Tuesday, April 7, 2009

In Defense of Financial Innovation

There is considerable talk (much of it rather regressive) about the future of the financial system. In one camp are the advocates of a return to basic banking. Think George Bailey and “It’s a Wonderful Life”. Paul Krugman, John Bogle, and Meredith Whitney appear to belong to this group. Then there are those who believe that the system should evolve from where it was, only with better oversight and far greater transparency. By all accounts, Secretary Geithner and Mohammed El-Erian belong to this group.

As unpopular as it currently may be, I’m on the side of the Treasury Secretary and PIMCO CEO for the following reasons:

I believe financial innovation must be allowed to grow and even flourish as the benefits of risk management and opportunistic investing through derivatives, structured finance, and other heretofore unknown instruments is vital to the complex world of globalization and global capital flows. Financial innovation allows for the more efficient use of capital in new and innovative ways thereby enabling greater growth potential across most markets and economies. Perhaps most importantly, as providers of global capital, financial innovation is important to the dominant players in the markets - major institutional investors (pension funds, sovereign wealth funds, endowments, hedge funds, etc) - and their ability to manage large sums of money in the vast and growing global markets and economy. They want it. Even need it.

The George Bailey model is simplification for its own sake. A Luddite-like natural recoil action to the pain and suffering caused by the failure of proper oversight and transparency. Moreover, the Bailey model would relegate the US financial institutions to a dumbed-down version of finance completely at odds with a globalized world and economic system (not to mention the unintended consequences of assets flowing to other, more forward-thinking markets). I believe Secretary Geithner sees and understands this and that is why, much to the consternation of many old school thinkers, he is intent on keeping the current financial infrastructure in place, just fix that which went out of control courtesy limited oversight and inadequate transparency.

With better oversight and greater transparency, the benefits of financial innovation to the global economic system far outweigh the damage wrought by the inept supervision of a complex world of finance and capital flows.

Think of it this way, did FDR blow up the stock market after the 1929 to 32 crash? What he did was create the SEC, which served the system well until the free market ideologues got control of it over the past several decades and, with the aid of financial innovation, allowed the animal spirits to run roughshod over common sense and prudent asset management. Another example would be the Internet and the tech bubble blow up. Did technology innovation stop because of Enron and WorldCom and the multitudes of dotcom implosions? Of course not.

Financial innovation is a tool. And like any tool, it can be used for good or ill. You don't ban knives because someone gets stabbed. You don't ban guns because someone gets shot. And you don't ban cars because someone gets run over. Innovation is essential for forward progress. And, in the case of finance, an enabler of better asset and risk management.

Financial innovation is the baby. Don't throw him out with the bath water of poor oversight and limited transparency.

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