Raising the right alarms on risk

FORTUNE -- When the rest of the world was busy buying second homes with no money down, MIT professor Andrew Lo was busy beating the drum over a coming financial crisis. For a while, he was playing to an empty room, but now his prescience makes him a voice of authority as we deal with the meltdown and its aftermath.

Fortune recently spoke with Lo about the goods and bads of financial reform, how to prepare for calamities to come, and the "holy grail" of good regulation.

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Andrew Lo

Edited excerpts of the conversation are below.

How far along are we in understanding the causes of the financial crisis?

We're somewhere between the third and fourth inning. The Financial Crisis Inquiry Commission hasn't even filed its report yet. We are quite a ways away form a detailed understanding of all the myriad things that caused the crisis.

With that in mind, is Congress moving too quickly to enact sweeping reform?

I'm of two minds regarding the legislation. On the one hand I think that Rahm Emanuel was right when he said, "a crisis is a terrible thing to waste." I think there are some positive elements of the bill as proposed and we should be thankful. But we still don't know about a number of important aspects of the crisis. There's great potential of unintended consequences. There are some of the causes of the crisis that this bill ignores.

What do you like about the existing plan?

The idea of creating an Office of Financial Research is terrific. The OFR is mandated to gather all the data to measure systemic risk, and also have subpoena power, which is crucial. And they're also independent, even though they are housed in Treasury. So they are free to criticize the Treasury.

The other great idea is the exchanges for things like credit default swaps. And the idea of the Volcker rule, as proposed, could be quite positive. Banks that rely on customer deposits should not be taking on these large risks. If the government is going to be on the hook for providing backstops, I think it has every right on behalf of taxpayers to limit the risks they could take. But the devil is really in the details here.

There's a lot of a talk about the dangers of overreaching with the derivatives exchanges.

Yes, I'm concerned that we could go too far. The over-the-counter markets are very important for financial innovation. I'm hoping that we ultimately develop some adaptive regulation that deals with problems that happen to develop. If we had a mechanism for monitoring all OTC derivatives and moving them to exchanges as they grow bigger, that would be a great regulatory advancement.

But not everything is suitable for the exchanges. Take interest rate swaps. These are extremely important for companies conducting day-to-day business. Swaps are finely tailored to particular companies, with particular terms and time frames. If we require that they be standardized, that could severely damage this market. If companies can only manage risk by reducing lending rather than by hedging their risk, it could result in a dramatic drop in business activity.

What else concerns you about the bill?

Putting the consumer protection agency under the Fed's purview is odd. The potential for conflicts is real. It's as if we ask the EPA to also run helicopter tours through the Grand Canyon. With the Gulf oil spill, the president quickly recognized that the agency that derives its revenue from oil royalties should not be overseeing the cleanup. It's a similar dynamic.

In your writing and testimony, you point to "lack of preparation" as one of the key drivers of the crisis? Can you explain?

The financial crisis is not about people losing money. People lose money all the time. On April 4, 2000, the stock market lost about $1 trillion in value, but nobody even remembers that date. People expect to lose money in the stock market. Financial crises occur when the wrong people lose money. It's when people aren't prepared. When a pension fund or a money market fund loses half their wealth, that's a real problem because they weren't prepared for their losses. What we need to do is think more carefully about where the risks reside in our economy and make sure the risks are being taken by the proper parties. And when we see parts of the economy that should not be taking such risks doing so, alarm bells should go off.

We do not have a systemic risk map to show where risk lies. We need a map like the National Weather Service for the financial system to warn those who are least likely to be able to survive such an event.

You suggest that some of the cause of the crisis is simply a lack of education -- in other words, that some top-level managers didn't understand what their companies were selling, and therefore misunderstood the risks. How do we mitigate that?

One of the things missing about this bill is any discussion of corporate governance practices. We expect companies to make as much money for their shareholders as possible, and that's exactly what firms like Lehman Brothers did. But that doesn't mean it doesn't damage the system as a whole.

One step in the right direction would be to require that chief risk officers report directly to the board of directors and not to CEOs and chief investment officers. And we should tie their pay to how stable, not how profitable, a firm is. And we should also require board members of a financial services company to exhibit a measure of financial expertise. We impose higher standards on stock brokers than on directors of these financial services companies. Some sort of certification would be a good thing.

You speak a lot about the emotional element -- Keynes's so-called "animal spirits" -- of financial crises. How should financial regulation account for human failings?

In my view, this is the holy grail of proper regulatory oversight, and no one is talking about it. In my view, the idea of regulation is to deal with our own human frailties. Most states have fire codes to force builders to put in sprinklers in. Why do we do this stuff and not leave it to the market to sort it out? Because nobody would choose to install these add-ons, because it's human nature to feel you don't need the sprinkler system until the flames are nipping at your feet. No, we force people to do it. That's an insightful thought that hasn't made it into financial regulation. The next generation of regulation will take into account behavior from the outset, and not just the financial players, but the legislators and regulators. The best regulation deals with these human instincts. We're not there, and I'm not sure we'll get there in my lifetime, anyway.