Wednesday, December 17, 2008

The death of innovation

People have woken up to the belief that the international banking sector seems to have spent the last decade working on false assumptions.  The staggering growth in innovative financial products that I tried to explain the other day was based, essentially, on the idea that by getting rid of the concept of default through the CDS market, and of the concept of capital adequacy through re-packaged CDOs, the capital markets could hyper-utilise every last penny in the system.

Unfortunately, this system has been demolished by the first real wave of defaults that it faced – the US housing foreclosures.  In a sense, banks’ assets were made up of semi-imaginary financial instruments, while their obligations had price tags on them.

But the question is where we go from here.  From all over the political spectrum has come the demand that we return to old-fashioned, responsible banking.  As Hamish McRae says in today’s Independent:

It [the financial sector] will become more conservative, more transparent, less innovative. On the one hand, people will not buy financial products they do not understand. On the other, financial institutions will not take risks with their clients' money.

The result of this will be a severe curtailment of credit.  McRae even refers to a return of Victorian values.  We should be under no illusion as to what this mean – a return of the tradition of the banks lending only to people who don’t really need it.  Brush up your golf skills chaps, and look out your old school ties, because they’re only going to lend money to the right sort of person.  If it transpires, as looks increasingly likely, that the financial sector of the 1990s and 2000s was built on sand, it’s important to remember that the people who will lose most will be the poor, the self-employed and the small businesses – because they are the ones who were too risky for the old-fashioned banks, and will be too risky for the new-old-fashioned banks.

If you want to pick an industry that’s going to do well out of this, look for pawnbrokers and loan sharks.

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