The Wall Street Alchemist - How does financial innovation impact the real economy?
The Wall Street Alchemist
How does financial innovation impact the real economy?
by Nathan Coplin
Alchemists were known for their efforts to transmutate common metals into more valuable ones like gold. Alchemy is uncommon today, but the practice of transforming the “bad” to “good” continues, especially in the financial industry through financial innovation. It is widely accepted that innovation, in general, improves productivity and stimulates economic growth. However, it is less clear how financial innovation impacts the real economy.
Recent research led by Thorsten Beck at the
Since then, regulatory measures (Basel III, Dodd-Frank, and EMIR) have sought to reduce risk in the financial sector by requiring higher quality capital and assets – which can be used as collateral to back risky activity, such as derivative trading. This is intended to increase stability and confidence in capital markets and by extension, the broader economy. However, Wall Street alchemists are well-prepared to eschew these new measures and in the process, undermine their intended purpose. The latest financial innovation is “collateral transformation” – essentially turning risky assets (low-quality capital) into collateral (high-quality capital) that can be used to back risky derivatives trading. This may be simply viewed as compliance with new rules, but risk exposure cannot just disappear. The recent JP Morgan “London Whale” trades demonstrate this; despite crafty manipulation and deceit (see Senate Permanent Subcommittee on Investigations report). Further slicing and divvying up of risky assets – particularly complex derivatives – will obfuscate where market risks are located and impede the ability of both regulators and banks to manage them. This is not to say that all financial innovation is destructive, but there need to be rules for how new financial products or activities can manipulate and hide risk. Without new rules, financial crises may become the new normal.
From 2001 to the 2009, innovative financial instruments helped
The world economy is still choking on these innovative financial products and its impact on the real economy is becoming clear. The current crisis in
When financial innovation leads to the manipulation and concealing of risks, the consequences are clear for
Given the recent damage and potential future consequences, the financial industry needs innovation. However, this innovation must be of a different breed – one that breaks free from pre-crisis models and the short-termism mentality. “We simply cannot have pre-crisis banking in a post-crisis world” said Christine Legarde, IMF Managing Director, earlier this week. We need new investment models not investment vehicles. To guide such a shift, the appetite for quick profits will have to be balanced by rules that encourage less-risky, long-term investing. Similar to the alchemist’s efforts to create gold from junk metals, Wall Street is trying to create profitable assets out of risky ones. Persuading Wall Street to reduce this activity will be challenging, but establishing strong incentives to discourage the creation of “fool’s gold” (i.e. garbage assets) could be a good start.