A NEW paper by Nicola Gennaioli, Andrei Shleifer, and Robert Vishny explains the dynamics by which financial innovation generates crisis:
Many recent episodes of financial innovation share a common narrative. It begins with a strong demand from investors for a particular, often safe, pattern of cash flows. Some traditional securities available in the market offer this pattern, but investors demand more (so prices are high), or perhaps demand securities with slightly higher returns and no extra risk. In response to demand, financial intermediaries create new securities offering the sought after pattern of cash flows, usually by carving them out from existing projects or other securities that are more risky. By virtue of diversification, tranching, insurance, and other forms of financial engineering, the new securities are believed by the investors, and often by the intermediaries themselves, to offer at least as good a risk return combination as the traditional substitutes, and are consequently issued and bought in great volumes.
At some point, news reveals that new securities are vulnerable to some unattended risks, and in particular are not good substitutes for the traditional securities. Both investors and intermediaries are surprised at the news, and investors sell these “false substitutes,” moving back to the traditional securities with the cash flows they seek. As investors fly for safety, financial institutions are stuck holding the supply of the new securities (or worse yet, having to dump them as well in a fire sale because they are leveraged). The prices of traditional securities rise while those of the new ones fall sharply.
Sound familiar? These risks seem like an intrinsic part of financial innovation, which means that the costs associated with crises are also an intrinsic part of financial innovation. So the question is, should we still embrace financial innovation? Back in February, Bob Litan assessed a number of financial products to try and determine whether, contra sceptics, financial innovation has managed to produce any socially useful products. It has, he says: credit and debit cards, investment funds, inflation-indexed securities, options and swaps. Other innovations have been less of a boon for the economy, including collateralised-debt obligations (securities built from other securities, pooled and chopped up) and structured investment vehicles (off-balance sheet investment funds used by banks). But, as he notes, socially useful financial innovations can be misused (just as socially useful technical innovations can be misused). He concludes:
I believe that financial innovations in general are much less like drugs and nuclear power, which deserve some kind of preemptive screening or regulation, and much more like virtually all other innovations to which U.S. policy historically has applied a “wait and see” regulatory approach. To be sure, given the various events that led up the recent financial crisis, policymakers must be better prepared in the future than they were before the financial crisis to step in – first with disclosure standards and possibly later with more prescriptive rules – when finance looks like it is taking a wrong turn.
The one area where an exception to this general “be prepared” strategy may be appropriate and even necessary relates to long-term contracts entered into by consumers, such as mortgages (when borrowing) or annuities (for retirement). There is a strong and growing literature in behavioral finance indicating that individuals are not always rational in their investment decisions. This tendency is dangerous when even well-informed individuals are making long-term financial commitments, with heavy penalties (in the case of mortgages) or perhaps no exit strategies (in the case of annuities) for changing one’s mind later. In these cases, preemptive approval of the design of the financial products themselves may be necessary to prevent many consumers from locking themselves into expensive and/or potentially dangerous financial commitments. But this exception should remain that way and not become the rule.
As Mr Litan admits, his analysis is more qualitative than quantitative, which is too bad. It leaves us arguing more about principles than about costs and benefits. Obviously, there is some benefit to an environment conducive to innovation. But there are also some costs to the creation of new financial products. Some of these costs are minor—stemming from products that give issuing firms new market power, for instance. Others are the large, tail-risk costs associated with crisis. These are painful enough that greater pre-emptive vigilance may be warranted.
Though as Mr Litan also points out, financial regulations can themselves induce financial innovation, to get around bank-profit limiting rules. And because finance is global, innovation that occurs outside a highly regulated market can nevertheless disrupt that market. One can’t just consider the costs of innovation; you also have to understand the extent to which action can limit those costs.
It might not make sense, then, to try and rein in innovation in the financial sector. But it is critical to remember that there is an inherent element of danger in the activities of the financial sector and in financial innovation, and private rewards and government policy should reflect the risk that related costs may well be passed on to the broader economy.
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