Innovations and Limitations
Where financial innovation went wrong, and how to set it right


In order to foster an environment where good and socially useful innovations are discovered, regulation must take the wait-and-see approach. Some of the best innovations were created to service a particular client need. Financial products that are not born from market demand — complex innovations for the sake of complexity — are often just marketing ploys that create opacity and provide little value. Regulation under the presumption of guilt would make the process of demand-driven innovation prohibitively slow. It takes years for the FDA to approve a drug. A similar timeline would undermine the competitiveness of financial firms, because clients can go elsewhere. As perilous as it may be, the only lab where new financial products can be tested is the market.

Lerner and Tufano explain that new financial products are adopted in stages. The early creators and buyers are often the most sophisticated and competent. Then, as the product is adopted by others, more naïve investors participate. They take the fact of a product’s popularity as a substitute for adequate diligence. This tends to be the stage at which things go wrong. Transparency and accountability help get around this problem, and these must be the principles of successful regulation.

As the global economy continues to evolve, new needs will emerge, requiring more innovation. It is impossible to predict what all these needs will be, but I can already see a few.

One is how to deal with retirement. A notable feature of our time is that people live longer and retire earlier. This leaves people with the complex financial task of funding their retirement. Up until the 1980s, employers took on this responsibility with defined-benefit pension plans. The existence of large pension funds changed wealth- and risk-management. In the last 30 years, the burden has been shifted to individuals, and their investment needs differ from those of a large institution. Everyone now must figure out how much he needs to save and how he should invest for a comfortable retirement. New financial products have the capacity to help us with these decisions (full disclosure: I am working on developing such a product).

Another area is the environment. Pollution, for example, occurs in part because individuals often do not pay for the negative externalities they impose on others. Innovation can be used to create a sophisticated market that forces people to pay for their impact on the environment. There is also a need to provide capital for the development of new, sustainable forms of energy. They will require a large, up-front, fixed investment but may not be profitable for many years.

The scope for future innovation, in any field, depends on a paradox. On one hand, innovation becomes more difficult over time, because the most obvious, simple discoveries — the wheel, double-entry bookkeeping — already have been made. At the same time, innovators today have it easier, because they stand on the shoulders of giants and have a tremendous base of knowledge at their disposal. If we are to remain competitive, future financial innovation must continue to evolve in response to our changing economic environment. That may or may not mean more complexity of the sort we saw in housing finance: Often the best innovations are simple and do not require any mathematical complexity at all, and even the most complex products must hold up to basic common sense. It is the responsibility of the innovators and regulators to ensure that they do.

– Allison Schrager is a New York–based economist and writer. She has worked at the Bank of England and the International Monetary Fund.

October 3, 2011    |     Volume LXIII, No. 18

Books, Arts & Manners
  • Matthew Continetti reviews Keeping the Republic: Saving America by Trusting Americans, by Mitch Daniels.
  • Claire Berlinski reviews The Bond: Our Kinship with Animals, Our Call to Defend Them, by Wayne Pacelle.
  • Harvey Klehr reviews American Dreamers: How the Left Changed a Nation, by Michael Kazin.
  • Quin Hillyer reviews The Man in the Middle: An Inside Account of Faith and Politics in the George W. Bush Era, by Timothy S. Goeglein.
  • Ross Douthat reviews Contagion.
  • John Derbyshire gears up.
The Long View  .  .  .  .  .  .  .  .  
Athwart  .  .  .  .  .  .  .  .  
Poetry  .  .  .  .  .  .  .  .  
Happy Warrior  .  .  .  .  .  .  .  .  
The Bent Pin  .  .  .  .  .  .  .  .