The Future of Financial Services Regulation

Sometimes it is good to remember some basic notions…

Some General Principles We must begin with an understanding of the role of financial markets in our economy. It is hard to have a well-performing modern economy without a good financial system. However, financial markets are not an end in themselves but a means: they are supposed to perform certain vital functions which enable the real economy to be more productive, including mobilizing savings, allocating capital, and managing risk, transferring it from those less able to bear it to those more able. In America, and some other countries, financial markets have not performed these functions well: they encouraged spendthrift patterns, which led to near-zero savings; they misallocated capital; and instead of managing risk, they created it, leaving huge risks with ordinary Americans who are now bearing huge costs because of these failures. These problems have occurred repeatedly and are pervasive, evidence that the problems are systemic and systematic. And failures in financial markets have effects that spread out to the entire economy. We thus have to understand why markets have failed so badly and what can be done about these failures. Markets only work well when private rewards are aligned with social returns. Incentives matter, but when incentives are distorted, we get distorted behavior. In spite of their failure to perform their key social functions, financial markets have garnered for themselves in the US and some of the other advanced industrial countries 30% or more of corporate profits—not to mention the huge compensation received by their executives. But the problem with incentive structures is not just the level but also the form—designed to encourage excessive risk taking and short-sighted behavior. From: Joseph E. Stiglitz: Testimony on "The Future of Financial Services Regulation" pdf