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Putting the Financial-Innovation Genie Back In Its Bottle

June 2, 2010
Putting the Financial-Innovation Genie Back In Its Bottle

(Editor’s note: This is the second post in the HBR Debate, “Finance: The Way Forward.” The first post is here.)

Does financial innovation contribute to economic growth and employment?

If you asked this question up until mid-2007, most observers would have automatically answered “yes.” After all, the last few decades of global GDP growth coincided with rapid financial innovation. The link seemed obvious. The crisis that has unfolded since 2007, however, has led a growing number of experts to question such conclusions.

Evidence from the credit bubble and its aftermath suggests that financial innovation contributed to economic growth mostly by increasing leverage and concealing risk. It contributed to employment temporarily by making the financial services sector an instability-increasing, rent-seeking, GDP-dominating monster.

In any event, there is a clear case to be made that the wrong questions are being asked.

There is an old anecdote about asking for directions in a strange town only to be told, “I wouldn’t start from here.” Financial innovation is sometimes assumed to resemble technological innovation, appearing in a vacuum and making life better. The reality is slightly different.

Most financial innovation exploits inefficiencies created by regulation and governance mechanisms — for example accounting rules, credit ratings, securities listing rules and politically-motivated fiscal distortions. What does this tell us? Rather than assuming inefficiency is bad, and innovation is good, we need to address the causes of inefficiency.

For example, mortgage securitization became huge in the United States largely because of two factors: a failure to properly regulate mortgage banks (S&Ls) in the 1970s-1980s and the presence of government-sponsored agencies to guarantee mortgage-backed securities. Originate-to-distribute securitization does not lead to cheaper mortgages or a more stable system by itself. As in the anecdote, the answer depends on your starting point.

Financial regulation and government incentives (such as encouragement of home ownership) exist for a reason. They have a social value tested by democratic consent, and inefficiency is sometimes the price of consent. Financial innovation may provide a short-term safety valve when politics and regulation become stalled or dysfunctional. By the same token, allowing financial innovation to undermine the values that the rules imperfectly embody can prove to be damaging and inequitable, overriding shorter-term benefits.

It could also be argued that so long as regulation and governance mechanisms can make the distinction between good and bad, financial innovation should be permitted to flourish as a free market mechanism. However, that places an unrealistic burden on the shoulders of supervisors and investors.

At a micro scale, financial innovation almost always appears good and indeed ethical. It is always locally possible to maximize a “private good” (such as shareholder value relative to a benchmark) using financial innovation. Unfortunately, it is less easy to perceive the “public good” being undermined when large numbers of economic actors collectively do what locally seems the right thing.

Liquidity, corporate governance standards, banking confidence and consumer responsibility are all example of public goods undermined by untrammelled financial innovation. Identifying these public goods and intervening in a timely way is a challenge for so-called macroprudential or systematic risk regulation and is likely to be a politically fraught process. In the face of such challenges, there is a case to be made that some financial products and innovation should be quarantined or even banned from the banking system.

The role of financial innovation in society is subject to interpretation.

The most important financial innovation either happened a long time ago (such as the joint stock corporation, centrally cleared exchanges, bankruptcy law) or is fairly mundane in nature (electronic payment systems to replace bills of exchange). In 2009 Paul Volcker famously described the automated teller machine (ATM) as the peak of financial innovation.

Most of the financial innovation that occurred over the past twenty years has had a destructive impact. That isn’t to say that all derivatives or securitizations were bad, but as of today the negatives have outweighed the positives. The phenomenon whereby 60 percent of the Harvard College graduating class of 2006 moved into finance or consulting was a signal of the social damage being done to the capitalist system.

It’s time to utilitize finance, focusing on cheapness and stability rather than the fetish of innovation for its own sake.