Does Financial Innovation Benefit the Society?

We live in a world which idolizes innovation. We tend to idolize companies which have produced some products which can be considered to be innovative. The underlying belief in the capitalistic system is that innovation is beneficial.

It is innovation which creates more value, and since the capitalistic system allows the creator of innovation to reap the most benefits, it encourages innovation. However, when the word financial is put in front of innovation, the opinions tend to change very fast. This is because the general public believes that financial innovation isn’t really beneficial to them. Maybe it helps a few investment bankers earn bigger bonuses.

However, the lives of common people aren’t really better off because of financial innovation. In this article, we will have a look at some of the examples of financial innovation. Then we will try and analyze whether this innovation has been beneficial to society as a whole.

Examples of Financial Innovation

Financial innovation can be divided into multiple categories. There are innovations related to personal banking, corporate banking as well as capital markets. Some examples are as follows:

• Automated Teller Machine (ATM)
• Credit Cards
• Electronic Banking
• SWIFT Messaging System
• Lockbox
• Credit Default Swaps
• Collateralized Debt Obligations
• Securitization etc.

If the above list of innovations is scrutinized carefully, all innovations in the financial world can be broadly divided into two categories viz. technical and non-technical. These technological innovations definitely make the world a better place. For instance, because of e-banking, people spend lesser time in the banks. As a result, they can use this time to either earn more money or for leisure activities.

On the other hand, non-technical innovations need to be scrutinized more. Some of these innovations do benefit society. However, many of them aren’t as beneficial.

Some of the common metrics that can be used to classify financial innovations have been given in this article.

What Is A Good Financial Innovation?

• Excessive Risk Taking: A good financial innovation does not support excessive risk-taking. Financial innovation is only good if it allows decentralization of risk. It is important that the tool being developed cannot be used for risk-taking at all.

  For instance, consider the case of credit default swaps. These products work as insurance if you already hold a bond. Hence, if you have bonds of company A and you buy credit default swaps, you are buying insurance. However, the problem is that credit default swaps can be purchased without any interest in the underlying.

  In such cases, the investor stands to benefit if company A falters on its debt. This is where insurance is turned into gambling. Hence, credit default swaps would qualify as a good financial innovation if the possibility of their misuse was drastically reduced.

• Excessive Production: It is important to realize that credit affects the real economy. If all the credit starts flowing to one sector, then that sector will witness a boom whereas the other sectors will witness a bust. It is the job of the financial sector to ensure that the resources are proportionately distributed amongst the different sectors in the economy. However, a lot of times financial innovation does the exact opposite. It leads to the congestion of resources in one or a few sectors of the economy.

  Consider the case of securitization. Securitization allows banks to sell their old loans to investors. Then they receive the money and can start making new loans. The problem with securitization is that it allows excessive funds to be pumped into one sector of the economy.

  Hence, the real estate sector received a lot of funds whereas the other sectors tend to be starved of funds. This is the reason why it is important to look at financial innovations from this point of view as well. If the so-called innovation leads to an asymmetrical distribution of wealth in favor of certain sectors, then it shouldn’t really be called an innovation.

• Excessive Debt: Lastly, it is important to ensure that the so-called financial innovation does not foster a culture of excessive debt. The proliferation of credit cards can be taken as a case study.

  Before credit cards became common in the world, the household sector was not really that indebted. However, this so-called innovation provides credit to young people at the beginning of their careers.

  Many times, this credit is utilized irresponsibly. Of course, the responsibility of usage lies with the borrower. However, credit card companies are known for creating enticing offers which promote excessive and irrational spending. Financial innovation needs to be analyzed from this angle as well. If a product promotes excessive spending, then it would be incorrect to call it an innovation.

To sum it up, it is important to note the difference between financial innovation and general innovation. Inventing credit default swaps is not the same as inventing the internet. This is because there is a possibility that credit default swaps will be misused. It is for this reason that financial regulators need to stand their ground.

Sometimes, it may be alleged that these regulators stifle financial innovation. However, as we have seen in this article, not all financial innovation makes life better for the people using it.