Thursday, December 20, 2007

Financial Innovation and History

"Many of the financial institutions and instruments caught up in the crisis are part of the centuries old phenonenon of financial innovation. The new instruments--often designed to avoid regulation--are then proved to be successful or not by the test of financial stress such as we have been recently encountering. ... A key dynamic in the crisis is information asymmetry in the spread between risky and safe securities. ... Historically, financial crises originate on the liability side of banks balance sheets as depositors rush to convert deposits into currency in the face of a financial shock. In recent decades, since the advent of deposit insurance, pressure has come from the asset side. ... In many of these cases financial innovation which increased leverage and was often designed to circumvent regulations was an integral part of the story of the boom", Michael Bordo (MB) at, 17 December.

I agree with MB. Much financial engineering is designed to "circumvent regulations". As Bethany McLean wrote in Fortune on 26 November, it's a "black art". See my 2 October and 8 December posts.


Anonymous said...

GW --- From my observation, investors need to start with the premise that:
New financial device = fraud.
--- HDF

Independent Accountant said...

My premise is: every financial innovation is suspect until it has survived at least one business cycle. Even then, it should be viewed skeptically. Further, every financial innovation must be studied to see if it is an old financial innovation wrapped in new terminology.