ANALYSISRegulatory changes for investment banking may stifle initiative - no bad thing considering the kind of innovation we had, writes Proinsias O'Mahony

LOOKING TO understand the complex derivatives that have plunged world markets into chaos over the last year? Hundreds of thousands of people have logged on to YouTube to watch the explanation by British satirists John Bird and John Fortune.

After explaining that an overpriced mortgage is sold to "an unemployed black man sitting on a crumbling porch somewhere in Alabama", Bird refers to how "these mortgages are taken by a bank and packaged together with a lot of other similar debts".

Once it makes its way to Wall Street, "this package of dodgy debts stops being a package of dodgy debts and starts being what we call a structured investment vehicle". Bird will then "ring up someone in Tokyo and say I've got this package, do you want to buy it? And they ask what's in it and I say I haven't got the faintest idea and they say how much do you want for it and I say a hundred million dollars and they say fine, that's it. And that's the market."

As explanations go, it's not bad. CDSs, SIVs, CDOs, CDOs of CDOs - not only did the general public not understand the brave new world of financial engineering, it seems the giants on Wall Street didn't either. Just last December AIG chief executive Martin Sullivan said that the probability of losses on its portfolio of credit swaps was "close to zero".

Goldman Sachs warned last month that "the intricacies of AIG's business are so complex that management may not even know the extent of the company's ultimate exposures, let alone losses".

So who is to blame for this mess? Alan Greenspan, the previous governor of the US federal reserve has been widely blamed for allowing the financial industry to police itself.

Greenspan protested against efforts to increase regulation in the wake of several derivative disasters, even calling for a looser regulatory burden just six months after the implosion of hedge fund Long Term Capital Management (LTCM) threatened to unravel the global financial system in 1998.

Crucially, the passing of the Commodity Futures Modernisation Act in 2000 helped "protect financial institutions from overregulation", as one advocate put it. Deregulation led to the massive growth of the shadow banking system, so-called "because it has lain hidden for years, untouched by regulation, yet free to magically and mystically create and then package subprime loans into a host of three-letter conduits that only Wall Street wizards could explain", to quote bond manager Bill Gross. By 2007, the shadow system had accumulated $10.5 trillion in assets - as much as the traditional banking system.

It also led to greater risk-taking and less transparency by ordinary commercial banks. When asked by a congressman why billions of dollars of investment liabilities were not on its balance sheet, Citigroup chief executive Chuck Prince said doing so would put the firm at a disadvantage compared to less-regulated investment banks who could indulge in greater risk-taking.

Banks like Lehman Brothers.

In 2006 and 2007, Lehman was the top US underwriter of mortgage bonds. It held almost $700 billion in assets despite having equity of approximately $23 billion - a ratio of 30 to 1. When the housing bubble burst, Lehman was left with illiquid and depreciating assets that would eventually strangle the company.

There's no doubt that regulation is coming. Treasury secretary Hank Paulson, himself a former chief executive of investment banking giant Goldman Sachs, said "the world has changed" after the Bear Stearns collapse, promising "major regulatory changes".

Opponents counter that less-informed regulators should not be second-guessing the best and brightest who work in the major institutions and that the problem is one of bad bets rather than the actual derivatives.

It's a minority argument today, however. "The bright new financial system - for all its talented participants, for all its rich rewards - has failed the test of the market place," according to former Fed chairman Paul Volcker. He said it " "all adds up to a clarion call for an effective response".

Hedge fund legend George Soros agrees. "The newly invented methods and instruments were so sophisticated that the regulatory authorities lost the ability to calculate the risks involved."

Princeton economics professor Paul Krugman says: "If institutions need to be rescued like banks, they should be regulated like banks".

There's little protest from Wall Street. Last June, Lehman chief executive Dick Fuld said: "If they're going to give the investment banks access to the [ discount lending] window, I for one do believe they have the right for oversight."

Gerald Corrigan, Goldman Sachs' managing director, said that banks would have to "accept changes to market practices that in the past have generated sizeable revenues but at the cost of weakening the underlying foundation of the markets".

Nobel-prize-winning economist Joseph Stiglitz this week suggested that there needed to be a move to the "psychology of supervision away from the presumption that institutions know what they are doing". Stiglitz suggests a "financial product safety commission" ensuring products are fit for "human consumption".

For investment banks, more capital, lower leverage and more disclosure seem inevitable. Securitisation - the slicing and dicing of debt into securities - had been a huge source of profit in recent years but that market will be greatly reduced.

Nouriel Roubini last week warned that a Lehman collapse would lead to a "run on most of the shadow banking system".

That's exactly what happened, with both Goldman Sachs and Morgan Stanley being butchered despite reporting results that beat market expectations this week.

Roubini says investment banks are "structurally unstable" because they don't have access to a bank deposit base and are reliant on short-term funding. Therefore, they will be forced to merge with traditional commercial banks.

Merrill Lynch has already done so, jumping into the arms of Bank of America. Morgan Stanley is in preliminary merger talks with Wachovia and other banks, with chief executive John Mack reportedly saying: "We need a merger partner or we're not going to make it."

That just leaves Goldman Sachs, whose share price has also been cratering. In Europe, UBS is slashing jobs from its investment banking. After buying Dresdner Bank earlier this month, Commerzbank said it would fire half the investment bankers.

Whatever about the effect on investment banks, will greater regulation of the financial engineers prevent the kind of events of last week? Stiglitz says that the "ingenuity" of market players ensures that they will probably be able to circumvent various regulations but reforms nevertheless make another crisis "less likely" and "less severe". Will it stifle innovation? Maybe, "but that may be a good thing considering the kind of innovation we had".