Financial innovation and the public interest

inSight

18 Sep 2008

Financial innovation and the public interest

Balancing private and public interests is difficult, but necessary.

However fancily or innovatively financial services are packaged and delivered, their essential purpose is to match the needs of investors and fund raisers, and in the process, help the economy to function effectively. It is important to remember that the financial system exists to serve the public interest in effective financial intermediation, not the private interests of the financial intermediaries.

One measure of the efficiency of financial intermediation is of course its cost. We often see marketing materials for financial services promising higher returns for investors and a lower cost of funds for fund raisers. Sometimes they sound so convincing that the very substantial fees charged for the services seem small or at least affordable. How does one reconcile this anomaly? Where is the catch?

To find the answer, one needs to consider the time dimension. For a long time, we did enjoy a happy situation in which investors, fund raisers and financial intermediaries all did well. Innovative products, which I have previously referred to as "alphabet soup", did enable investors to achieve a higher return and borrowers, even those who were actually not very credit-worthy, to have access to cheaper funding. But, all of a sudden, we have a situation where investors are losing large amounts of money and borrowers are being denied access to funds, and some financial institutions even face insolvency. In other words, all of a sudden, the intermediation spread has widened. Investment returns are falling sharply, or becoming negative depending on what financial products one is holding; and borrowing costs have surged.

This sharp widening of the intermediation spread reflects and is compounded by, among other things, risk aversion and de-leveraging by financial institutions, indicating (with the benefit of hindsight) the unrealistic and unsustainable nature of the previous scenario. It turns out that the earlier narrowing of the intermediation spread – the apparently greater financial efficiency made possible by financial innovation – was achieved at the expense of a sharp widening later on. The dynamic linking the intermediation spread of the present and that of the future is a complex one. Essentially it involves the parties concerned overlooking or ignoring the risks associated with financial innovation, allowing them to snowball to a systemic level with serious implications for financial stability.

It is important for financial regulators responsible for financial stability, which is crucial to the smooth functioning of the economy, to keep a watchful eye on financial innovation. But this is easier said than done. In many jurisdictions the financial sector constitutes a strong political lobby. Its views on financial issues are often respected by the authorities and they are often reflected in regulatory policies. Viewed realistically, there is a risk of the private, short-term interests of the financial lobby being given more attention than any adverse implications for financial stability. It is also difficult for regulators to keep up with the market players who are at the forefront of financial innovation. And there is the danger of over-regulation stifling financial innovation. It is a balance that is very difficult to strike.

The debate on how best to strike this balance is probably eternal, but the current turmoil in the financial markets has already led to a new round of discussions in the US and elsewhere and this looks set to continue for some time. We will continue to observe developments in this area with interest.

Joseph Yam
18 September 2008

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