March 17, 2013 5:03 pm

Innovation gone bad requires regulation

New products may have helped fuel the financial crisis, but R&D has its place

Is innovation a good thing? Normally it is one of those things, like virtue, spinach or motherhood, that are deemed good almost by definition. But there is an exception for the world of financial services.

The years leading up to the crisis saw a ferment of financial innovation. This helped stoke both a boom and a bust. Now, the financial industry complains that over-regulation could stifle innovation in future. But many regulators think that would be no bad thing.

Former Federal Reserve governor Paul Volcker, arguably the world’s foremost financial curmudgeon, once commented that the most important innovation he had seen in finance was the humble automated teller machine. Telling bankers to “wake up” to the negative consequences of innovations such as credit default swaps and collateralised debt obligations, he said: “I wish somebody would give me some shred of evidence linking financial innovation with a benefit to the economy.”

The search for evidence is on. Research by Thorsten Beck of Tilburg University of the Netherlands, which he unveiled at the Long Finance spring conference in London last week, measured innovation by looking at the share that research and development spending made up of financial institutions’ budgets, using data from 32 countries in the years from 1996 to 2006, the decade before the crisis.

Generally R&D intensity will be lower as industries grow more mature or become “ex-growth”. And on this scale, financial services looked like a mature business, with R&D less important in adding value than in services or manufacturing. However, R&D intensity doubled over the period, showing that financial groups were spending more in an attempt to innovate. This innovation was driving results.

Higher expenditure on R&D was directly related to higher off-balance sheet items (the UK and the US were the highest in both categories), and also with the offer of international syndicated credit facilities. Those that spent the most on trying to innovate were the most active in pursuing globalisation, but also in trying to put the world financial system where its regulators could not see it.

This is not surprising. Banks grew startlingly more profitable during their phase of intense innovation, extending credit to far more individuals thanks to changes in risk management. But the risk management systems eventually failed, and it transpired that it would have been better not to have lent to those individuals in the first place. Thus it was the banks that had spent most on innovation that suffered the greatest falls in profits post-crisis.

As Mr Beck puts it, the research reveals both that innovation can stoke economic growth, and that it leads to greater fragility in the financial system. Thus the dilemma over how to manage it is intense.

Perhaps this dilemma can best be reconciled by judging financial innovation through the lens of human nature. The growth of complex derivatives, in particular, fuelled overconfidence. If people truly believed they could put a number on risk and control it, they were more likely to go too far.

There are parallels with road safety. It is not a bad idea to design a new fast car. But put a young man behind the wheel, and he will soon be tempted to drive too fast, and take excessive risks. Powerful cars make their drivers feel all-powerful. That is why there are laws to give drivers an incentive not to drive too fast, and why they are unerringly enforced.

The same needs to be true of the financial innovations. Those using a new financial tool must know that there are limits, and a price to be paid for crossing them.

Regulation also needs to note that much innovation has the effect of splitting principals from agents. For example, mortgage-backed bonds (no longer so innovative these days) split the risk of default away from the lending officer who made the loan, or from traders in the market, and gave it to external investors. This created an incentive to make unsafe loans that had not existed before. Regulation needs to acknowledge this.

It also needs to get out of the way of genuine innovation. Mr Beck points to the example of m-Pesa, a Kenyan payment network operated over mobile phones, which is exciting increasing attention around the world. More than half of Kenyans have used the service, and the country has more m-Pesa agents than bank branches. The technology has the potential to split the payment system away from banks altogether, opening new vistas for how the financial services industry could be run and regulated.

This looks like an example of positive innovation, and regulators allowed it to take root before beginning to impose rules. That seems right. Financial innovation, the evidence shows, spurs both economic growth and financial fragility. It cannot be thwarted, but it must be regulated.

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