Is financial innovation a good thing?
In the context of a free market, innovation is a positive-sum game. The innovations that survive — most don’t — are the ones that conserve resources and improve quality. In the case of financial innovation, improving quality could mean better risk management.
But financial innovation does not take place in the context of a free market. Our financial system is permeated with government guarantees. Some guarantees, like deposit insurance or pension guarantees, are explicit. Other guarantees, like “too big to fail,” are implicit.
These guarantees can be exploited by firms that take on excessive risk. If a gamble pays off, the gains go to owners and managers of the firm. If the gamble turns out badly, some of the losses go to taxpayers. Even though managers might not consciously be searching for ways to game the system, the competition for returns will push them in the direction of doing so.
Innovative financial instruments and practices can facilitate gaming the system, without regulators realizing it. Clever innovations can enable a bank to comply with the letter of a regulation while violating its spirit. Sometimes, even the executives of the bank are fooled. They do not realize that their profits are coming from this “regulatory arbitrage,” rather than from real business skill.
Systems exist to be gamed. The only real rule is what works and what you can get away with.
All complicated financial vehicles are shell games. Beware derivatives.
Essentially all non-recourse leverage operates this way. The profit-maximizing strategy is often to make the biggest number of high-variance, high-leverage, independent bets you can get away with. Keep the home runs and walk away from the losers. A rational strategy for hollow men.
I hadn’t previously considered it “regulatory arbitrage.” It might be an apt description, as regulations tend to increase de facto non-recourse leverage.