In Defense of Financial Innovation
Robert Shiller writing in the FT:
The problem is that financial breakdowns come with low frequency. Since flaws in the financial system may appear decades apart, it is hard to figure out how some new financial device will behave. Moreover, because of the low frequency of crises, people who use financial instruments often have little or no personal experience with the crises and so trust is harder to establish.
When people invest for their children’s education or their retirement, they are concerned about risks that will not become visible for years. They may not be able to rebound from mistaken purchases of faulty financial devices and they may suffer if circumstances develop that create risks that could have been protected against.
Thus, to facilitate financial progress, we need regulators who ensure trust in sophisticated products. They must work towards clearing the way to widespread use of better products, concerning themselves with both safety and creative ideas. They must not simply be law enforcers against the shenanigans of cynical promoters, but also be open to making complex ideas work that have the potential to improve public welfare. Unfortunately, the crisis has sharply reduced trust in our financial system.
…Unfortunately, people do not trust some good innovations that could protect them better. The innovations in mortgages in recent years (involving such things as option-adjustable rate mortgages) are not products of sophisticated financial theory. I have proposed the idea of “continuous workout mortgages”, motivated by basic principles of risk management. The privately issued mortgage would protect against exigencies such as recessions or drops in home prices. Had such mortgages been offered before this crisis, we would not have the rash of foreclosures. Yet, even after the crisis, regulators seem to be assuming a plain vanilla mortgage is just what we need for the future.
Another example of a potentially useful innovation is the target-date fund (also called life-cycle fund) that invests money for people’s retirement in a way that is specifically tailored for people their age. Such a fund plans for young people to take greater risks and for older people to invest more conservatively. Target-date funds, first introduced by Wells Fargo and BGI in the 1990s, are growing in importance, but few people commit the bulk of their portfolio to such funds, or make use of target-date funds that might make adjustments for their other investments. It appears that people do not fully trust that these funds are designed correctly, or would protect them from crises.
…It is critical that we take the opportunity of the crisis to promote innovation-enhancing financial regulation and not let this be eclipsed by superficially popular issues. Despite the apparent improvement in the economy, the crisis is not over and so the public continues to support government-led interventions. Doing this means encouraging better dialogue between private-sector innovators and regulators. My experience with regulators suggests that they are intelligent and well-meaning but often bogged down in bureaucracy. Regulatory agencies need to be given a stronger mission of encouraging innovation. They must hire enough qualified staff to understand the complexity of the innovative process and talk to innovators with less of a disapprove-by-the-rules stance and more that of a contributor to a complex creative process.
Read the full article here
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