Monday, September 28, 2009

Why Financial Innovation Is A Very Good Thing

Destructive financial innovations like derivatives have eroded the public's trust and made financial innovation a bad word. However, there are still financial innovations that can help the average American, and Robert Shiller argues why financial innovation is still needed. See the following post from Economist's View for more.

Robert Shiller defends financial innovation:
In defense of financial innovation, by Robert Shiller, Commentary, Financial Times: Many appear to think that the increasing complexity of financial products is the source of the world financial crisis. In response to it, many argue that regulators should actively discourage complexity. ... They do have a point. Unnecessary complexity can be a problem ... if the complexity is used to obfuscate and deceive, or if people do not have good advice on how to use them properly. ...

But any effort to deal with these problems has to recognize that increased complexity offers potential rewards as well as risks. New products must have an interface with consumers that is simple enough to make them comprehensible, so that they will want these products and use them correctly. But the products themselves do not have to be simple.

The advance of civilization has brought immense new complexity to the devices we use every day. ... People do not need to understand the complexity of these devices, which have been engineered to be simple to operate.

Financial markets have in some ways shared in this growth in complexity, with electronic databases and trading systems. But the actual financial products have not advanced as much. We are still mostly investing in plain vanilla products such as shares in corporations or ordinary nominal bonds, products that have not changed fundamentally in centuries.

Why have financial products remained mostly so simple? I believe the problem is trust. ... People are ... worried about hazards of financial products or the integrity of those who offer them. ... When people invest for their children’s education or their retirement, they ... may not be able to rebound from mistaken purchases of faulty financial devices...

Thus, to facilitate financial progress, we need regulators who ensure trust in sophisticated products. ... They must ... be open to ... complex ideas ... that have the potential to improve public welfare.

Unfortunately, the crisis has sharply reduced trust in our financial system..., people do not trust some good innovations that could protect them better. ... I have proposed ... “continuous workout mortgages”...[to] protect against exigencies such as recessions or drops in home prices. Had such mortgages been offered before this crisis, we would not have the rash of foreclosures. Yet, even after the crisis, regulators seem to be assuming a plain vanilla mortgage is just what we need for the future. ...

Another innovation that is underused is retirement annuities... There are ... annuities that protect people against outliving their wealth,... that protect against inflation,... that protect against having problems in old age... and generational annuities that exploit the possibilities of intergenerational risk sharing. But most people do not make use of any of these.

Ideally, all of these protections for retirement income should be rolled into a unified product. Such products are not generally available yet. Certainly, people might be mistrustful of committing their life savings to such a complex new product at first even if it were available. So, such products are not offered and people often do nothing to protect themselves against most of these risks.

Behind the creation of any such new retail products there needs to be an increasingly complex financial infrastructure... It is critical that we take the opportunity of the crisis to promote innovation-enhancing financial regulation and not let this be eclipsed by superficially popular issues. ... Regulatory agencies need to be given a stronger mission of encouraging innovation. ...

Something has to assure people that these product are safe before they will purchase them. We might have expected the market to regulate risk not so long ago, and trusted it to do so, but that seems like a bad bet now. An "interface with consumers that is simple enough to make [the products] comprehensible" could build trust if people could believe that the person doing the simplifying had considered and understood every possible risk that is attached to the product, but did anybody really comprehend the big picture in our most recent crisis? If there were such people, there weren't very many of them, not enough to inspire confidence and trust more generally.

Another method of building confidence is ratings agencies, but they won't be trusted again any time soon. Regulators that make the public confident that nothing can go wrong would help too, but building that kind of trust in regulators after what just happened is a tall order. Private insurance of some sort is an option, but absent some sort of government guarantee, can private insurance companies be trusted with your life savings if there is a severe financial meltdown? People have even lost faith in government's ability to insure people against medical and financial calamity in old age, so when it comes to providing financial insurance, government is not the solid, trusted institution it was not so long ago.

As you tick down the list of ways trust might be restored, you find one failure after another in terms of providing reliable information on the risks of particular financial products or strategies, and no matter what regulators or anyone else tries to do to rebuild the trust in financial institutions and products that has been lost, recent track records make it likely that this will be a long, drawn out process. Given that forgetting about such risks over time seems to be an ingredient in the development of bubbles, I'll let you decide whether that's good or bad.

This post has been republished from Mark Thoma's blog, Economist's View.


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