Two views of financial innovation
The final hour of Frontline’s Money, Power and Wall Street documentary will air on Tuesday; I’ll be participating in an online chat about the program with producers Martin Smith and Marcela Gaviria on Thursday at 1pm ET. I watched a preview this weekend, while also reading the World Economic Forum’s 92-page report on “Rethinking Financial Innovation”.
The two could hardly be more different. Frontline concentrates on international finance’s discontents, most of whom are convinced that no matter how assiduous financial-market regulation, the big banks will always find a way to extract enormous rents for themselves. The WEF, by contrast, is convinced that financial innovation is nearly always a good thing, and that a few tweaks to internal risk controls, and maybe a high-level council of graybeards thinking deeply about systemic risk, should suffice to protect us all from any downside it might have.
The WEF report is not an easy read. Literally: it’s printed in a light-grey sans-serif font on a white background. And for anybody hoping for an indication that the highest levels of the financial-services industry are taking the problems with financial innovation seriously, it’s particularly depressing. Taken as a whole, the report is a full-throated defense of financial innovation, says that substantially all financial innovations are good things, and downplays all possible downsides to the maximum possible extent.
The first words of the executive summary are “Financial innovation has a long history of success” — and that very much sets the tone for the rest of the report. Weirdly, the success of financial innovation is invariably asserted, rather than argued. For instance, on the left you can see the report’s list of financial innovations since the debit card. “Many of the historical examples of financial innovation listed in the timeline have at some point been misused and misapplied by market participants, and have contributed to significant financial system disruptions,” says the report. “Over time, however, most have been accepted as beneficial.” The passive voice is telling: nowhere are we informed who is accepting these things as beneficial, or what criteria they may be using.
Looking at this list, I can see three unambiguously good innovations: point-of-sale terminals, ACH, and CHIPS. All of them represent evolutionary improvements in the banking system’s payments and clearing architecture. With the rest, I certainly see a lot of innovations which resulted in banks and other private-sector finance players making lots of money. But was the publication of the Black-Scholes equation really a great thing for society as a whole? Are we better off now that we’ve moved from defined-benefit to defined-contribution pensions? Or, to take a slightly earlier innovation which the report dates to 1968, did the originate-to-distribute securitization model really help society as a whole?
It’s disappointing that over the course of its 92 pages, the WEF report never attempts to answer these questions. Instead, we just get lots of unsupported assertion, like the statement on page 40 that “most financial institution failures and insolvencies are not linked to financial innovations”. Well, I’m glad that’s cleared up. Eventually, we end up with a series of recommendations for regulators. The very first one? “Acknowledge the importance of innovation and its role in a competitive, free-market structure.”
From the point of view of someone who has been writing about the failures of various financial innovations for the past four years, there was very little in the Frontline documentary which was new to me. I would hope, similarly, that the documentary would also come as little surprise to any of the financial-services industry’s leaders. Reading this WEF report, however, I’m forced to conclude that they don’t actually have a clue how bad the 2008 crisis was; how closely the devastating global fractures coincided with various financial innovations; and how much it’s necessary to revisit all our priors in the wake of the worst financial crisis since the Great Depression.
The fact is that there’s almost nothing in the WEF report — beyond the simple fact of its existence — which demonstrates that anything at all has changed since 2008. The world’s most important bankers are desperately trying to convince themselves that they’re wonderful people doing God’s work, and that somehow the financial crisis was just one of those unpleasant hiccups along the way. Which it was, for the people who still have jobs at the top of the financial sector, paying millions of dollars a year.
All of which is to say that the WEF report suffers deeply from an unreliable-narrator problem: sometimes the people closest to an issue are the people who are the least trustworthy on that subject. The Frontline documentary might not talk about how it’s trying to “encourage dialogue among stakeholders” by providing “a taxonomy of potential negative outcomes”: that would be Swiss Re’s Stefan Lippe, a chief architect of the WEF report. But if you want to see what kind of damage the financial sector can wreak, you’ll be much better off with the TV show than with the WEF.