Is Financial Innovation Constructive or Destructive?

After decades of praising innovative financial mechanisms and models for their ability to create value, the tools of wealth creation have come under attack. Some economists claim that the authorities have failed to uphold their regulatory responsibilities of channeling financiers whims toward sustainable economic growth and social development. Others argue that these mechanisms are inherently self-serving, generating profits solely for their creators. Most recognize that policy plays an important role in ensuring that financial innovations benefit the broader economy. But not all financial innovations have been socially and economically destructive.  While there are plenty of examples of tools that have failed us recently, it is important not to overlook the ones that continue to shore up our financial system.

First let’s tear apart some of the more detrimental innovations of our time. First and foremost, collateralized debt obligations (CDOs) played a major part in financing way too many subprime mortgages that led to the financial crisis. Similarly, the Structured Investment Vehicle (SIV), created by Citigroup in the late 1980’s to warehouse asset-backed securities and avoid bank capital rules proved fatal for long-term financial stability. Other innovations that were originally designed to aid buyers and increase liquidity, such as the adjustable rate mortgage (ARM) and the home equity line of credit (HELOC), were abused by both borrowers and lenders throughout the 1990’s. These initially useful mechanisms became detrimental when they lured people into loans they couldn’t service and allowed decision-making based on asymmetric and inaccurate information.

Now let’s take a look at many more beneficial financial innovations and the ways they have positively impact our economy.  Beyond buying stocks and bonds, money market funds, indexed mutual funds, exchange traded funds and inflation-protected treasury bonds (TIPS) have revolutionized the way people save for the future. These funds offer not only added convenience but better risk-adjusted returns than previous alternatives. As for payments, the introduction of credit cards, debit cards and internet payment options like Paypal have changed the way people consume and spend (for better, and in some cases for worse). Mobile banking is paving the way in developing markets, empowering producers and consumers who were previously deemed un-bankable and providing increased transaction security.

Finance also helps translate society’s savings into socially valuable investment. Although mortgage related innovations have taken their toll, securitization has been and will continue to be constructive by expanding sources of financing. Though its future is uncertain, venture capital has benefitted the U.S. economy in many ways, and private equity has fueled start-ups and saved struggling firms that needed a push. And finally, the rise in options, futures, interest-rate and currency swaps and has allowed firms and institutional investors to hedge all kinds of risks. As long as these swap arrangements are standardized, centrally cleared and traded on exchanges to reduce systemic risk and pricing, another AIG misuse of CDs will not be likely.

The sweet spot for policy makers then, is to fully understand the side effects of innovation and limit negative unintended consequences without stifling positive progress. Being mindful of destructive innovation and the misuse of constructive innovation is a first step to preventing financial bubbles. Meeting this challenge is not an easy, but certainly a worthwhile undertaking.

Photo Credit: Andres Rueda