VR Logo

Financial Innovations: Not Always Good

Innovations in the financial products that we see today are not the kind we need, says Dhirendra Kumar...

Learning from others' mistakes is a smart thing to do. And I suppose the bigger the mistakes, the more learning there is in them. By this measure, there must be a great deal of potential learning to be had from the US credit crisis that is now threatening the world's financial system.

Many of these lessons are meant for regulators and many for those who are running financial services companies, since the crisis has been caused by the failure of the former and the unchecked greed of the latter. However, individual investors have a lot to learn too.

It is widely believed that the US crisis has badly affected all financial companies and investors and that no one is immune. But this isn't quite true. There are people, even within the investment community, who did the right things and are largely unaffected.

The most shining example is of course the great investor Warren Buffet. For all practical purposes the old man is the last guy standing. Back in 2003, he called exotic financial instruments 'Financial Weapons of Mass Destruction'. In the annual report of his company, he said that rapidly growing trade in derivatives held a "mega-catastrophic risk" for the world economy. He also said that "Derivatives generate reported earnings that are often wildly overstated and based on estimates whose inaccuracy may not be exposed for many years" and that "Large amounts of risk have become concentrated in the hands of relatively few derivatives dealers, which can trigger serious systemic problems."

This is 'I told you so' on a grand scale. He's the one man who can turn around and say 'I told you so' to almost anyone on Wall Street. While Buffett one of the richest men in the world, there are lessons that even the smallest investor can draw from his approach.

One central tenet of Buffett's approach is that innovation is bad. Most people react in horror to this idea. We are tuned to think that innovation is a good thing and new ways of doing things are better than the old ones. Businesses are very fond of using the word innovation.

However, financial innovation is something different. In the area of savings and investments, innovation has been shown to be rarely a good idea. Savings deposits, mutual funds, equity shares are all one needs and these were all invented decades or centuries ago. When I examine newer financial products, they all seem to invented around a few themes. They are far more difficult to understand, even by those who invent them. They enable risk to be hidden. And compared to older products, they make more money for those who are offering them. This is not the kind of innovation anyone needs.

Here's what the US Federal Reserve chairman Ben Bernanke had to say about financial innovations in May 2007. "The increasing sophistication and depth of financial markets promote economic growth by allocating capital where it can be most productive. And the dispersion of risk more broadly across the financial system has, thus far, increased the resilience of the system and the economy to shocks."

Sixteen months later, standing in midst of destruction wrought by financial innovation, he should be eating those words. Of course if he eats all his words that he should be eating then he'll get indigestion for many years.