The Failure of Models and Labels and the Success of Experience and Emergence

Abstract

Little did Bernanke know how blind reliance on rules would, only one year later, lead the financial world to one of its nastiest surprises. Rule-based regulation allowed banks, mortgage companies, and real estate investors to exploit and ignore the risks involved in subprime lending. The financial markets relied on strict compliance with rules, rather than situational compliance with principles. Bernanke thought he was speaking about the need to loosen up the financial markets. Two years later, he would use much the same language to discuss how to tighten regulation and counter abuses in those same markets. The goal had become to prevent more nasty surprises.