Written testimony of Andrew W. Lo, prepared for the U.S. House of Representatives Committee on Oversight and Government Reform.

Congressional testimony prepared for the U.S. House of Representatives Financial Services Committee Hearing on Examining Private Market Exemptions as a Barrier to IPOs and Retail Investment, held on September 11, 2019. Professor Lo discusses proposed legislation intended to allow innovative companies to gain greater access to investors who are comfortable with the higher risks (and rewards) of private investments. He highlights the "Rare Disease Fund Act" sponsored by Representatives Juan Vargas (CA-51) and Scott Peters (CA-52), which proposes the development of a "megafund"—created under the full supervision of the SEC—to acquire the development rights to multiple rare disease therapeutic candidates. Such a public-private fund focused on rare diseases could serve as a viable pilot project for further development of the megafund concept. Professor Lo remarks, "With more innovative financial and business structures, and the already existing close partnership between orphan drug developers and government agencies like the National Center for Advancing Translational Sciences, we can make even greater progress in easing the burden of disease for millions of Americans."

This document is the written testimony submitted to the US House of Representatives Financial Services Committee for its hearing on systemic risk regulation, held October 29, 2009, and it is not a formal academic research paper, but is intended for a broader audience of policymakers and regulators. Academic readers may be alarmed by the lack of comprehensive citations and literature review, the imprecise and qualitative nature of certain arguments, and the abundance of illustrative examples, analogies, and metaphors. Accordingly, such readers are hereby forewarned—this paper is not research, but is instead a summary of the policy implications that I have drawn from my interpretation of that research. This testimony focuses on three themes: (1) Establishing the means to measure and monitor systemic risk on an ongoing basis is the single-highest priority for financial regulation reform; (2) Systemic risk measurement and regulation will likely require new legislation compelling systemically important entities to provide more transparency on a confidential basis to regulators, e.g., information regarding their assets, liabilities, holdings, leverage, collateral, liquidity, counterparties, and aggregate exposures to key financial variables and other risks; and (3) Because systemic risk cuts across multiple regulatory bodies that do not necessarily share the same objectives and constraints, it may be more efficient to create an independent agency patterned after the National Transportation Safety Board (NTSB), solely devoted to measuring, tracking, and investigating systemic risk events in support of—not in competition with—all regulatory agencies.

PURPOSE: The purpose of this paper is to analyse regulatory reform in the wake of the financial crisis of 2007-2008.

DESIGN/METHODOLOGY/APPROACH: The paper proposes a framework for regulatory reform that begins with the observation that financial manias and panics cannot be legislated away, and may bean unavoidable aspect of modern capitalism.

FINDINGS: Financial crises are unavoidable when hardwired human behavior—fear and greed, or“animal spirits”—is combined with free enterprise, and cannot be legislated or regulated away. Like hurricanes and other forces of nature, market bubbles, and crashes cannot be entirely eliminated, but their most destructive consequences can be greatly mitigated with proper preparation. In fact, the most damaging effects of financial crisis come not from loss of wealth, but rather from those who are unprepared for such losses and panic in response. This perspective has several implications for the types of regulatory reform needed in the wake of the financial crisis of 2007-2008, all centered around the need for greater transparency, improved measures of systemic risk, more adaptive regulations,including counter-cyclical leverage constraints, and more emphasis on financial literacy starting in high school, including certifications for expertise in financial engineering for the senior management and directors of all financial institutions.

ORIGINALITY/VALUE: The paper stresses how we must resist the temptation to react too hastily to market events, and deliberate thoughtfully and broadly, instead, craft new regulations for the financial system of the twenty-first century. Financial markets do not need more regulation; they need smarter and more effective regulation