Role of Financial Innovations

Innovation is a two-edged sword. The internet has a great benefit to society overall, but also promotes fraud and a great deal of time-wasting activity. The automobile and other motor vehicles brought mobility, freedom and massive economic efficiencies. They also brought deaths each year and most of them preventable, along with major pollution problems.

Innovation in financial services is also an easy and effective way. I believe that it has done more good than harm, but it has caused damage. First, there is no clear and objective way of balancing the good and the bad. Most analysts would agree that financial innovation helped cause the recent terrible financial crisis, but then the one question always raised that why the crisis happened and how it evolved?

Recent discussions showed that financial innovation is negative but I mentioned some of the positive innovations that are benefiting the society:
• Automated Teller Machines (ATMs)
• Credit cards
• Debit cards
• Money market funds
• Indexed mutual funds
• Treasury Inflation Protected Securities.
• Interest rate and currency swaps

The overall negative impacts of the financial innovation have strongly driven by the recent financial crisis. In some theories of the crisis, these innovations play a central role, with the implication that without them we would have suffered far more pain. If one accepts these views, then there are at least certain types of innovation that do so much harm that we as a society should be exceedingly cautious about financial innovation in general.

There is not space here for anything like a full discussion of the causes of the financial crisis, but let me just note that there are many respectable theories of the crisis in which these innovations play a much more role.

My own view is that there were many, many causes of the financial crisis and that individuals and institutions made major mistakes. A principal reason so many people contributed in so many ways to the crisis was an excessive relaxation about and underestimation of risk that stemmed from 25 years of very favorable financial markets interrupted by only brief storms. When things go so well for so long, mistakes of over-confidence will abound. Viewed in that light, bad financial innovations or misuse of good ones were important contributors, but we should be careful not to overestimate their effects.

If all this is so complicated, why should we even bother evaluating “financial innovation” as a concept? The reason is that we are facing major choices about how to regulate financial institutions and markets, which will have a substantial effect on the volume and form of future financial innovations. If you believe, that financial innovation has been more positive than negative, then it makes sense not to regulate them away by imposing harsh standards or bans on new products. The current overall approach remains the right one, although it needs to be executed better. Let innovation occur and react appropriately to any flaws that become apparent. However, I must emphasize the need for regulators to pay more careful attention and to react quicker and more sharply to problems. The regulators allowed bad financial innovation to create much unnecessary harm, even the two-edged nature of innovation.