Financial Innovation, Regulation and Crises: A Historical View
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Third, financial innovations have tended to increase returns earned by the intermediaries who market them, and thus have often had a positive impact on the overall profitability of the financial sector. Indeed, in the decades preceding the 2007–8 crisis, banks increased their returns considerably thanks to the development of a structured credit market (credit derivatives, structured investment vehicles, collateralized debt obligations), which allowed them to move capital intensive assets off balance sheet through the direct pairing of non-bank liquidity providers (fixed income investors) with corporate and sovereign borrowers.11 It should be immediately added that precisely because of these higher returns the incentive or justification for pushing such innovations and high-risk activities ever further proved irresistible, often enough beyond what was sustainable over the longer term. For all these reasons, and notwithstanding repeated excesses, a strong case can be made that, on balance, financial innovation has been a positive force for economic growth, wealth creation and development globally. Joseph Schumpeter has argued that many of the technological and commercial innovations of the nineteenth and twentieth centuries would not have been possible without financial innovations such as the joint-stock company and limited liability.12 Given the apparent Jekyll and Hyde quality of financial innovation, the key question seems to be: how can we ensure that financial innovation remains a force for the good and prevent it from going awry? Proper risk management and regulation may seem the most logical answers. Risk management – be it in the form of collateral, hedging, hidden reserves or the sophisticated types of risk modelling currently in vogue – is at least as old as the financial system itself. Regulation too has a long history, for instance in the form of religious interdictions on usury. If unregulated financial innovations are an important cause of financial crises, it would appear reasonable to aim for tighter, or at least more effective, regulation. However, due to the very nature of innovation, regulation will practically always be behind the curve – that is to say, it will try to regulate to avoid a repetition of what already went wrong rather than to prevent things that still may go wrong.13 There is a race between financial innovators and regulators that the regulators will always lose, ‘but it matters how much they lose by’.14 Tighter supervision and new regulations typically aim to address the deficiencies – perceived or real – of loose or outdated regulation. But regulatory reform may also hold the risk of over-regulation – particularly when it is undertaken under the impression of a severe crisis. Over-regulation tends to stifle innovation and therefore might have negative welfare-effects. In short, the difficulty is to strike the right balance. It should be clear that there are no easy fixes in this area. A financial crisis and the almost inevitable regulatory responses to it, have longer-term effects when they shape the future path of financial development. New risk management strategies, adopted to contain a crisis situation, may in
