31/8/2012: Financial Innovation : Positives v Negatives

Following on my previous post, here's a new paper by Frankin Allen titled "Trends in Financial Innovation and Their Welfare Impact: An Overview" (link here) published in the European Financial management (vol 18, issue 4).

Core paper findings are:

• "There is a fair amount of evidence that financial innovations are sometimes undertaken to create complexity and exploit the purchaser... As far as the financial crisis that started in 2007 is concerned, securitization and subprime mortgages may have exacerbated the problem.  
• "However, financial crises have occurred in a very wide range of circumstances, where these and other innovations were not important.  
• "There is evidence that in the long run financial liberalization has been more of a problem than financial innovation.  
• "There are also many financial innovations that have had a significant positive effect.  
• "These include venture capital and leveraged buyout funds to finance businesses.  In addition, financial innovation has allowed many improvements in the environment and in global health." 

The paper concludes that "On balance it seems likely its effects have been positive rather than negative."

I find the arguments strained. Much of the financial innovation that Allen declares to be positive is innovation that is driven directly by either force of the states or co-financed by the states. Thus these forms of innovation are not really innovative at all, but superficial. For example - debt-for-nature swaps are hardly a form of financial innovation but rather a form of state subsidy. Likewise, much of carbon permits trading is driven by restrictions imposed by the states via coercive systems. These might be positive - the point is not to dispute their social or environmental or economic value - but they are not what I would term 'financial innovations'.

About the only positive financial innovation that Allen cites that does not involve such state interventions is leveraged buyout. Allen does cite evidence that this had a positive effect, but in the periods immediately preceding some financial crises (the latest one being case in point, as was Japan's crisis of the 1990s and Nordic countries crises of the early 1990s etc) leveraged buyouts carry excessive leverage. Thus, the only unequivocally positive effect such buyouts might have at the times of rising debt overhang, in my view, is the effect of triggering future insolvencies that clear the path (via creative destruction) to new or more efficient incumbent firms growth. This positive effect, however, has little or nothing to do with the financial innovation per se.

Lastly, let me point that I am not disputing that some (the issue is really more of how much and of what variety) financial innovation is positive, but that Allen's article fails really to prove his hypothesis. Neither does it do any justice to the article to state that "the long run financial liberalization has been more of a problem than financial innovation" without actually proving this.