Sunday, February 28, 2010

Understanding "Financial Alchemy"

As a result of the financial crisis, there has been a widespread vilification of Wall Street "alchemy" and the related realization that there is little understanding among the general public of what financial innovation has accomplished.  Addressing these two points is an excellent short paper, "In Defense of Much, but Not All, Financial Innovation" by the Brookings Institution's Robert Litan.

Writing in an accessible style easily understood by a layperson, Litan provides a nice overview and examination of the finance landscape, from basics such as bank deposits, credit/debit cards, and mutual funds to the development and use of collateralized debt obligations (CDOs) and structured investment vehicles (SIVs).

Despite the prevailing anti-finance backlash of the moment, Litan reminds us that there has been a lot of financial innovation in recent decades that have been beneficial, such as ATMs, credit cards, index funds, and the rise of venture capital.  Positive financial innovations have increased convenience for customers, improved access to credit, better allocated risk, and contributed to economic growth.

On the flip side, Litan identifies socially destructive inventions like the misuse of adjustable rate mortgages (ARMs) with ludicrous interest rates; collateral debt obligations (CDOs) reliant on artifically inflated housing prices; and structured investment vehicles (SIVs) which were held off of a bank's balance sheet--thus circumventing regulation on minimum capital requirements--and reliant on the ability to rollover short-term debts.

Litan explains finance and the roots of the financial crisis very well, and his paper is full of interesting history and citations.  For example, despite the popular reputation of private equity (PE) firms' as ruthlessly buying up companies, slashing jobs, and then selling the parts, research indicates that the majority of PE acquisitions are held long-term, that they maintain normal employment growth over time, and they contribute positively to economic growth.

In concluding, Litan argues that regulation shouldn't become so cautious as to stifle the creation of new financial innovation that could be socially useful--but that reactions to threats should be quicker.  I agree.  Check out his whole paper here.


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