Financial Innovation and Regulation
By Arnold Kling
While I was at the beach, the last two essays in my series on finance came out. The first one discussed financial innovation. (note: URL corrected 8-14)
The previous essay described how the Capital Asset Pricing Model (CAPM) says that there is no reward for taking idiosyncratic risk. Everyone should hold the same market portfolio. No one should specialize in holding specific types of risk.
In practice, risk specialization is the rule rather than the exception. One way to understand financial innovation is that it serves to bring us closer to a financial system in which risks are spread and the advantages of diversification are achieved.
The next essay looks at Financial Regulation.
Private financial markets are not there to cause risk. There is no need for politicians to presume that their services are needed in order to control private-sector risk-taking.
Private financial contracts are not there to cause moral hazard. Private contracts evolve in an attempt, given the state of technology, to find the most efficient resolution of the conflict of interest between managers and shareholders. Legislative rewriting of such contracts does not advance the public interest.
It is legitimate to want to protect gullible investors. People who deliberately give advice in bad faith ought to face prison. People who give advice in good faith should have their backgrounds and track records disclosed. One may hope that disclosure will ultimately reduce the extent of bad advice given unknowingly.
I took a vacation from blogging, but my co-blogger, at the same beach this week, promises to keep working. Go Bryan!