Market Failure Cannot Be Resolved Without Regulation

While there is little doubt that regulatory failure played an important role in the recent economic crisis, the solution should not be to walk away and leave systemic risk in place.

I am all for free markets and not mucking them up with government intervention. But the economic theory of regulation tells us that if there is a market failure, it cannot be resolved privately. The public sector must get involved.

The most illustrative examples of such failures in U.S. financial markets were the frequent financial panics from the 1850s until the Great Depression. Those episodes taught us that when illiquid, asset holdings (e.g., loans) of the financial sector are financed short-term (e.g., by deposits), and are hit by a severe macroeconomic downturn, failures of financial firms can lead to system-wide runs on deposits. This in turn leads to a massive disruption of the system that provides credit to households and corporations. When economists bandy about the term systemic risk, this is the type of event they are referring to.

The market failure here is that, although each financial institution may have been behaving optimally on an individual basis, the firm had no incentive to take into account the effect of their actions on the system as a whole. In economics, we call this a negative externality and it is analogous to an industrial firm causing pollution. In the example above, financial failure of one bank increased the possibility of runs on other banks, leading to the system-wide collapse.

The government regulation to address the market failure in this case was to insure retail depositors against losses (today’s FDIC guarantee), thus stopping the cycle of bank runs. Of course, these government guarantees came at great cost, not least the resulting moral hazard. So the government had to enact offsetting regulation and charge banks premiums for deposit insurance, restrict them from certain risky activities, and subject them to prompt corrective action.

This served financial markets well for over a half century. As time passed, however, the regulation became antiquated.  Over the last two decades, deposit premiums became mispriced, some financial firms like Fannie Mae and Freddie Mac grew so large that they became too-big-to-fail, and shadow banks—banks such as off-balance sheet vehicles, money market funds, and investment banks that operate outside of the system—proliferated, performing bank-like functions albeit with little or no regulation. In fact, in this financial crisis, we faced modern day equivalent runs on most of the shadow banking sector.

One might argue that the government is not capable of effective regulation and makes matters so much worse that it would be better to accept systemic risk and deregulate. But the legislative response to the Great Depression and its success would suggest otherwise.

And in terms of the government’s latest financial reform, the Dodd-Frank Act is clearly well intended by focusing regulation for the first time on systemic risk. Moreover, the legislation plugs some obvious holes in the financial system like off-balance sheet financing, OTC derivatives, rating agencies, and mortgage underwriting, among other areas. That said, the legislation ultimately falls short in both its approach and focus.

After a recent presentation to 170 or so risk management executives on Dodd-Frank, I took a quick poll and the vast majority believed another financial crisis was going to occur within the next ten years. This should not be surprising.  The legislation does not charge systemically risky firms upfront for the systemic risk imposed upon others; instead, choosing to penalize surviving firms when a crisis occurs. This creates a free rider problem which will lead to a race to the bottom.  Moreover, in terms of moral hazard, the legislation leaves in place mispriced government guarantees, and, with respect to excess leverage, conditions for regulatory arbitrage persist. There is also no attempt to create a level playing field by regulating shadow banks and banks similarly

Nevertheless, while there is little doubt that regulatory failure played an important role in the crisis, the solution should not be to walk away and leave systemic risk in place. I would still take Dodd-Frank over the current system or, more extreme, a world with zero financial regulation and frequent financial panics. But we still have plenty of wood to chop on the regulatory front. This is just the middle innings of a very long game ahead.


Matthew Richardson is a professor of finance at NYU Stern School of Business.

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Researchers hope the technology will further our understanding of the brain, but lawmakers may not be ready for the ethical challenges.

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  • Researchers at the Yale School of Medicine successfully restored some functions to pig brains that had been dead for hours.
  • They hope the technology will advance our understanding of the brain, potentially developing new treatments for debilitating diseases and disorders.
  • The research raises many ethical questions and puts to the test our current understanding of death.

The image of an undead brain coming back to live again is the stuff of science fiction. Not just any science fiction, specifically B-grade sci fi. What instantly springs to mind is the black-and-white horrors of films like Fiend Without a Face. Bad acting. Plastic monstrosities. Visible strings. And a spinal cord that, for some reason, is also a tentacle?

But like any good science fiction, it's only a matter of time before some manner of it seeps into our reality. This week's Nature published the findings of researchers who managed to restore function to pigs' brains that were clinically dead. At least, what we once thought of as dead.

What's dead may never die, it seems

The researchers did not hail from House Greyjoy — "What is dead may never die" — but came largely from the Yale School of Medicine. They connected 32 pig brains to a system called BrainEx. BrainEx is an artificial perfusion system — that is, a system that takes over the functions normally regulated by the organ. The pigs had been killed four hours earlier at a U.S. Department of Agriculture slaughterhouse; their brains completely removed from the skulls.

BrainEx pumped an experiment solution into the brain that essentially mimic blood flow. It brought oxygen and nutrients to the tissues, giving brain cells the resources to begin many normal functions. The cells began consuming and metabolizing sugars. The brains' immune systems kicked in. Neuron samples could carry an electrical signal. Some brain cells even responded to drugs.

The researchers have managed to keep some brains alive for up to 36 hours, and currently do not know if BrainEx can have sustained the brains longer. "It is conceivable we are just preventing the inevitable, and the brain won't be able to recover," said Nenad Sestan, Yale neuroscientist and the lead researcher.

As a control, other brains received either a fake solution or no solution at all. None revived brain activity and deteriorated as normal.

The researchers hope the technology can enhance our ability to study the brain and its cellular functions. One of the main avenues of such studies would be brain disorders and diseases. This could point the way to developing new of treatments for the likes of brain injuries, Alzheimer's, Huntington's, and neurodegenerative conditions.

"This is an extraordinary and very promising breakthrough for neuroscience. It immediately offers a much better model for studying the human brain, which is extraordinarily important, given the vast amount of human suffering from diseases of the mind [and] brain," Nita Farahany, the bioethicists at the Duke University School of Law who wrote the study's commentary, told National Geographic.

An ethical gray matter

Before anyone gets an Island of Dr. Moreau vibe, it's worth noting that the brains did not approach neural activity anywhere near consciousness.

The BrainEx solution contained chemicals that prevented neurons from firing. To be extra cautious, the researchers also monitored the brains for any such activity and were prepared to administer an anesthetic should they have seen signs of consciousness.

Even so, the research signals a massive debate to come regarding medical ethics and our definition of death.

Most countries define death, clinically speaking, as the irreversible loss of brain or circulatory function. This definition was already at odds with some folk- and value-centric understandings, but where do we go if it becomes possible to reverse clinical death with artificial perfusion?

"This is wild," Jonathan Moreno, a bioethicist at the University of Pennsylvania, told the New York Times. "If ever there was an issue that merited big public deliberation on the ethics of science and medicine, this is one."

One possible consequence involves organ donations. Some European countries require emergency responders to use a process that preserves organs when they cannot resuscitate a person. They continue to pump blood throughout the body, but use a "thoracic aortic occlusion balloon" to prevent that blood from reaching the brain.

The system is already controversial because it raises concerns about what caused the patient's death. But what happens when brain death becomes readily reversible? Stuart Younger, a bioethicist at Case Western Reserve University, told Nature that if BrainEx were to become widely available, it could shrink the pool of eligible donors.

"There's a potential conflict here between the interests of potential donors — who might not even be donors — and people who are waiting for organs," he said.

It will be a while before such experiments go anywhere near human subjects. A more immediate ethical question relates to how such experiments harm animal subjects.

Ethical review boards evaluate research protocols and can reject any that causes undue pain, suffering, or distress. Since dead animals feel no pain, suffer no trauma, they are typically approved as subjects. But how do such boards make a judgement regarding the suffering of a "cellularly active" brain? The distress of a partially alive brain?

The dilemma is unprecedented.

Setting new boundaries

Another science fiction story that comes to mind when discussing this story is, of course, Frankenstein. As Farahany told National Geographic: "It is definitely has [sic] a good science-fiction element to it, and it is restoring cellular function where we previously thought impossible. But to have Frankenstein, you need some degree of consciousness, some 'there' there. [The researchers] did not recover any form of consciousness in this study, and it is still unclear if we ever could. But we are one step closer to that possibility."

She's right. The researchers undertook their research for the betterment of humanity, and we may one day reap some unimaginable medical benefits from it. The ethical questions, however, remain as unsettling as the stories they remind us of.

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