Andrew Palmer joined The Economist as Management Correspondent in February 2007, became Banking Correspondent in September 2007 and Finance Editor in June 2009. Prior to this he was at the Economist Intelligence Unit, a sister company, where, among other roles, he led the editorial team conducting bespoke research programmes, surveys and reports. Andrew Palmer is a frequent commentator on radio and television.
As well as the people mentioned in this special report the author would like to thank the following for their help: Francisco Arcilla, Amar Bhidé, Mike Bodson, Peter Carroll, Dominic Casserley, Leo Civitillo, Guy Coughlan, Onur Erzan, Geert Glas, Will Goetzmann, Chi Hum, Ross Levine, Emmanuel Naim, Jim Overdahl, Robert Pickel, Craig Pirrong, Michael Poulos, Andrew Reid, Pretty Sagoo, Nick Shellard, Susan Smith, Conrad Voldstad, David Weild, the staff of the Observatory for Responsible Innovation at the École des Mines de Paris and a number of people who wished to remain anonymous.
Financial innovation
Such seething brains, such shaping fantasies
Playing with fire
How innovation happens
The ferment of finance
Retail investors
The little guy
Exchange-traded funds
From vanilla to rocky road
High-frequency trading
The fast and the furious
Financial infrastructure
Of plumbing and promises
Small firms
On the side of the angels
Collateral
Safety first
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Other PENGUIN SHORTS you could try
Financial Innovation: Playing with Fire
Andrew Palmer
Pakistan: Perilous Journey
Simon Long
Who’s in Charge Here?: How Governments are Failing the World Economy
Alan Beattie
China: Rising Power, Anxious State
James Miles
The Future of Jobs: The Great Mismatch
Matthew Bishop
Personal Technology: Beyond the PC
Martin Giles
Women and Work: Closing the Gap
Barbara Beck
Video Games: All the World’s a Game
Tim Cross
The Unbearable Lightness of being a Prawn Cracker: A Selection of Real Meals
Will Self
At the Hairdresser’s
Anita Brookner
Perfect Christmas Day: 16 Essential Recipes for the Perfect Christmas
Felicity Cloake
Protection
Helen Dunmore
How to be a Rogue Trader
John Gapper
The Happiness of Blond People: A Personal Meditation on the Dangers of Identity
Elif Shafak
A Guest at the Feast: A Memoir
Colm Tóibín
How to Set Up a Free School
Toby Young
Great Battles
The Battle of Isandlwana: The Great Zulu Victory of 1879
Saul David
Great Battles
The Battle of Alamein: North Africa 1942
Colin Smith and John Bierman
*A list of sources is at Economist.com/specialreports
Innovation is not the problem with finance. It’s what comes later that matters
ONCE it was Alan Greenspan’s view of financial innovation that held sway. The former chairman of the Federal Reserve believed that new techniques and products made America’s financial system more resilient. Securitisation–the bundling of mortgages into securities that were sold to investors–diversified and dispersed risk. Credit-default swaps (CDSs) cushioned lenders from shocks.
Now the view of Paul Volcker, Mr Greenspan’s predecessor, is much more in tune with the times. He has implied that nothing useful has come out of finance since the ATM. Far from preventing the 2008 crisis, the inventions of Wall Street’s finest stand accused of exacerbating it by making instruments too complex to value, by spreading uncertainty over where toxic assets sat and by concentrating risk.
Mr Greenspan’s judgment was clearly wrong: far from shrugging off the crisis, America’s economy has by some measures gone backwards by ten years. But Mr Volcker’s is far too dismissive. Securitisation is an important source of credit to the real economy; Europe would be better off if it was less dependent on banks. CDSs are considered useful enough that India’s conservative financial authorities allowed a market in them to start last year.
In any case the innovation balance-sheet for the past 25 years does not just include instruments implicated in the crisis. It also contains exchange-traded funds (ETFs), which have slashed costs for retail investors; catastrophe bonds, which help insurers spread the costs of natural disasters; microfinance products aimed at the very poor; and all manner of whizzy payment technologies.
True, financial creativity is often put to unproductive ends–gaming capital regulations, for example–but it is also needed to solve genuinely big problems. Witness attempts to invent financial markets in longevity, so that the risks of surprising increases in life expectancy are transferred from pension schemes and annuity providers to capital markets. And if the euro-zone crisis spawns a mutualised Eurobond, investment bankers will be in at the birth.
Even bad ideas are not a problem when they first arise. If only a few people get burned by a duff product, the wider world need not care. Scale is what makes finance worrying. When products or techniques become systemic, everyone has a stake in ensuring that they are well managed. As this special report shows, inventions can take hold at tremendous speed. CDSs were dreamed up in the 1990s; by 2007 they had a notional value of $62.2 trillion. Products also mutate constantly, in part because patenting is not common: in a global ranking of firms assigned patents in America in 2011, the first financial company in the list was American Express–in joint 259th place. If an innovation catches fire, this is an industry that pours on paraffin.
Ignore this Volcker rule
The problem of rampant growth and mutation has two answers. One is a willingness on the part of regulators to raise red flags. A good example of this approach came in 2011, when the IMF and others voiced concerns about the rapid evolution of the ETF market and, in particular, a corner of the industry that uses derivatives to achieve desired returns. The warnings sparked a bout of introspection within the industry and led to better disclosure practices.
The second imperative is to make sure that the infrastructure of finance keeps pace with its ingenuity. When there is demand for a product, sales teams can pump out almost unlimited supply. The back office is left trailing. Insiders shudder to think what the crisis would have looked like if regulators had not acted to clear up a massive paperwork mess in the CDS market in 2005, for instance. Even then, supervisors missed the huge exposures being taken on by AIG, an insurer, in over-the-counter trades. Data on such transactions are now being gathered and made available to regulators, which should make it harder for vulnerabilities of this sort to go unnoticed.