Defending financial innovation

John Plender has a fascinating defense of financial innovation in yesterday's Financial Times - Originative sin: the future of banking. The discussion is a wonderful tour of the subject, including a sidebar on the role of financial innovation in the rise of the Genoese bankers, who developed the equivalent of interest rate swaps in their lending to the Spanish government. The heart of the argument is as follows:

The financial system does many things. Among others, it provides a means of payment and exchange; it transfers the spare cash of savers to those with investment opportunities; it allows assets to be traded; and it provides insurance, whether in conventional contracts or in such instruments as swaps, options and other derivatives.

In all these areas, innovation has provided tangible benefits. Computerisation has improved the payments system, while technology such as automated teller machines has been a huge convenience to retail bank customers. The internet is transforming the availability of financial information and is lowering transaction costs in broking. Like many other innovations in retail finance, these advances do not involve the creation of debt.

Even in those areas that do, the outcome can still be beneficial. The development of the swaps market, for example, led to the new disciplines of treasury and risk management whereby the banks’ ability to swap fixed for floating interest rates and vice versa allowed them to insure against rate volatility. Currency swaps fulfilled a similar function. With the huge increase in market volatility stemming from deregulation and the abandoning of fixed exchange rates in the 1970s, this ability to hedge was a boon to banks. At the same time, computerised trading increased the efficiency of markets.

More often than not, innovation is satisfying genuine demands. Where the curse comes in is that many innovations are double-edged. Plastic cards, in so many ways a benefit to bank customers, may lead to over-­indebtedness, a growing social problem. Derivatives can be used to punt as well as to hedge. Credit default swaps were developed as insurance to protect investors against a failure to honour loans or bonds. Then came the collapse of Lehman Brothers, which revealed the extent to which people had underestimated the risk of their counterparties defaulting.

Thus, the need to look at innovations carefully. As they used to say in technology assessment, technology is neither good nor bad, nor is it neutral. Substituting the word "innovation" would be completely appropriate. Innovation -- by its very definition -- is not neutral because it changes things. When things change, both good and bad can happen. The trick is to facilitate the good and mitigate the bad -- and, because it all depends on where you stand, it might be hard to tell the difference between the two.

Minor case in point, I would take some exception to Plender's concluding argument that most financial innovation stems from regulatory arbitrage -- the desire to get around government regulations. He points to the 1970's and 1980's experience with the imposition and then removal of Regulation Q interest rate caps. I have a slightly different set of lessons from that experience. He points to how Regulation Q created a wave of regulatory arbitrage. I would point to how the imposition and then removal of Regulation Q led to a wave on unintended consequences -- including the S&L crisis -- because of the lack of a systemic view. One action creating problems and issues, the solution of which created other problems, and so forth in a cascading manner. The result was a completely different regulatory environment by happenstance, not design.

That is a lesson that I fear we appeared to have forgotten in our current crisis.