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

16 Pages Posted: 23 Apr 2009 Last revised: 24 Jun 2009

See all articles by Joseph R. Mason

Joseph R. Mason

Louisiana State University - Ourso School of Business; University of Pennsylvania - Wharton Financial Institutions Center

Multiple version iconThere are 2 versions of this paper

Date Written: April 17, 2009

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

Suggested Citation

Mason, Joseph R., Regulating for Financial System Development, Financial Institutions Stability, and Financial Innovation (April 17, 2009). Available at SSRN: https://ssrn.com/abstract=1393409 or http://dx.doi.org/10.2139/ssrn.1393409

Joseph R. Mason (Contact Author)

Louisiana State University - Ourso School of Business

2900 Business Education Complex
Baton Rouge, LA 70803
United States
202-683-8909 (Phone)

University of Pennsylvania - Wharton Financial Institutions Center ( email )

3641 Locust Walk
Philadelphia, PA 19104-6218
United States

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