There is a single plausible explanation that politicians and bankers alike have fallen back to, whenever challenged as to why the global investment banking system was left to its business, up to the point of it's near freefall collapse. Financial innovation is what banks cared most about, when explaining why there should be no control over derivatives - no effective oversight on off-balance sheet operation. In brief to have a free-for-all playground funded by cheap FED loans.

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There are several interpretations of the phrase financial innovation. In general, it refers to the creating and marketing of new types of securities. Economic theory has much to say about what types of securities should exist, and why some may not exist (why some markets should be "incomplete") but little to say about why new types of securities should come into existence.

One interpretation of the Modigliani-Miller theorem is that taxes and regulation are the only reasons for investors to care what kinds of securities firms issue, whether debt, equity, or something else. The theorem states that the structure of a firm's liabilities should have no bearing on its net worth absent taxes, etc. The securities may trade at different prices depending on their composition, but they must ultimately add up to the same value.

Furthermore, there should be little demand for specific types of securities. The capital asset pricing model, first developed by Markowitz, suggests that investors should fully diversify and their portfolios should be a mixture of the "market" and a risk-free investment. Investors with different risk/return goals can use leverage to increase the ratio of the market return to the risk-free return in their portfolios.

However, Richard Roll argued that this model was incorrect, because investors cannot invest in the entire market. This implies there should be demand for instruments that open up new types of investment opportunities (since this gets investors closer to being able to buy the entire market), but not for instruments that merely repackage existing risks (since investors already have as much exposure to those risks in their portfolio).

Finance is powerful. As the last few years demonstrate, financial innovations can be used as tools of economic destruction. But the last few centuries demonstrate that financial innovation is crucial, indeed indispensable, for sustained economic growth and prosperity.

The right kind of innovation obviously would help the financial sector fulfill its core functions; and if the financial sector fulfilled those functions better, and at lower cost, almost surely it would contribute to growth and societal well-being. But, for the most part, that is not the kind of innovation we have had.

The financial innovations discussed in the pro and con statements did not cost the taxpayers money, it was the bailout that cost money. If the government from the beginning had believably stated that there would be absolutely no help from the government and that no firm was too large to fail, the economic actors would arguably have been more careful.

Financial innovations that have not been helpful include the Federal Reserve and the related laws of legal tender. Without its easy money there would not have been a financial crisis of the magnitude we now see.

Hi

Financial innovation enhances sustainability of institutions and their outreach to the poor. A useful distinction between different types of financial innovations include:

1. Financial system/institutional innovations.
Such innovations can effect the financial sector as a whole, relate to changes in business structures, to the establishment of new types of financial intermediaries, or to changes in the legal and supervisory framework. Important examples include the use of the group mechanism to retail financial services, formalizing informal finance sysems, reducing the access barriers for women, or setting up a completely new service structure.

2. Process innovations
Such innovations cover the introduction of new business processes leading to increased efficiency, market expansion, etc. Examples include office automation and use of computers with accounting and client data management software.

3. Product innovations
Such innovations include the introduction of new credit, deposit, insurance, leasing, hire purchase, and other financial products. Product innovations are introduced to respond better to changes in market demand or to improve the efficiency.

Thanks

Hi

The financial innovations discussed in the pro and con statements did not cost the taxpayers money, it was the bailout that cost money. If the government from the beginning had believably stated that there would be absolutely no help from the government and that no firm was too large to fail, the economic actors would arguably have been more careful.

Thanks