Financial Innovations in the Banking Industry

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For this post, I wanted to look at the role that financial innovation played in the Great Recession. Financial innovations are ways in which banks foster investments and are able to create value (often times false value) through different methods. These new forms of investments have really only been developed since the 1970’s, and were formed in an effort to move the banking industry from a stale and constricted marketplace to a vibrant and accessible one.

People inherently believe that innovation is a good thing, but Simon Johnson and James Kwak present a very different argument to this belief and relate it to the banking industry. They argue that the deregulation and expansion of the banking sector has been a bad thing because it has led to financial innovations that are risky and harmful to the economy. In the last few decades, banks have created new forms of trading such as Collateralized Debt Obligations (CDO’s), Credit Default Swaps (CDS’s), and negative-amortization mortgages.

In theory, some of these new forms of trading are good and can help to stimulate the economy if used properly and effectively. The idea behind negative-amortization mortgages is that more people are inclined to buy homes since they don’t have to pay off all of the debt up front and can do so over a long period of time.

Johnson and Kwak agree that this is a good thing if the money is used effectively. However, this was not the case in the last few decades. These new mortgages and the greater availability of credit allowed virtually anyone to get a loan to buy a home, even if there was no chance the person would be able to pay back the debt. This led to developers building thousands of homes thinking that more people would want to buy these houses, and ultimately the housing bubble.

In addition, other forms of financial innovation such as CDO’s and CDS’s also had a major contribution to the Great Recession. In fact, Johnson and Kwak mention in their article that some people such as Michael Lewis even believe that AIG’s sales of CDS’s were the main contributing factor to the recession. The concept of Credit Default Swaps is complicated and something that I will talk about in my upcoming blog posts, but these financial vehicles are essentially unregulated insurance policies for subprime mortgages. AIG grouped these worthless assets together and solid them to boost their short-term profits. This is an example for why these innovations are so risky. Banks can pretend that worthless assets are valuable and create a marketplace for them.

In the future, people agree that the banking sector needs to be more regulated so that this cannot happen again. Whether is is creating stronger regulations for banks or breaking up these bigger institutions and imposing laws on how big these banks can be, Americans want to see something done to prevent another Great Recession.

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7 Responses

  1. This is the main source I used for my post:

    http://www.democracyjournal.org/article.php?ID=6701

  2. Love the picture. Where is it from? Is it real or staged?

    • I actually found it on the main page of your link from planet money:

      http://www.npr.org/blogs/money/2009/11/podcast_breaking_up_big_banks.html

      I wanted to write about an aspect of the banking industry for this post and so I clicked on this source first. Although I didn’t write directly on breaking up the big banks, it will still an interesting concept to me and I did mention it towards the bottom of this post as an area of reform that some Americans want to see in the future.

  3. Interesting take on the topic of innovation. I have rarely heard anybody mention innovation in anything but a positive way, and I think that you bring up a good point by highlight how not all innovations have a positive impact. In addition to the banks you discussed, Like so much else we have covered, I can see how Innovation damaged Enron as well. Deregulation and innovating new business processes became so important to Enron that they lost sight of what was moral, sustainable, and legal. Resulting in a collapse that clearly displays the dangers innovation can bring. Therefore the lesson I tried to take away from this was that, while innovation can be very useful for a company to move forward, it must done in a controlled manner that leaves room to learn from failed innovation without damaging an organization as a whole.

  4. It was really interesting thinking about innovation as a bad thing because I really do believe that people (including myself) assume that it is always a positive form of change. These new financial innovations were definitely ways for banks to boost their own profits at the expense of their customers. It is hard to believe that they did these things without knowing it would backfire at some point down the line. I really want to focus my next post on CDO’s and CDS’s since these things seemed to have a major impact on the collapse of the economy. I feel like there will be a lot of good information and a lot of varying opinions about the effects of these financial vehicles.

  5. I’ll definitely be discussing negative-amortization mortgages in relation to the housing bubble, which I plan to center my paper on. However, it’s very interesting to bring in the innovation factor. Along with Will and Derek, I too often only think of innovation in a positive sense and never considered the concept while brainstorming my housing bubble ideas. Thanks for enlightening me Will.

    Now that we have seen that innovation can in fact backfire, that explains why many organizations initiate their new ideas in special divisions or spin-offs. This limits the potential damage that can be done by failed innovations. I’m not sure how this could actually be performed, but perhaps the banks should have limited their use of innovative mortgages, CDO’s and CDS’s until their potential and risk could be evaluated better.

  6. Like everyone else, I found your post to have a refreshing outlook on innovation. We seem to forget the negative impacts innovation can have on organizations and societies. I think a key aspect of innovation being used in a good way verse a bad way depend greatly on the people creating/using it. When studying Enron, many of the executives were praised for their use of innovation, in fact Enron even earned awards for innovation, so it is not surprising to see that this has impacted more than just the energy market. The question is will more regulation stop people from finding loopholes within policies?

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