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A thought on financial innovation

We talk a lot about "financial innovation." This sounds pretty good, though it turns out to be pretty hard for anyone to make a very good case in its favor (this is the best attempt -- warning: pdf -- I've seen). If we were more precise, however, and asked whether we think it should be a high priority to craft our regulatory regime so that Wall Street has maximal freedom to invent new financial instruments that neither they nor regulators really understand, I think feelings would sour on this pretty quickly.

And just to add a second level onto that, when Wall Street is really innovative, it's very lucrative, which means it sucks talent away from other sectors. I'm not ready to embrace an innovation-depressing regulatory regime based on this, but I've really not seen a case for worrying about preserving financial-instrument innovation in the way we worry about preserving, say, pharmaceutical company innovation.

By Ezra Klein  |  March 26, 2010; 5:08 PM ET
Categories:  Financial Regulation  
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Comments

financial innovation = staying 1 step ahead of regulators.

financial innovation = path to wall st crash

financial innovation = the super rich becoming oligarchs while everyone else bails them out.

Posted by: srw3 | March 26, 2010 5:23 PM | Report abuse

financial innovation = privitizing profits and socializing losses.

Posted by: srw3 | March 26, 2010 5:25 PM | Report abuse

I think the most "innovative" thing we could do right now is to put back every single bit of financial sector regulation that was in force in the 1970's.

Posted by: Patrick_M | March 26, 2010 5:37 PM | Report abuse

Well, not all financial innovation has been bad. I think the world is better off having stock and bond markets, commodity futures, interest rate swaps and the like - and at one point these were all financial innovations. It's hard to know what will one day become a useful innovation. You could have argued that the stock market a few hundred years ago was a negative innovation because of all of the booms and crashes, but on net I think most would agree that the world is better off having stock markets.

I think that perhaps some financial products which are vilified today - say the credit default swap - might be seen one day as a useful financial innovation. The problems with CDS probably won't ever be repeated - modest regulation and a clearinghouse for these products should prevent most problems. I would imagine that CDS in a well regulated market increase the flexibility of market participants to manage their risks, ultimately increasing available capital /lowering the price of capital. The main problem with CDS in '07 was that you could offer to insure someone's bond without saving up money for losses. Homeowner's insurance would have been a 'negative financial innovation' if insurers were allowed to sell homeowners policies and then require bailing out because they didn't reserve for losses.

Even securitization might turn out to be okay provided someone faces the consequences of losses (such as the originators being required to hold a part of the riskiest tranche) or safeguards are placed on collateral (like 20% down on mortgages).

Posted by: justin84 | March 26, 2010 5:41 PM | Report abuse

justin, the problem is that innovation was preceded by Graham/Leach/Bliley. That's why derivatives, CDSs and MBSs were completely unregulated and crashed the economy. The more money wall st has, the more influence they wield with congresscritters to keep them unregulated, which makes wall st more money that is used to bribe congress to fight regulation, and so on...until the house of cards falls again and taxpayers bail them out like in the savings and loan debacle, the hedge fund bailout and the most recent tarp and treasury buying spree that kept the fat cats in caviar and bentleys.

Why haven't all of the top management in the bailed out firms been replaced and their assets (earned while they screwed the economy) seized to pay back the govt?

Posted by: srw3 | March 26, 2010 5:51 PM | Report abuse

You know what really sucks away talent? The fact that Pell grants only pay for, at most, about a third of the cost of an education, and a lot less than that at private or top tier public institutions. For the rest, you have to load up on debt, and someone in that condition simply can't afford to go into anything less than a high paying position like financial Oz.

Posted by: pj_camp | March 26, 2010 6:26 PM | Report abuse

Srw3,

Point taken. With financial innovation often times things might not initially work out well, and finance companies oppose corrective regulation. I think that's a good case to fight very hard for financial regulation, while still recognizing that innovation tends to be (while isn't always) a good thing. Over the long haul, I think we'll figure out the appropriate regulation, and the financial innovations that survive will be ones that have proven to have long term value.

All I'm really saying is that the arguments against financial innovation because of the crash could have been used to put a stop to the stock and bond markets centuries ago, or to other innovations more recently, and I think it's pretty clear that despite the occasional crash we are better off today for those innovations.

Posted by: justin84 | March 26, 2010 8:15 PM | Report abuse

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Posted by: sandraallen27 | March 27, 2010 2:14 AM | Report abuse

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Posted by: sandraallen27 | March 27, 2010 2:25 AM | Report abuse

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