8
Financial Innovation, Regulation and Crises in History
turn prompt financial innovations in the quest to achieve a better spread and reduction of risks. Regulation may block undesirable developments and undo earlier innovations, and thereby elicit new ones and open up new trajectories. Finally, the long and winding road of financial development is marked out not only by innovation, crisis and regulation, but also by the financial policies – monetary, fiscal, institutional – pursued by central banks and governments. The result of these interlocking, and often conflicting, events, influences and interests is that the financial system does not develop linearly, but rather along a tortuous, often unpredictable, path, with many ups and downs and characterized by sometimes violent pendulum swings between financial repression and financial liberalization. This volume explores a few stretches of this road, highlighting many of the key issues in the dynamic relationship between financial innovations, crises, risk management and regulation. When or under what conditions are financial product innovations most likely to occur? And, equally important, what makes them stick? (Chapter 2) How and when do institutional innovations arise and what is their longer-term effect? Do they give rise to alternative models in financial development that tend to lead to a better (or worse?) risk mitigation? (Chapters 3 and 5) Under what circumstances can financial innovations become a threat to financial stability? Does history suggest that there is an almost inevitable sequence from financial innovation to ‘irrational exuberance’ (to borrow Alan Greenspan’s famous phrase) to crisis? Or does one rather have to look to misguided policies and failing oversight to explain why financial crises occur over and over again? (Chapter 6) Finally, once a financial crisis has broken, what strategies have been adopted in the past to deal with it – at company, national and international level? How have companies managed the fall-out of severe financial crises? (Chapter 4) How have national and international authorities reacted, and what has been the longer-term impact of their actions on regulation and, eventually, on further innovation? (Chapters 5, 6 and 7) Most chapters look at historical episodes of financial innovation and crisis, but there is also a conscious attempt, particularly in the final section of this book (Chapters 8 and 9), to reflect, from a historical perspective, on the current crisis. In Chapter 2, Lodewijk Petram deals with a financial innovation that has had a durable institutional impact. Petram traces the origins of the secondary shares market to the Dutch Republic in the early seventeenth century. Secondary trading in shares of the Dutch East India Company (VOC) developed in a full-fledged financial market that allowed investors to actively manage their portfolio and thereby to diversify risks. The consistent enforcement of the related contracts through the courts was decisive in making this innovation stick. This created a larger measure of legal certainty, which reduced risk and transaction costs and consequently persuaded more investors to become active in this new market. Drawing on extensive research in the original court records,
