Feb. 12 (Bloomberg) -- It’s easy to forget that just a year ago a young trader at Societe Generale SA, eager to boost his share of the bonus pool, engaged in suspect trades that forced the bank to liquidate massive equity-derivative positions. It triggered unusual stock-market volatility that temporarily hijacked U.S. monetary policy.

Besides SocGen’s loss of $7.2 billion, here was a case where large numbers of innocent bystanders faced real financial damage or increased systemic risk because of just one poorly supervised trader working in just one financial firm in just one country.

Ancient history in a business where long-term means after lunch? Not quite. In the last year, global finance has been about systemic risk and its consequences. Confronting the key causes will be at the core of any effort to create a more robust global financial system.

Borrowing from a very different field, we suggest that the successful evolution of policy on pollution and the natural environment over the past half-century carries some useful lessons on how to proceed.

What causes environmental damage? It usually involves a market failure that neglects to price a key resource: nature. People and businesses produce or consume in ways that make sense for themselves, but in doing so cause pollution and damage to others. Toxic effluent hurt users of water resources, smokestack emissions reach downwind residents, solid-waste dumps contaminate groundwater and despoil the local terrain, and so on.

Once we get serious about pollution, we set out either to control the physical activities that cause pollution or to impose charges that encourage polluters to clean up their act.

Polluter Pays

The best solution is usually found in a simple rule -- “the polluter pays” -- because it uses market forces to correct the problem in the most efficient way. Society, through political and regulatory processes, sets environmental standards and policies to enforce them, and polluters themselves figure out the best way to meet those standards. The external environmental costs are forced back onto the polluter, who deals with them and passes any costs on to customers in the form of higher prices, or back to shareholders as lower returns.

Either way, the magic of the market reinforces environmental policy. The more polluting a product or service, the more expensive it will be to buy or the less profitable it will be to produce. Society sets the environmental targets, and the market economy helps achieve them by properly allocating environmental resources. There is no free lunch, so somebody has to pay for a cleaner environment.

Financial Pollution

Market failure in global finance isn’t much different. It involves “financial pollution” when firms and individuals impose large costs on the system in the pursuit of private gain.

Some examples: Financial engineers design highly profitable products that nobody understands. Dodgy credits originated in one part of the world are repackaged and distributed to institutional and retail investors globally. Risk managers in the basement assure senior managers and directors that all is well, based on unrealistic models. Managers of banks and other financial intermediaries who think they are too big to fail go for broke, with excessive leverage underwritten by debt holders who figure they will be bailed out by taxpayers if things go wrong.

This sort of behavior makes sense to those directly involved, but each potentially degrades the integrity of the financial system as a whole -- the “financial commons.” When things do go off the rails, the damage, like pollution, extends far beyond those directly responsible. The risks are aggregated, compounded and turbocharged. Innocent bystanders are caught in the maelstrom.

Market Contamination

Investors facing financial losses and needing liquidity find few buyers and sell whatever they can, causing all kinds of market turmoil, even in industries far removed from the original mess. The ensuing panic in financial markets contaminates the broader economy, reinforcing the financial meltdown itself.

Meanwhile, policy makers desperate to stop the bleeding push healthier banks to acquire the mortally wounded, leading to still greater consolidation among financial intermediaries. The nightmare scenario of a small group of players that may be too big, too interconnected, too conflicted, too complex, too hard to manage, and possibly too difficult to regulate, creates a new generation of financial megapolluters.

A cohort of such dominant financial Goliaths, free to wreak havoc and immune to failure, can’t possibly be good for the financial system or the public interest.

Fair Price

The key to restoring stability and robustness is to recognize, measure and price the systemic risk created by private financial activities, and force those who create it to pay for insuring it. The way to do this is a financial version of the polluter-pays principle.

First, government deposit insurance and too-big-to-fail guarantees of financial institutions must be repriced, commensurately increasing the costs to those who directly benefit from deposit guarantees: the banks and their depositors.

Second, capital adequacy needs to be redefined in a world that will have lots of financial casinos once again, likewise raising the cost of taking risk for the companies that choose to participate. They then pass it along to shareholders or customers.

Third, liquidity needs to be ramped up and aligned to market conditions, even at the cost of profit opportunities forgone as a result of larger liquid-asset holdings.

Fourth, structural complexity and interconnectedness of financial intermediaries themselves call for a special systemic surcharge, in order to recognize that some internal transfers of risk aren’t captured by conventional regulatory oversight.

However it is done, any new regulations for banks and other financial intermediaries must impose big costs on shareholders of the firms and their clients in order to correctly price systemic risk. Chances are, they will respond in line with their self- interest to seek the most cost-efficient ways to comply.

The market will again work its magic. Financial products and institutions imposing high levels of risk on the financial system will rise in price and fall in profitability relative to others, and money flows will better incorporate systemic risks. The polluters will end up paying.

(Thomas Cooley is dean of the Stern School of Business New York University. Ingo Walter is vice dean of faculty at the Stern School. They are contributors to a new volume titled “Restoring Financial Stability,” to be published by John Wiley & Sons in March 2009. The opinions expressed are their own.)

To contact the writers of this column: Thomas Cooley at tcooley@stern.nyu.edu Ingo Walter at iwalter@stern.nyu.edu

Last Updated: February 12, 2009 00:01 EST