Nobel laureates Myron Scholes and Joe Stiglitz have been debating the question of regulation for financial services on Economist.com. Its fascinating, and not as clear as one would think.
For example, Scholes writing against additional regulation, notes
And, in particular, since successful innovations are hard to predict, the infrastructure necessary to support innovation needs to lag the innovations themselves, which increases the probability that controls will be insufficient at times to prevent breakdowns in governance mechanisms.
His point being that additional regulation will only deal with what we have already recognised as a problem. In the case of sub-prime mortgages, and lack of adequate equity in banks to address their loan loss problems, the problem is known, and its too late to solve it with regulation.
If you agree that innovation is the only means to sustained new economic growth as Link Exchange offers, then by definition new regulation will always fail because it cannot anticipate the next innovation, therefore its only solution will be to stop innovation.
How do you solve a problem like regulation? | Economist Link Exchange
Looking at the recent and explosive growth of some financial derivatives, I wonder if something Schumpeterian occurred in financial innovation. Perhaps too much was invested in these products, thanks to an incomplete understanding of them and the risks they posed. Schumpeter predicts that such investment, in any industry, inevitably leads to a contraction.
On the other hand, innovation is ultimately the only sustainable driver of long-term growth. It also, by definition, causes market fluctuations. Policies aimed at undermining innovation hinder an industry’s ability to compete globally.
Relevance to Bankwatch:
Its hard to see how banks will be very innovative under the current climate of expected regulation, combined with government inclusion on bank boards.
By definition, the primary innovation must appear in non-traditional financial services, but as we see with social lending, this causes new sets of issues for regulators, and businesses, as they try to apply old rules to new services.
All to say new regulation, must be considered carefully to avoid the risk of unintended consequences.
Bankwatch 
It’s certainly a complex area.
Online retail markets seem best served by facilitative regulation that evolves bottom up, rather than prescriptive, top-down regulation. The latter tends to stifle innovation and competition by favouring incumbents with sunk compliance costs and lobbying programmes, and it is difficult to influence and change once in place. The former is more flexible and takes many alternative forms, like co-regulation, self-regulation and may involve a wait-and-see approach to markets that are rapidly evolving.
But this is a comparatively gentle debate amongst common lawyers. As I’ve blogged before (http://sdj-pragmatist.blogspot.com/2008/09/civil-law-view-of-states-role-slows.html), the civil law view is that the role of law is to tell people what they’re entitled to do. So regulation is seen as a catalyst for markets. That definitely hasn’t worked in relation to cross-border retail markets in the EU.
It will be interesting to see what regulations are imposed on social or peer-to-peer lending.
Speaking of regulation the same debates are going on right now in the payday loan world. Ohio and Arizona have votes coming up in November that will potentially rid the states of payday loans. While I don’t really agree with traditional payday lenders, I think the government can make things even worse.
@Jared … I assume you are connected to that industry. In Canada the legal system has clearly differentiated, and social lending is not in the category of payday lending. Social lending is being governed by securities regulation.
Colin
while the wallnut of social lending is subject to the sledgehammer of securities regulation in the US (and Canada, as you point out), in the EU it is generally treated simply as consumer credit. That is a far more proportionate regulatory approach that has fostered real innovation – very simple, direct, low cost loans to borrowers at great returns to lenders – rather than requiring the facilitator to engage in an expensive registration and, worse, the charade of borrowing money from the lenders only to lend it to borrowers.
Of course, that’s not to say that all consumer credit is the same as payday loans. There is a place for short term, low value loans at reasonable rates. But borrowers must not be allowed to “roll-over” those loans to create large balances over longer terms than the rates are geared for – that’s a slippery slope.
Simon … the securities vs consumer debate appears to be over in North America. However one would think that given the innovation intrinsic in social lending that it would bring some challenge to either.
In any event, the evolution will be interesting.
I’ve met people from the other p2p lenders in London, and regulation is something that’s genuinely troubling for people. Fortunately, the UK is biased towards letting “consenting adults” do as they please, provided you can find the right form. Got that horrible might-go-to-jail-factor around it regardless though… 😦
Implicitly the laws seem to assume that there’s an ins-intrinsic difference between public securities [bearer notes circulated by men in the City wearing bowler hats], and private financial contracts [Midlands businessmen signing a business loan in a pub over a basket of chips]. But technology has made blurring that line so much easier.
In my opinion, the crack in the system for p2p lenders is making their transactions ones between knowledgeable parties, so that they’re treated as private credit deals. Of course, my main professional skills are in web development and hostings, so I’d put very little store in my own opinions 🙂
More generally, the rules that were bent to give us the current crisis were about bank capital. Rationally banks ought to be allowed to carry on innovating all they like, provided they keep safe assets around to back their deposits. It’s a pity it’s going to be used as stick to beat banks over every perceived fault.
@Thomas .. thoughtful and well made point regarding private and public loans. Time will tell.