The global financial crisis is rightly prompting calls for a rethink of how we regulate financial institutions and markets. Most such calls are focused on what might be called “fail-safe” regulations, designed to reduce the risk that institutions will make reckless lending and investment decisions. Even libertarian-leaning policymakers and thinkers, such as Alan Greenspan, are now concerned with the capacity of our globally connected financial system to spread failures of risk management from one institution to another.

In this crisis, institutions that bought up buckets of complex mortgage-linked securities found themselves facing huge losses as house prices fell. Their counterparts and clients, fearing the worst, provoked the worst by ceasing to do business with them. Others who wrote insurance against their failures-to-pay (credit default swaps) then lost huge sums as well, fuelling the fires of system-wide panic and default. But better regulation of lending standards and risk management, the argument goes, will prevent such systemic problems in the future.