M]ore than anywhere else in the world, the United States remains a place where a visionary can risk everything on a dream or an idea and have a fair chance of fighting for it.  And he or she can do so in an environment where the investors who underwrite that dream are protected. -SEC Chairman, Elisse Walter

 

How do you build a financial regulatory system that constrains risk-taking but still allows financial institutions and others to take innovative chances?  This question is at the very heart of financial regulatory reform world wide. No regulator wants to pull the reins so tight that financial innovators will take their creativity elsewhere.  But at the same time, investors deserve some protection in return for their finance, and taxpayers should no longer be expected to bail out the risk takers.  The financial crisis revealed a regulatory regime that was improperly focused, mismatched with what financial institutions were doing outside traditional banking, and unable to keep pace with technological and other innovation. It demonstrated that regulators had placed too much confidence in the capacity of firms to measure and manage their risks. Post-crisis, regulators found themselves faced with the choice of regulating in a highly prescriptive New Deal manner or a more prudential and flexible manner.  Their goal: "to maximize stability and to minimize risk, to enhance capital requirements, to minimize moral hazard and to increase scrutiny by regulators who collectively can see across sectors, grasp their interrelated operations and diagnose problems that have the potential to grow and spread."  All this, while at the same time being nimble enough to permit, yet understand, monitor, and react to new innovations.

 

The systematic effect of money market funds on the wider financial system is a topic of hot debate, with finance ministers, regulators, and standard setting bodies all over the globe weighing in. The New York Federal Reserve Bank is the latest to do so, asking "does money market fund intermediation make the banking system inherently unstable?" The New York Fed's latest paper, "Money Market Funds Intermediation, Bank Instability, and Contagion," addresses the question by comparing two market structures – direct finance, where investors deposit directly into the banks, and money market fund intermediation, where the relationship between investors and banks is intermediated through money market funds. The paper concludes that, because money market funds are themselves subject to runs, the intermediation they provide to investors makes the financial system more fragile, and acts as a source of contagion when a run occurs.