Document Type

Working Paper

Publication Date

2017

Abstract

Financial regulations often encourage or require market participants to hold particular types of financial assets. One unintended consequence of this form of regulation is that it can spur innovation to increase the effective supply of favored assets. This Article examines when and how changes in the law prompt the spread of “investor-driven financial innovations.” Weaving together theory, recent empirical findings, and illustrations, this Article provides an overview of why investors prefer certain types of financial assets to others, how markets respond, and how the spread of investor-driven innovations can transform the structure of the financial system. This examination suggests that investor-driven innovations can enhance efficiency and provide other benefits, but they can also increase complexity, interconnectedness, and rigidity in ways that render the financial system as a whole more fragile. This Article thus draws attention to a core mechanism through which legal changes affect the structure and resilience of the financial system. This Article provides a framework for identifying the regulatory changes most likely to trigger investor-driven innovation, a critical first step toward improving rulemaking to reduce the likelihood of unintended consequences. The framework focuses attention on the need to develop an appropriate baseline when assessing the impact of an intervention and the need to cover the costs of innovation. This frame reveals that the regulations often blamed for contributing to bad forms of innovation are probably less transformative than commonly believed. Meanwhile, interventions outside the current debate could have important systemic effects. The main policy implication is that, when the framework warrants, regulators should assess how a proposed rule change is likely to impact investor preferences, the types of innovations that might arise or spread in response, and how the intervention might otherwise affect the financial system structure. Focusing attention on a specific mechanism through which legal changes can inadvertently alter the structure of the financial system can help regulators develop the data, models, and mindset they need to assess the systemic ramifications of their actions.

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