Innovation and Regulation in Financial Markets: A Summary of the 2007 Philadelphia Fed Policy Forum

By Mester, Loretta J. | Business Review (Federal Reserve Bank of Philadelphia), Fall 2008 | Go to article overview

Innovation and Regulation in Financial Markets: A Summary of the 2007 Philadelphia Fed Policy Forum


Mester, Loretta J., Business Review (Federal Reserve Bank of Philadelphia)


The planning for our 2007 Policy Forum began well before the onset of the financial market disruptions in the summer of 2007. By the time of our conference on November 30, 2007, the timeliness of the topic--innovation and regulation in financial markets--could not be denied. The continued problems in the financial markets, which began with subprime mortgages but expanded to other financial instruments, the ensuing spillovers from the financial market disruptions to the real sector of the economy, and the steps taken by the Federal Reserve and the U.S. Treasury to help ensure financial stability have led to various proposals for new regulatory structures to help limit systemic risk in our evolving financial markets. Given the importance of the financial markets to our economy, it is vital that we get the reforms right. Better understanding of the pros and cons of financial innovation and financial market regulation--the topic of our 2007 Policy Forum--is an important step in doing so.

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Charles Plosser, president of the Federal Reserve Bank of Philadelphia, provided opening remarks and outlined the Policy Forum's three sessions. He pointed out that whenever there is innovation, regulation often follows. By its very nature innovation is a messy process with winners and losers. Market discipline is an important part of the process, helping to weed out flawed from beneficial innovations. But the fact that there are winners and losers sets up an environment that is ripe for regulation.

Our first session addressed issues in corporate governance. In financial markets, the innovation of high-yield bonds contributed to a boom in corporate restructuring and buyouts, which in turn led to changes in corporate governance structures. The boom and bust in technology stocks highlighted some of the shortcomings of these new governance structures, leading to the passage of the Sarbanes-Oxley Act in 2002. Some have argued that Congress was too quick to act. Plosser asked whether there were lessons to be learned for our current situation.

Our second session examined several innovations in financial markets and the role regulation may play in helping innovations yield more efficient economic outcomes. Regulation and innovation are interrelated--regulation, or the desire to evade regulation, can help spur innovation. Some of these innovations may be inefficient and some may fail, causing painful corrections. The current situation is a case in point. Better understanding of the interplay between innovation and regulation may help us avoid these types of situations in the future.

Our third session covered the role of regulation in financial markets. Technology can spur innovation, but regulation also affects the way markets function. For example, different regulatory structures can affect the competitiveness of financial markets. As Plosser pointed out, there are subtle trade-offs in the benefits and costs of particular types of regulation, and these have implications for the health of financial markets. Thus, assessing the costs and benefits will be an important part of redesigning our financial market regulatory structure.

CORPORATE GOVERNANCE (1)

Roberta Romano, of the Yale University Law School, began the first session with a discussion of the Sarbanes-Oxley Act and its effect on corporate governance. Romano pointed out that the act was passed swiftly with little opposition, but since then, some flaws in the act have become apparent and four major commission reports on the act have been published. (One of these, by the Committee on Capital Market Regulation, was discussed by committee co-chair R. Glenn Hubbard in the final session of our Policy Forum.) Two criticisms are that the costs of compliance are disproportionately high for smaller public firms and that there has been an adverse impact on U.S. capital markets' competitiveness. …

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