Bring Silicon Valley to Wall Street

Rahm Emanuel famously said what everyone was thinking when he noted earlier this year that "a crisis is a terrible thing to waste." The financial industry has been bruised and battered. There's a golden opportunity to refashion a fairer and more stable system, one less susceptible to "the reemergence of an American financial oligarchy," as Simon Johnson so memorably put it in a recent article in The Atlantic.

What we need in order to accomplish this -- aside from better government oversight -- is a new generation of financial innovators to fix today's broken system. This is what happened in the energy sector when, as oil prices climbed to $150/barrel and climate-change worries crescendoed, venture capitalists sensed a once-in-a-lifetime opportunity and poured money into clean technology. Although oil prices have since collapsed, that money is still at work, and might yet produce the Google or Microsoft of the cleantech world.

The same should happen in the financial world, but I'm increasingly skeptical that it will. One reason for the skepticism is that the SEC and other government agencies charged with regulating the financial sector are in no way set up to encourage Silicon Valley-style innovation. In fact, they often discourage it.

I'm thinking about this topic after a recent meeting with Chris Larsen, the CEO of Prosper, along with its main competitors, Lending Club and Zopa, is a peer-to-peer lender. These companies enable people to lend directly to one another online. Because there's not a bloated bank sitting in between the two parties, borrowers and lenders tend to get a better deal than they would by going through more traditional channels.

Financial innovations tend to be either unquestionably good (ATMs, credit cards) or arguably malevolent (credit default swaps), and peer-to-peer lending is widely considered to be among the former. It is the internet era's version of community banking, in which borrowers actually know their bankers, and it's also, in this time of tight credit markets, an alternative way for consumers and small businesses to get access to money when they need it.

But the SEC isn't making it easy for peer-to-peer lending to, ahem, prosper. Last summer, as the mortgage crisis waxed and the regulatory agencies' failures became more apparent, the SEC overcorrected and effectively shut down Prosper, requiring the company to enter a "quiet period" while it registered with the federal government. (While that process continues, on Tuesday, California regulators gave permission for Prosper to start operating again within the state. Lenders from in-state and borrowers from anywhere in the U.S. can use the site as they did before, with the addition of some important features.) Zopa, a UK-based P2P lender, sensed the changing regulatory winds and retreated back to the rainy Isles. To date, only Lending Club has "gone through all the legal pain needed to get full SEC registration."

Larsen is pretty good-natured about the ordeal, largely because Prosper has enough backing ($40 million in venture capital money) to pay the legal and accounting fees associated with SEC registration. But he's fully aware that most young innovators and venture capitalists in the country's technology hubs aren't willing to put up with months or years of regulatory limbo and the associated costs. When the government wanted to print out Prosper's regulatory filings, they sent the bill for all the paper to Larsen. It came to $75,000. The average, fresh-out-of-college entrepreneur might be able to comprehend the mysteries of solar panels and gas-electric hybrids, but understanding -- or affording -- the SEC? Forget about it. And the time for that to change, and for financial innovation to make headway against today's incumbent oligarchs, is swiftly dwindling, according to Larsen. The window is open, but it will only last 18 months, he says:

Either you're going to have a total collapse or the existing incumbents are going to reestablish themselves. They're crawling all over Washington, they're lobbying, because they get it, too -- they're under threat right now. Things are going to change but they're going to change one of two ways: fundamentally, or on the margin. You know, tighten up this, tighten up that, and you'll have another crisis in 10 years. This has been a meltdown. And it should be a call to actual innovators to come up with new things.

Larsen thinks it would be a good idea for the SEC to set up a Department of Innovation and make itself more accessible to would-be financial entrepreneurs. I think he's right, and it's a step that just might reduce the chance of the next crisis.