One of root causes of the current financial instability is ascribed to the growth of financial innovation in mortgage structured products over the last decade. This has lead to the development of products which are complex, illiquid and hard to value in normal market conditions, let alone in the abnormal conditions as it is now. Banks which brought these products had little understanding of the inherent risks, and the rating agencies understood them even less when they rated products which were sliced and diced by smart investment bankers driven by greed and ambition. When default rates in the underlying mortgages went up, the result was that the mortgage markets went awry, and the series of collapses resulted in systemic shocks which are being felt across the globe.
The history of the financial markets indicates that there are periodic booms and busts with a financial disaster lurking around every now and then. Over the past decade one saw key events such as the collapse of LTCM and the Asian financial crisis, all of which focused the need for the regulators to have an adequate and reliable early warning system.
The cycle of periodic booms and busts has a theoretical perspective and is euphemistically called as a state of ferment by Joseph Schumpeter. According to this theory, capitalism itself is in a creative destruction mode with spurts of innovation destroying established enterprises and yielding new ones. Unfortunately, this theory did not focus on the resulting financial instability that could result from an overdose of innovation from all stakeholders.
Prescribing Limits?
This brings us to the central question of this blog: Should financial regulation prescribe limits on the growth of financial innovation? Or should financial regulation adopt a laissez-faire approach which allows participants to self regulate and market forces to play out?
History of Financial Innovations
Let us try to put some perspective in order to answer these questions. Financial innovations are not necessarily a bad idea. In fact the history of financial sector is replete with innovations which are driven by the invisible hand of the entrepreneur in search of personal gain. Examples quoted here include an entrepreneurial bank that extended loans to individuals and small business in the aftermath of the San Francisco earthquake in 1906. The concept of retail banking was thus born and the bank grew by establishing a network of retail branches all over California. Today, we know this entity as the Bank of America.
Other important financial innovations that have promoted efficient allocation of capital resources are the access to the junk bond markets and the securitization of illiquid loans. In the former case, access to capital drove a series of M&A deals which resulted in inefficient firm being taken over and in the latter case it resulted in dispersion of risks across a wider cross section of participants.
Let us also not forget that risk management itself is the beneficiary of the process of financial innovation. In fact the need to measure risk of all trading positions on a daily basis and communicate to the top management on the same day by 4:15 PM lead to the development of the concept of value of risk (VaR). This innovation was found so useful that the Basel Committee recommended its usage in the Market Risk Amendment to the Capital Accord in 1996.
Objectives of Financial Regulation
To answer the laissez-faire approach question first, Governments and regulators will continue play an important role in the regulation of the financial sector. As Joseph Stiglitz, says there are limits to a self regulating and self correcting system of free markets as there are always imperfections in the markets in the form of externalities. A humbled Alan Greenspan recently admitted that he had put too much faith in the self-correcting power of free markets and had failed to anticipate the self-destructive power of wanton mortgage lending. In his words: Those of us who have looked to the self-interest of lending institutions to protect shareholders equity, myself included, are in a state of shocked disbelief.
In addressing the risks that financial innovation may create, we should also always keep in view the economic benefits that flow from a healthy and innovative financial sector. As we have seen above, some innovations promote efficient capital allocation and enables greater resilience of the system. When proposing regulation, the intent should be to encourage financial innovation as before while seeking to address the risks that may accompany that innovation. The real challenge is to find a balance which encourages innovation on the one hand, while also discouraging excessive risk taking.
A policy of regulating specific products (which are deemed risky or complex) or singling out institutions for greater regulatory oversight may not be workable since moral hazard concerns may well follow.
The alternative, i.e. an across the board regulatory oversight framework based on principles is preferable. Such a system will have three principal objectives (1) financial stability, (2) investor protection, and (3) market integrity. These objectives have been the bedrock of regulation ever since central banks came into existence and are even more so in these troubled times .
The actual implementation of financial regulation has been a mix of both a rule based and a principle based approach. In fact the rule book issued by regulators around the world (the FSAs rule book runs into 8,500 pages) seems to suggest that the regulators have put a microscope to the banks under their jurisdiction.
In practice, given the dearth of resources (both in qualitative and quantitative terms) in Central Banks, regulators will adopt a risk based supervisory approach: greater the risk posed by the bank, greater the supervisory attention and resources devoted to the review of that bank.
Conclusion
The title of the blog suggests a circular link between financial innovation and regulation. Does excessive financial innovation (and the resulting risk taking) lead to excessive regulation? Will excessive financial regulation lead to a different kind of financial innovation in order to get over the restricting regulations?
As I completed this blog, I received an alert from the Mckinsey Quarterly which had an article which answered some of the issues that I had raised in my blog.
I found the answer in my mailbox!
Mckinsey on Creative Destruction and the Financial Crisis:
The article is an interview with Richard Foster, a senior Director with Mckinsey who is also the Co-author of the book Creative Destruction: Why Some Companies That Are..... The Authors argue that much of the regulations and the financial institutions that we see today have evolved as a response to financial crisis over the past century. In the long term these have proved beneficial to markets and its participants.
Equally the Authors also argue that the regulations also force any self respecting entrepreneur to get over the restrictions by finding a way out...The example given here is that of the phenomenal growth of credit default swaps which was because other options were regulated.
The full article can be downloaded here:
Download file
Some Excellent Reading
The Washington Post examines how Wall Street innovation outpaced Washington regulation
How did the most dynamic and sophisticated financial markets in the world come to the brink of collapse?
The NY Times examines what went wrong in Risk Mismanagement
The great housing-fueled market bubble couldn’t burst, could it? The best Wall Street minds and their best risk-management tools failed to see the crash coming.
