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Reviving the Reputation of Financial Innovation

By Justin Schardin

Thursday, February 6, 2014

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The benefits of financial innovation depend on how such innovations are used and understood by market participants and regulators. Moreover, what seems like a good financial technology at first could later be revealed to have serious flaws. Collateralized debt obligations (CDOs), for example, were first hailed as innovations that would reduce the cost of borrowing and only later recognized as potential weapons of financial destruction. As regulators and market participants continue to build the new post-crisis financial market structure, they should consider how new regulations and practices are likely to incentivize beneficial innovations and limit innovations that are potentially harmful.

Innovation is usually seen as a positive force. It is easy to see the broad upsides of online banking, convenient access to cash at ATMs, and new forms of financing such as crowdsourcing that make capital more readily available to entrepreneurs. But financial innovation got a bad name in the wake of the financial crisis. Former Federal Reserve Chairman Paul Volcker famously said that the ATM is the only recent financial innovation with real value, but one can look skeptically even with a narrower brush. Exotic mortgage products with teaser rates and negative amortization, naked credit default swaps (CDS), and synthetic CDOs are examples of complex innovations that arguably exacerbated the crisis.

There is no definitive answer as to whether financial innovation is inherently beneficial. This is not only because of the difficulty in measuring and tying together the impacts of specific innovations, but also because of the inherent subjectivity of valuing outcomes. The practice of securitizing loan obligations increased liquidity in the marketplace and allowed lenders to more efficiently transfer risk to other investors willing to take on the risk. The experience of the crisis, however, suggests that securitization muted a key incentive of lenders, who have the most direct knowledge of the riskiness of borrowers, to maintain strong underwriting standards when making loans. It is not obvious that securitization has provided a net benefit to society since its invention.

Measuring particular financial innovations and the value they provide is also difficult. One recent attempt found evidence that financial innovation supports higher economic growth but also makes the financial system more fragile with more volatile economic growth and bank profitability. In addition, financial innovations are often not patentable, which incentivizes innovating companies to operate in secret to avoid seeing their techniques duplicated. This gives rise to uncertainty and volatility when problems are revealed.

Although each case of innovation is different, below are four questions one should apply when thinking about whether an innovation is or will be socially beneficial.

Does the innovation create economic growth? A new product or service that adds to the size of the economic pie, or offers another benefit like reducing risk, delivers benefits. This must be viewed over the long term, as innovation that boosts growth temporarily at the cost of a larger drop later is a poor outcome.

Are benefits broadly shared? A product or service directly or indirectly benefits only a small group at a net cost to others, or does not generally benefits its users, is likely not sustainable. CDOs provided significant benefits to key market participants and also broadly lowered the cost of capital. However, when used improperly by certain institutions, they conferred a massive risk on taxpayers, who had to backstop the financial system.

Are innovations transparent and well-understood? Even innovations that offer benefits can destabilize markets. For example, CDS can be used to reduce portfolio risk, but in the run-up to the crisis, key buyers and sellers did not know how to appropriately price them, and few understood the risk they posed to the financial system. A product intended for hedging ended up amplifying the impact of the crisis. Ensuring that the workings and risks of new products and services are transparent and well-understood helps minimize the chances of dangerous side effects.

Have regulations kept pace with change? No regulatory regime will ever be perfect. Financial regulatory agencies can improve their effectiveness, however, by adjusting regulations to account for new financial products and services. Such an iterative process will be especially helpful in the next few years, as regulators test the implicit assumptions, and see the unintended consequences, of the many new Dodd-Frank regulations they are implementing in the real world.

Rather than seeing financial innovation as either inherently virtuous or predatory, we need to ask questions that help us analyze potential implications of any given financial innovation, and try to set up a structure that maximizes benefits and minimizes costs.

2014-02-06 00:00:00
Four questions one should apply when thinking about whether a financial innovation is or will be socially beneficial