Monday, 23 April 2012

The Anti-Innovation Regulator.


Last week Adair Turner, Chairman of the Financial Services Authority or FSA, gave a lecture at the School of Advanced International Studies (SAIS) John Hopkins University on the topic of “Securitisation, shadow banking and the value of financial innovation”. In it, Lord Turner argues that when financial innovation and shadow banking are “concentrated on activities central to or closely related to the money and credit process”, this innovation creates “macro instability” and “negative externalities” that the regulator must tackle.

Lord Turner admits that the regulator should not be concerned with trying to achieve an optimal result (in his own words: “regulators cannot and should not pursue some precise target of social optimality”). However, Lord Turner claims that regulators “should seek to constrain the instability potentially created by credit and money creation processes, by credit and asset price cycles." In other words, the proposal is to hit the brake pedal of the financial sector to ensure that innovation in a specific area chosen by the regulator is, at least, slowed down if not brought to a complete halt, while allowing innovation in other areas.

It is remarkable that Lord Turner himself admits that “measuring with any precision the value of innovation is difficult in all sectors of the economy, but particularly so in finance”, however, in a moment of enlightenment, he is keen to share with all of us his own (and hence the FSA’s) measure of the social value of a particular innovation. It is understandable that he has a view on this point. But so do most people familiar with the subject. Yet, we sense in this speech by Lord Turner a feeling of anxiety to wield some sort of supervision and dominance over an area which has grown too free and untouched from the long hands of the central planner. The intentions of Lord Turner are even clearer in this statement: “securitisation in itself might have had the potential to be a socially valuable innovation, and might be able to perform socially valuable functions in future if developed in appropriate form”. It is really adventurous how Lord Turner can feel so confident that the regulator will know what the appropriate form is.

The problem is that Lord Turner doesn’t get it. The problem was not financial innovation in itself (such as that kind of innovation that developed in the credit derivatives and securitisation area). What failed was not “innovation”, what failed was the underlying (i.e. bad household and corporate credit decisions) and in this failure financial innovation had no input. The reasons of this failure are still hotly debated, but it seems to me that governments, central banks and regulators also had their part. It is true that innovation can be the cause of unwanted consequences and be socially undesirable, but blaming financial innovation for the financial crisis is like blaming the gun for the murder. Therefore the FSA is off target again and the consequences of this squeeze on the wrong causes of the crisis are yet to be seen. Nonetheless it is understandable that the regulator is so keen to wash his image. Indeed, it was looking to another side when shadow banking and credit innovation were developing in the run up to the financial crisis and did nothing to control such activities now portrayed as creating “negative externalities”. Moreover, shadow banking is the latest area of the financial sector that the regulator has not yet fully grabbed with its long hands and the FSA’s fingers are itchy to regulate it sooner than later.

Innovation is the free development of (better or worse) techniques and application of resources by free individuals in order to maximise their returns within the given legal framework and social customs. But if we want to allow great innovations to flourish we cannot direct their course or otherwise we will be restricting potential innovations and consequently the potential number of successful innovations. 

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