Why financial innovation is overrated

Next time you hear bank lobbyists complain that regulation will extinguish innovation, direct them to the work of these folks.

Yes, they're a trio of pointy-headed academics, and European to boot. But what's the industry's response to their findings that "rents rise progressively to the point where the agents end up capturing the bulk of the return from the innovation?"

"Rent" here is econo-speak for profit derived by owners of assets from letting others use them (think of banks as landlords of money). And "agents" are employees of the owners (here think bank CEOs and traders.)

As evidence for this claim, the researchers cite a 2007 paper showing that rents in the financial industry accounted for 30 percent to 50 percent of the difference between compensation in that industry and pay in others.  And the last time the percentage was that large was in the late 1920s, that is, right before the Great Crash.

Meanwhile, the percentage of GDP produced by the banking industry soared from less than 3 percent in the late 1970, where it had been more or less since 1947, to almost 8 percent in 2006.

In other words, most financial innovation doesn't even benefit shareholders, never mind society at large, because the industry's profits are paid primarily as compensation to executives, traders and other employees.

Worse, the research shows that such innovation increases systemic risk and thereby leads to moral hazard, which is finance jargon for the "too big to fail" problem. And that in turn only leads to more such "innovation" until there's a crash.

How so? Most innovation comes in the form of opaque, complex products that give the agents an information advantage over customers (think CDOs, credit default swaps and other derivatives traded over the counter, often by unregulated hedge funds).

And because innovation of this sort produces systemic risk, the agents can depend on government bailouts (think gun to head), and those only incentivize more of the same sort of behavior.

Say the researchers: "The inability to punish gives rise to the moral hazard that characterizes finance at every level from individual traders to the banks that employ them."

But such innovation ends badly when failure goes unpunished, and for that reason may itself be a sign of impending financial crisis, according to them.

"Our model shows how a combination of high confidence in finance sector innovations and high rents for finance managers might act as a lead indicator of crisis," the researchers conclude.

Sure, the bank lobby will no doubt say this research is based merely on correlation. But as Yves Smith pointed out today in a post on it today, "While correlation is not necessarily causation, the pattern is awfully persuasive."