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This Article takes stock of post-financial crisis regulatory developments to tell a tale of two markets within a political economy of financial regulation. The financial crisis stemmed from excessive risk-taking and dodgy practices in the subprime home mortgage market, a market that owed its existence to private-label securitization. The pre-crisis boom in private label mortgage-backed securities could never have happened, however, without financing from an array of structured products and vehicles created in the capital markets-CDOs, CDO2 s, and SIVs. It was these capital markets products that magnified mortgage credit risk and transmitted it into the financial system's vulnerable nodes.
The post-crisis regulation has proceeded on different lines for mortgage markets and for capital markets. Post-crisis regulation of residential mortgage origination and securitization markets includes a set of strict prohibitions on particular products and practices. In contrast, post-crisis regulation of capital markets takes a much lighter touch, increasing regulatory costs for certain transactions but not prohibiting them outright. Capital market regulation has been particularly focused on the capital requirements of a particular type of user of structured products-banks. Outside of bank regulation, capital markets remain free to innovate with structured products. This distinction is precisely what the political economy of regulation would predict. Interventions in consumer markets are likely to be more politically salient to voters because they address products that voters use directly, while structured products are purchased only by sophisticated financial institutional investors.
Despite the lighter regulatory approach taken to capital markets, today's structured products are qualitatively different than pre-crisis products. Subprime mortgage-backed securities, CDOs, CDO2 s, CDO-based synthetics, and SIVs have entirely disappeared from the market even without regulatory prohibitions. Even so, post-crisis regulation may have had an unintended effect. The increased regulation of banks has resulted in a shift of high-risk behavior in both the mortgage and structured products markets to the more thinly regulated nonbank sector, where financial innovation and regulatory arbitrage still proceed apace. The hydraulic effect of entity-based regulation may here be sowing the seeds of the next crisis.