C. Financial innovation

It is true that the crisis has given financial innovation a bad name, and it may be that certain types of innovation have increased risk, but it is important to remember that financial innovation has increased welfare broadly and deeply by allowing worthwhile projects, which could not have been developed prior to financial innovation, to be financed after innovation, and by broadly allowing more efficient financial markets. It is tempting to say that we have already innovated enough and that all future innovation would only add to excessive complexity and uncompensated risk. However, just as with innovation in physical technology, it is to be expected that innovation in financial services will improve our lives in the future. Consider, for example, the rise of microfinance, which is still to some extent a frontier, but which holds promise for the alleviation of poverty.

What are the dangers of innovation? Innovation often involves increased complexity, making each step of the regulatory process more difficult, and making it more and more difficult for different types of market intermediaries or consumers to evaluate financial services products. Innovation in investments will require intellectual suitability standards that forbid sale to investors who lack the ability to evaluate the relevant complexity, or alternatively will necessitate prospectuses to explain the complexity in a usable fashion. Greater innovation will therefore put greater pressure on regulation.

Innovation, through swaps, derivatives and other devices, has already had significant impacts on globalization. Globalization, in turn, has resulted in greater need for innovation in order to allow companies to reduce the risks involved in international payments flows: the development of the swaps market was initially driven by the desire for arbitrage across markets. Furthermore, advances in information technology allow for greater innovation.

The availability of a government safety net is deeply problematic from an incentive standpoint, and gives rise to problematic regulatory efforts, such as capital requirements and powers regulation. However, the rise of information technology and financial innovation has moved us far beyond the days of banks as principally depository institutions and payments facilitators. It may be that technology and innovation have made deposit insurance less important, while making it easier to apply market disciplines that were not operative under the shadow of government safety nets for financial institutions. Under these circumstances, it may be time to wean most of the financial architecture off governmental support, while providing for narrow banks or even something akin to a postal savings system to allow consumers who require governmental support to obtain it, at reduced returns. Obviously, the implementation of such a solution would need to be evaluated separately, and customized, for each adopting state. But if some states were to withdraw their safety nets, while others did not, this might raise issues of external- ization of risk and regulatory competition.

D. Economic growth

Economic growth can be expected broadly to increase demand for financial services. It can also be expected to increase globalization, increase education and enhance information infrastructure. Thus, economic growth can be expected to increase the need for enhanced regulation in emerging market states, and also to increase the need for international cooperation. Greater homogenization in the economic position of states, and in their needs for financial markets, may make harmonization of financial regulation more attractive.

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