surprise" supervisors, for whom financial innovations outside their narrow legally-defined charge do not exist. Everything will look like systemic risk, merely because banks reside in a financial system! Today, off-balance sheet structured finance-based funding, the regulatory approval of banks' use of credit default swaps for hedging capital needs, and the preponderance of non-bank subsidiaries in bank holding companies after Gramm-Leach-Bliley led to multiple sources of unrecognized risks that took regulators by "surprise," not because they were unknown but because regulators refused to look outside their narrow charges to see the wider financial system. Similarly, however, any attempt to change regulations will inextricably affect other non- or differently-regulated institutions, thereby leading to "unintended" (not unavoidable) consequences.

Keywords: financial engineering, financial innovation, financial regulation, structured finance, securitization

JEL Classification: G2, E5, N2