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What Do You Mean by "Innovation?"

Justin Fox on financial innovation:

I'd rather have today's financial system, however flawed it is, than the financial system of [the year] 1200. But at the same time, an estimated 97.3% of all financial innovations (I just made that up, but it seems about right) are just new ways to fleece customers or hide risk, and all major financial crises have been associated with some financial innovation or another. So is there any way to still get the long-run evolution of the financial system that is on balance a good thing, while avoiding the blowups and wealth transfers to financial system players from the rest of us?

The answer may be no. But it seems like some sort of slowing and testing mechanism—akin to the FDA approval process for drugs—could bring more stability while still allowing for innovation. And that's what the Consumer Financial Protection Agency would be, right?

The term "financial innovation" is a bit of a weird one. Overdraft fees are a "financial innovation." So too is the noxious practice of universal default. But so are ATMs. And, for that matter, banks. It's all a bit broad.

"Innovation," in most other areas of life, means forward progress of a discrete sort. A new price for the Nintendo Wii, for instance, wouldn't be considered an innovation in video games. But the Nintendo Wii was considered an innovation. "Innovation," in that sector, tends to mean technical progress. Conversely, the financial sector takes a pretty relaxed view of the word "innovation": It seems to denote "new stuff we're doing." That stuff might be ways to eke out more profit or spread risk or hide risk or make it simpler to withdraw money. It would be a lot easier to say whether financial innovation is good or bad, however, if people were a bit more specific on what sort of innovation they were looking for. What I think we can say, with some certainty, is that simply trusting the financial sector's definition of worthwhile innovation hasn't worked out too well.

By Ezra Klein  |  July 20, 2009; 3:31 PM ET
Categories:  Financial Regulation , Solutions  
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Comments

A financial innovation is a new way for financial firms to make money.

Sometimes these benefit the clients and sometimes they benefit the consumer. Sometimes they make the allocation of capital more efficient. Sometimes they spread risk. Sometimes they make new areas for investment.

But it's telling that they always, ALWAYS, make the financial intermediary money.

That is what defines
"innovation" in this industry. Whether they add to the issuing firm's bottom line. Not their system, consumer, or client benefit.

Posted by: theorajones1 | July 20, 2009 5:08 PM | Report abuse

Ezra,
Your definition of innovation is perhaps a bit loose. You say "forward progress." I think of innovation as "action(s) that turn ideas into value."

If we accept that definition, than the key questions are: (1)Value for whom? and (2)Value for how long? At a minimum, the word "value" suggests that you are doing more than shuffling funds around (from the suckers to the "innovators").

Posted by: michael16 | July 21, 2009 12:53 AM | Report abuse

Well surely the game changing innovation in finance is the credit score. It allows loans to be processed instantly by a computer algorithm, instead of by loan officers laboriously scrutinizing the borrowers' pay stubs.

The critcal failure lies in he fact that the computer models were developed and validated against the old rules of laborious personal scrutiny. But the computer models changed the rules in such a way that they no longer predicted the default risk accurately.

Posted by: Aatos | July 21, 2009 9:01 AM | Report abuse

Ezra,

The most important financial innovation was the asset-backed securities market backed by the credit rating agencies. When the credit rating agencies squandered their reputation by rating subprime loans AAA the asset-backed securities market died.

There is a great on-line radio interview about the financial crisis that really explains what has gone wrong and where we need to go from here. It can be found at www.mindyourbizness.com

In my mind the question we need to ask is what new innovation do we need to move the economy forward, because we broke the old ones.

Posted by: Hailmaryyy | July 21, 2009 10:14 AM | Report abuse

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