A redesign of our financial system, driven by weaknesses revealed during the credit crisis, will be based largely on the goal of financial stability. Most of us thought we had it, but we did not. The financial sector intermediates wealth across the real sector. When the financial sector freezes up, as it did this year, consumers and producers do not get efficient levels of financing for their activities. Even worse, they understand the notion of self-fulfilling expectations: If I assume that others will cut back on consumption and production, then I should as well. This is how financial instability led us into a significant recession.

The philosophy of our market-based economic system has been that individual actors, by looking out for themselves, should be regulated mainly in order to mitigate “negative externalities” such as pollution. If I do not bear much of the costs of my air pollution, for instance, then my polluting activities should be regulated. The same applies to systemic risk in financial markets, another form of pollution. Systemic risk is the threat that financial institutions will fail catastrophically or become so crippled by a loss of capital that consumers and producers have difficulty getting financing for their activities. Governments attempt to reduce systemic risk by regulating the levels of capital that banks maintain. Those capital standards, or at least their enforcement, failed to prevent dramatic losses in the housing market from being trapped inside banks, causing this credit crisis. Something went wrong and needs to be fixed.

Several things went wrong. A large amount of wealth created by the “great moderation,” a relatively stable and healthy economy over many years, found a seemingly convenient investment: securities called collateralized debt obligations (CDOs) that offered repackaged home-mortgage payments. Because there was a general and misplaced trust that home prices would not fall broadly, highly rated CDOs were believed to be quite safe, and also promised somewhat higher payments than, say, Treasury bonds. Investors flocked to CDOs, creating demand for more, encouraging additional home ownership, and further driving up home prices. Once home prices began to fall, however, this self-reinforcement went into reverse, and CDO investors lost plenty. Many large “sophisticated” financial institutions held vast quantities of mortgage-related securities and were not sufficiently capitalized to withstand the losses. The most leveraged, Bear Stearns, Lehman, AIG, and Merrill Lynch, went first. Some went out of business; some had to be rescued. Even relatively tightly regulated institutions, such as IndyMac, Washington Mutual, and Wachovia, went south. The federal mortgage agencies, Fannie Mae and Freddie Mac, were special cases, but their failures were also caused by insufficient capital. The financial crisis went global and morphed into a costly global recession.

Financial institutions were extremely unlucky, or took more risk than was healthy for the economy. Going forward, they should presumably take less risk. Regulators, currently focused on treating the wounded, will soon turn to the task of redesigning our regulatory framework. The era of large and lightly regulated investment banks is over. The only two left standing, Morgan Stanley and Goldman Sachs, have become chartered banks, now overseen by the Fed and other regulators. Bank capital standards, which had only just been overhauled under the Basel II international accord, will be reviewed for weak links. Revisions may include higher capital requirements for off-balance-sheet exposures, such as structured investment vehicles (SIVs), and for extremely large concentrated investments, whether triple-A rated or not.

The credit derivatives market covered large default losses from failing home mortgages and financial institutions. Despite dire predictions, it appears that settlement claims in this default insurance market have been processed relatively smoothly. Regulators are right to insist, though, on central clearing of credit derivatives, a process by which bilateral exposures between counterparties to a derivatives contract are converted into bilateral exposures between each of the original counterparties and a central clearing counterparty. Clearing allows positive and negative exposures to be more easily and safely offset, and reduces the potential for domino effects, by which the failure of one financial institution could cause the failure of another. Regulators should also have more systematic information on counterparty exposures, whether from credit derivatives or other forms of risk taking. (For more on the importance of clearing and disclosure, see my op-ed in the Wall Street Journal, Oct. 29, 2008, and my Senate testimony of July 14, 2008.)

Although weak internal management of some financial institutions appears to have played a significant role in the credit crisis, it is difficult (if not counterproductive) to regulate good management. For instance, an attempt to prescribe by regulation the types of derivatives that financial institutions may trade could stifle innovation and efficiency, and could in any case lead to a migration of trading elsewhere. I do believe, though, that a renewed focus on the regulation of systemic financial risk is inevitable and timely.

Darrell Duffie is the Dean Witter Distinguished Professor of Finance at Stanford Business School.

Republished with permission from Stanford Knowledgebase, a monthly electronic source of information, ideas, and research published by the Stanford Graduate School of Business (http://www.gsb.stanford.edu/news/knowledgebase.html).