Robert Shiller says financial engineering can fix the instability problems in financial markets:
Engineering Financial Stability, by Robert J. Shiller, Commentary, Project Syndicate: The severity of the global financial crisis ... has to do with a fundamental source of instability in the banking system, one that we can and must design out of existence. To do that, we must advance the state of our financial technology.
In a serious financial crisis, banks find that the declining market value of many of their assets leaves them short of capital. They cannot raise much more capital during the crisis, so, in order to restore capital adequacy, they stop making new loans and call in their outstanding loans, thereby throwing the entire economy – if not the entire global economy – into a tailspin.
This problem is rather technical in nature, as are its solutions. It is a sort of plumbing problem for the banking system... Many finance experts ... have been making proposals along the lines of “contingent capital.” The proposal by the Squam Lake Working Group ... seems particularly appealing. ... The group calls their version of contingent capital “regulatory hybrid securities.” The idea is simple: banks should be pressured to issue a new kind of debt that automatically converts into equity if the regulators determine that there is a systemic national financial crisis, and if the bank is simultaneously in violation of capital-adequacy covenants in the hybrid-security contract.
The regulatory hybrid securities would have all the advantages of debt in normal times. But in bad times, when it is important to keep banks lending, bank capital would automatically be increased by the debt-to-equity conversion. The regulatory hybrid securities are thus designed to deal with the very source of systemic instability that the current crisis highlighted.
The proposal also specifies a distinct role for the government in encouraging the issuance of regulatory hybrid securities, because banks would not issue them otherwise. Regulatory hybrid securities would raise the cost of capital to banks (because creditors would have to be compensated for the conversion feature), whereas the banks would rather rely on their “too big to fail” status and future government bailouts. Some kind of penalty or subsidy thus has to be applied to encourage banks to issue them. ...
Contingent capital, a device that grew from financial engineering, is a major new idea that might fix the problem of banking instability, thereby stabilizing the economy – just as devices invented by mechanical engineers help stabilize the paths of automobiles and airplanes. If a contingent-capital proposal is adopted, this could be the last major worldwide banking crisis – at least until some new source of instability emerges and sends financial technicians back to work to invent our way of it.
The last sentence highlights why we shouldn't put all of our regulatory eggs into one policy basket, a point I've made before in arguing for broad based solutions that limit the damage if a breakdown occurs. That is, while contingent capital might help, and maybe even fix existing problems, we should also be sure to implement measures that limit the damage and protect us if the financial sector implodes again despite the creative financial engineering and regulatory changes designed to prevent it.