which the majority of funding had become non-bank intermediated. Because this shift to non-bank intermediated funding (usually referred to as is continuing, “shadow banking”) I will use it as an example throughout this article. In thinking about regulating a dynamically changing financial system, it may be more effective—or at least instructive—to focus on the underlying, and thus system’s less time-dependent, economic functions than to tie regulation to any specific financial architecture. When I was trained as an aerospace engineer, we called this a “black-box” approach: examining the functionality of a process or application without worrying about the details of its internal structure. This facilitates the analysis of a highly complex or unknown structure. It also facilitates the analysis of a rapidly changing structure. The financial system epitomizes each. Although unrelated to financial regulation, economists Robert Merton & Zvi Bodie likewise have recognized the utility of focusing on the underlying economic functions of the changing financial system. In order to try to understand how and why the institutional structure of the financial system changes and how it is likely to evolve, they view finance from a that they focus on functions “functional perspective”—meaning rather than on institutions. The rationale for their focus is similar to mine: that functions are more stable than financial institutions—that is, functions “[f]inancial change less over time . . . .” A functional approach should also inform financial regulation. As will be shown, the principal underlying economic functions of the financial system are the provision, allocation, and deployment of capital. Regulation thus should operate to correct “market that impair the ability of the components of the financial failures” firms and markets—to provide these (and any related) functions. Economists refer to the regulation of components of the financial system as regulation. The traditional approach to microprudential regulation, “microprudential” however, is tied not to functional components but to components defined by the financial
which the majority of funding had become non-bank intermediated. Because this shift to non-bank intermediated funding (usually referred to as “shadow banking”) is continuing, I will use it as an example throughout this article. In thinking about regulating a dynamically changing financial system, it may be more effective—or at least instructive—to focus on the system’s underlying, and thus less time-dependent, economic functions than to tie regulation to any specific financial architecture. When I was trained as an aerospace engineer, we called this a “black-box” approach: examining the functionality of a process or application without worrying about the details of its internal structure. This facilitates the analysis of a highly complex or unknown structure. It also facilitates the analysis of a rapidly changing structure. The financial system epitomizes each. Although unrelated to financial regulation, economists Robert Merton & Zvi Bodie likewise have recognized the utility of focusing on the underlying economic functions of the changing financial system. In order to try to understand how and why the institutional structure of the financial system changes and how it is likely to evolve, they view finance from a “functional perspective”—meaning that they focus on functions rather than on institutions. The rationale for their focus is similar to mine: that “[f]inancial functions are more stable than financial institutions—that is, functions change less over time . . . .” A functional approach should also inform financial regulation. As will be shown, the principal underlying economic functions of the financial system are the provision, allocation, and deployment of capital. Regulation thus should operate to correct “market failures” that impair the ability of the components of the financial firms and markets—to provide these (and any related) functions. Economists refer to the regulation of components of the financial system as “microprudential” regulation. The traditional approach to microprudential regulation, however, is tied not to functional components but to components defined by the financial
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