Financial innovation: a balanced view

Financial innovation considered in the past as something undeniably positive for the whole economy, has become the target of a barrage of criticism since the onset of the financial crisis in 2007 and the subsequent great recession.

The institutions, the markets and the financial instruments perform four general functions of a social and economic nature. By definition, any innovations that improve the way these functions are carried out are useful. Other innovations, however, can be considered as temporary improvements, but in fact they ultimately have collateral effects that are socially damaging. Before outlining specific examples of these two types of innovation, it is important to know what these functions are.

The first function of finance is to provide channels for payment and for the deposit of assets. What we now know as money was originally embodied by coins, livestock and food products, and subsequently by paper and then bank accounts. More recently, money has been digitalized in the form of multi-use credit cards and is electronically transferred wholesale in large quantities through the automated clearing houses in the American Federal Reserve's electronic transfers and payments network (which also plays a crucial role in handling personal checks and checks issued by commercial banks) and in major banks in the United States and other developed countries through the Clearing House Interbank Payments System (CHIPS).

The second function consists of providing the means to obtain capital interest, dividends, and earnings on the money invested in finances, so that financial institutions and instruments encourage saving. Saving is important for society because it serves to finance investment in physical and human capital, which in turn generates greater income in the future.

Third, financial institutes and markets, provided they act correctly, transfer the savings from national and foreign residents to productive investments.

Finally, an essential function of finance -and one that is sometimes overlooked- is the assignment of risk to people who are more willing and able to assume it. Sometimes this function is conflated with the belief that finances reduce global risk. They do not and cannot. Instead, the most finances can do is to transfer risk to those who are best equipped to assume it and spread it in such a way that it is not excessively concentrated in very few hands.

One of the most important lessons learned from the financial crisis is that the securitization models that made possible such high-risk loans were unable to deconcentrate the risk of foreclosure on the underlying mortgage loans, as a number of market players and other analysts —including the author of this article— had maintained or expected.

Future public policies

In the summer of 2010 the United States Congress approved and the President ratified the Dodd-Frank law, which thus became the most far-reaching legislation in the area of financial reform enacted in that country since the Great Depression. This is only natural in view of the fact that the financial crisis of the period between 2007-2009 was the most serious since the 1930s, and it would have been surprising if Congress not done anything to address this.

There is no doubt that the debate on the merits of the definitive formulation of the Dodd-Frank law will continue for years, and what is more important, on the way in which it is implemented through the more than 200 applicable regulations that will ultimately convert its generally ambiguous legal language into much more specific regulatory guidelines. As the regulatory authorities return to business as usual, and future legislators make minor —or possibly major— adjustments to this law, their attitudes to financial innovation will be of primary importance.

One of the lessons learned from the recent crisis is that potentially dangerous bubbles can form when particular classes of assets or specific financial instruments grow very fast. The future regulatory authorities will be much more effective in their actions in identifying and preventing potential bubbles -and thus future sources of systemic crises- if they take note of the significant market-based warning signals such as were triggered in the case of credit default swaps, which the regulators could use to justify their own early preventive actions.

In short, an impartial analysis of the financial innovation carried out in recent years reveals a more positive outlook than has been outlined by some more skeptical observers. However, regardless of how we assess the financial innovation of the past, the recent crisis has shown that political leaders must act more promptly to correct abuses when they arise and prevent destructive financial innovations from wreaking the type of economic havoc that we have unfortunately just witnessed.