6
Financial Innovation, Regulation and Crises in History
New financial products that claim to spread risks more evenly are easily perceived as safe. Rating agencies play an important role in this process: although these new products are untested in times of market stress, they nevertheless receive a clean bill of health in the form of a triple-A rating. The underlying risks are still present, but are largely ignored.6 Moreover, while risks with a normal distribution can be mathematically modelled and thus factored in in the pricing of financial products, uncertainty, due to the use of systematic errors, cannot. In a boom market, this potential weakness of new financial products is further compounded by their over-issue and financial institutions’ over-leveraging. Because they are supposedly risk-free and at the same time promise high returns, there is a high demand for and excessive issuance of such new products.7 Over-issuing finally contributes to a loss of confidence and a collapse. The end result is often that the economic and social value the initial innovation may have had is wiped out altogether. Some even go so far as to argue that many of the recent financial innovations had little or no economic or social value to begin with, but were mainly driven by an insatiable market appetite or, worse, merely aimed ‘to give banks new instruments to allow them to profit at the expense of unsophisticated individuals and households’.8 Indeed, Paul Volcker once famously remarked that the only socially valuable financial innovation of recent decades has been the automatic teller machine. In short, the current crisis has cast financial innovation in a bad light. However, this should not mean that it is necessarily or always a bad or dangerous thing. In fact, financial innovation per se is not inherently bad or good. It is the use that is made of it that matters. As Michael Haliassos puts it: ‘financial products have something in common with building materials. One can use a brick to build a house or to smash a window’.9 In economic literature, financial innovation is most commonly seen as a positive force. There are plenty of examples in which financial innovation has played the positive role it is supposed to play. First, much of the financial innovation over the past centuries has helped to expand access to credit for households and firms (and government), by tapping into new sources of funding. Secondly, many financial innovations have indeed been aimed at improving the spread of underlying risks – market risks, credit risks, liquidity risks – and have been successful in doing so. They have thereby enhanced the capacity of the financial system and of the economy as a whole to take on more risk without necessarily jeopardizing overall stability. A good example of an institutional innovation that has achieved precisely that, is the introduction of limited liability in the nineteenth century.10 A good example of a successful financial product innovation would be exchange-traded forward contracts (futures), which first appeared in Japan in the 1730s (Dōjima Rice Exchange, Osaka) and which became fashionable in the sector of commodity trading as of the late nineteenth century.
