Some Innovation Can Be Harmful to Your Health
Financial engineering can cause more harm than untested medicines.
BY Caroline Cakebread | December 2, 2010
Professor Edward Kane, keynote speaker at this year’s Investment Innovation Conference in Phoenix, Arizona, discussed the “taxpayer put” in the US and Europe and the expectation that citizens will pay to fix a poorly regulated financial system. Kane is professor of finance at Boston College and a founding member of the Shadow Financial Regulatory Committee. His keynote address, Regulation and Innovation in the Financial Industry” kicked off this year’s event.
Kane was critical of financial engineering and an industry that praises innovations that don’t benefit the real economy. The kind of innovation stemming from complex financial engineering in the run-up to the financial crisis was designed to simply “transfer risk elsewhere” and get around regulation. “The biggest banks have talked about the cleverness of financial engineering,” said Kane, who bluntly stated that there is no true engineering involved in the financial world. “Despite its profitability. Financial engineering does not appear on Forbes Magazine’s 2009 list of top 10 innovations of the past 30 years,” he said. Perhaps his strongest statement came when he called new financial instruments as potentially harmful as untested medicines or surgery – the harm done to entire economies and ordinary citizens as a result of the financial crisis plays this out.
Taxpayers have been footing the bill for financial innovation and its painful impact on global economies, Kane notes. US taxpayers contributed to mortgage markets that have subsidized financial institution leverage. Moreover institutions lean on the safety net of implicit government guarantees through subsidies that ensured they could not fail. This “taxpayer put” is unfair and could lead to political instability as US citizens become less willing to pay these big tax bills to repair damage.
Kane pointed to Canadian financial regulation as a model the world could learn from. He talked about the “extent of regulatory capture” in Canada, where mergers of large banks were prohibited in 1998 because regulators feared these financial institutions would be too big to regulate. This was not the case in the US where such mergers were and are still prevalent. He also pointed to stiffer capital requirements in Canada. He also talked about Canada’s more restrictive conditions on mortgage lending.
Kane was adamant in rejecting the term credit rating “agencies” preferring to use the term “credit rating organizations” – the word agency, he noted, gives these organizations far more credibility than they deserve.
In the end, he gave three main takeaways for investors with long-term time horizons:
1. Resisting foreign bank takeovers is a wise policy. US and European financial institution stocks are very risky — regulatory capture and short horizons of regulators encourage delusional “bubbles” and regulation-induced crashes.
2. The issue for US and European crisis managers is how long they can expect taxpayers and voters to let themselves be suckers in the regulation game.
3. It was no accident that Canadian institutions stayed out of the crisis. If Canadian authorities can keep their current success in perspective while climate change expands the supply and demand for Canadian resources, Canada will remain a great place in which to invest.