Financial Engineering and Engineering of Financial Regulation: Guidance for Compliance and Risk Management

Abstract

As observed in at least the last two decades, financial engineering has not only changed the way in which business is conducted in the finance world, but also the daily life of the average citizen in the leading economies. Structured products have been deemed weapons of mass destruction in some post-crisis comments, but it is fair to say that few people could understand the nature and risks of these instruments before the crisis. In this paper, the author analyses how regulators failed to understand/manage the risks of financially engineered products during/before the global financial crisis. After defining the risks/benefits, the measures to enhance good regulatory governance in general and hence engineered products also are discussed. It is concluded, first, that engineered products have important benefits for the global economy, but that the regulatory/supervisory structure should be improved for better firm/system-wide risk management. Secondly, four components are recommended to improve the prudential regulatory/supervisory framework: to employ timely, effective action to balance sheet problems, to increase the effectiveness of firm/industry-wide risk management, to improve the independence and quality of prudential regulation and to increase the accountability of supervisors.

Keywords: financial engineering, structured finance, financial crisis, risk management, regulation

JEL Classification: G32, G01, G24, G38