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The glory of financial innovation

The fundamental lesson of this crisis is that, given the complexity of the division of labor required of modern global economies, we need highly innovative financial systems to assure the proper functioning of those economies.  But while, fortunately, much financial innovation is successful, much is not.  And it is not possible in advance to discern the degree of future success of each innovation.  Only adequate capital and collateral can resolve this dilemma.  If capital is adequate, no debt will default and serial contagion will be thwarted. We can legislate prohibitions on the kinds of securitized assets that aggravated the current crisis.  But investors have shown no inclination to continue investing in much of the past decade’s faulty financial innovations, and are unlikely to invest in them in the future. The next pending crisis will no doubt exhibit a plethora of new assets which have unintended toxic characteristics, which no one has heard of before, and which no one can forecast today.  But if capital and collateral are adequate, and enforcement against misrepresentation and fraud is enhanced, losses will be restricted to equity shareholders who seek abnormal returns, but in the process expose themselves to abnormal losses.  Tax payers will not be at risk. Financial institutions will no longer be capable of privatizing profit and socializing losses – Testimony of Alan Greenspan, Financial Inquiry Commission, April 7, 2010