Financial innovation tends to be a bit of a bad word these days. But while I and many other people are in favor of an overhaul of our regulatory system, that still leaves open the question of how the system should be managed.
A reader pointed me to a 2005 paper by Zvi Bodie and Robert Merton on the “Design of Financial Systems.” They argue that neoclassical finance theory – frictionless markets, rational agents, efficient outcomes – needs to be combined with two additional perspectives: an institutional approach that focus on the structural aspects of the financial system that introduce friction and may lead to non-efficient outcomes; and a behavioral approach that focuses on the ways in which and the conditions under which economic actors are not rational (see my post on bubbles, for example). The paper walks through examples of how to think about some real problems we face, such as the fact that households are increasingly being forced to make important decisions about retirement savings, but generally lack the knowledge and skills to make those decisions. One of their arguments is that while institutional design may not matter in a pure neoclassical world, it does matter in the world of irrational actors: deposit insurance to stop bank runs is an obvious example.
Some of the content may be tough going, but in general the paper offers one perspective on how to think about the relationships between markets, institutions, and individual behavior that make up our financial system.