Student Contributor: Tom Gole (Tom is an Australian PhD student in the Harvard Economics Department. He is a Frank Knox Fellow, and holds degrees in Law and Economics from the University of Queensland.)
In a recent paper, Gennaioli, Shleifer and Vishny proposed a model of the role of innovation in causing financial crises. Their basic story is that investors seek a particular type of cashflow, usually riskless, and financial intermediaries create new types of assets that meet those demands. The problem arises when investors neglect the possibility of extreme, but unlikely, negative events: in that case, intermediaries issue too many of the new securities, and when investors receive news that reminds them of the unlikely events, the market crashes as they flee to the genuinely secure assets.
The beauty of this model is that it provides a simple framework for thinking about how to we should regulate the financial industry in the future. At the heart of the story is the idea that financial innovation itself is not always welfare improving, and so in addition to focusing on transparency and leveraging levels, governments should consider regulating forms of financial innovation itself.
What I find interesting about this paper is a second implication: if problems with financial innovation are driven by the local thinking of investors, then we should look closely at how investors form their opinions of the risks they are taking. The obvious targets of such an examination would be ratings agencies, which are already under scrutiny, but I think this approach also suggests that we should think seriously about the communicative role of our regulators. If we can minimise the chance of excessive financial innovation by having regulators remind investors of the range of risks they face, then we might be able to lower the chance of future crises.
This approach is not without precedent: in the early part of the last decade, the Reserve Bank made a number of public warnings about the possibility of a bubble in the Australian housing market, and there’s a reasonable argument the RBA is doing something similar now. That approach stands in fairly stark contrast to the behaviour of the Fed in the build-up of the US housing bubble. It might not be a bad idea for governments and central banks to make public commentary on the state of financial and asset markets a more formal part of the regulatory arsenal in the future
Core Economics 
good post. gut responses: restricting innovation would be a very bad idea. having rules based proto-testing of innovations in, say, the wholesale (ie, sophisticated investor) domain prior to releasing to the retail market is something regulators are already thinking about, for better or worse. josh has suggested similar things.
i have written a lot about the RBA’s jawboning. they have made a bit of a hash of it in the last year in some respects, but generally I am very supportive of the practice and the RBA’s efforts more generally. luci’s speech was the best of the bunch in this respect.
sitting on a beach in bali.
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I think that what the innovation was primarily aimed at was gaming the rating agencies, creating paper that obtained high ratings even though it also had high embedded risks (as Tom describes).
So, perhaps the answer is to regulate the ratings. Perhaps novel securities should not be permitted to be awarded conventional ratings until a thorough, open examination of the risk characteristics has been undertaken: by the regulator or by the agency.
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