Regulators Need to Catch Up to Financial Innovation

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When Paul Volcker challenged a room of bankers to provide a single shred of unbiased evidence that financial innovation has led to economic growth, he gave a powerful voice outside the U.S. administration to a concept that is gaining credence throughout the world.

Eight months ago, Charlie McCreevy as the EU commissioner for internal market and services stated in a New York Times interview that "there is no doubt that some of the so-called innovation in financial products was more about opaqueness and about trying to turbo-charge risk to deliver maximum returns for the seller while transferring concealed layers of risk to the buyer." [emphasis added]

Financial innovation seeks to shroud a product in opacity so as to maximize the profitability to the seller and Wall Street trader.

The question a systemic risk regulator needs to ask is, "How do we slow the pace of financial innovation so that regulation can effectively protect us from the disastrous effects when financial innovation fails miserably?"

Richard Field of the structured finance consulting firm, TYI, LLC, believes that the most effective means of slowing financial reform so that regulators can effectively discharge their duty to protect the public is to require that a financial product should not be approved for sale until the back office can effectively transmit granular data on a daily basis to a central database administered for the government by an independent, third party. As long as the product is opaque to regulators and the back office is unable to produce such granular level data for the systemic risk regulator, the product should not be permitted by the systemic risk regulator to be sold or purchased by regulated entities. The financial innovation machinery will be slowed down to a pace that regulators will be able to handle.

A transparency database is not a new concept, by the way. As early as August 2007, former Treasury official Phillip Swagel propounded the idea that such a database could help to alleviate the incipient credit crisis by giving regulators [and ultimately investors] access to granular level data as to the loans underlying securitized assets.

Unfortunately, that idea was not embraced by bankers, regulators or central banks.

As Mark Gilbert wrote yesterday for Bloomberg:

"The financial authorities appear to have missed a golden opportunity to force transparency on the securitization market, where different kinds of debt are bundled together in packages that can be sliced, diced and resold.

Central banks have been the only buyers of such debt for months, after the subprime crisis revealed the toxicity of what lay beneath the misguided AAA ratings slapped on many asset- backed securities. As lenders of last resort, the Federal Reserve, the European Central Bank and the Bank of England could have forced the banks they funded to start giving granular detail on every individual loan being securitized." [emphasis in bold added]

The opportunity to protect investors, save taxpayers' money and insulate the economy from failed financial innovations should not be squandered.

Disclosure: No stocks mentioned

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