How to Prevent the Next Financial Crash

MoneyWatch's Eric Schurenberg talks about the principles that should be considered when Congress starts writing legislation for a new regulatory regime. He says, accountability, and the acceptance of uncertainty should be at the top of the list.

How to Prevent the Next Financial Crash One result of the crash, clearly, will be a new system of financial regulation. As you probably noticed, our 70-year-old system is no longer up to the task of policing things like derivatives and the so-called shadow banking system. And the market itself, contrary to the dogma of the past 20 years, isn't capable of policing itself. Fortunately, people much smarter than I will be writing the details of the new system but it seems to me like whatever new regulatory regime we have, it would be nice if it returned a few principles to prominence. First, accountability. The sub-prime crisis could not have happened if the firms that originated high-risk mortgages had been on the hook if the mortgages didn't pay off. Instead, they were able to pass the hot potato of default risk down the line. Yes, financial firms that take risks with other people's money should be rewarded if the bets pay off but they should also have to pay the price if they don't. Second principle, acceptance of uncertainty. Underlying the financial crisis was the assumption, which is built into a lot of Wall Street financial models, that housing prices simply couldn't collapse nationwide. Regulation must make sure that the system has sufficient margin of error that it can survive when things don't turn out as expected, just as you need to do in your own personal finances. The system needs to acknowledge that improbable does not mean impossible. And in the long run, the improbable is almost sure to happen. Finally, everyone needs to understand why regulation is needed. It's not because regulators can foresee every new circumstance; they can't. That's why we have markets. But markets inevitably fail because participants inevitably give in to emotional folly. You need both markets and rules because circumstances always change and human nature never does.