Financial Innovation - The darker side

The question about financial innovation is, however, somewhat different: it is whether most of the innovations that have been widely touted, such as credit default swaps, have in fact enhanced economic performance. What is evident is that they contributed to the current economic crises, and added greatly to the burden on taxpayers. The AIG bailout alone—linked directly to these innovations—cost taxpayers almost $180 billion, a sum that is hard to fathom. The present crisis even leaped the world into another depression. It took the life long savings form million people. It brought many families on the road. It created the panic . There is also ample evidence that they have been useful in accounting, regulatory and tax arbitrage, activities that may enhance the profits of the companies employing them, but not necessarily the efficiency of the economy. They have helped governments and firms hide their financial doings from taxpayers and investors. And those benefiting from such deception have been willing to pay amply for it, with large profits to the innovators, even if society as a whole loses. It has been found products such as packaging of toxic assets as AAA securities and selling to people is unethical . No one can disagree that this industry comprises of some of the most greedy people on this earth. From them their clients are every thing.
We should not be surprised that the so-called innovation did not yield the real growth benefits promised. The financial sector is rife with incentives (at both the organizational and individual levels) for excessive risk-taking and short-sighted behaviour. There are major misalignment between private rewards and social returns. There are pervasive externalities and agency problems. We have seen the consequences in the Great Recession which the financial sector brought upon the world's economy. But the consequences are also reflected in the nature of innovation, which, for the most part, was not directed at enhancing the ability of the financial sector to perform its social functions, even though the innovations may have enhanced the private rewards of finance executives. (Indeed, it is not even clear that shareholders and bondholders benefited; we do know that the rest of society—homeowners, taxpayers and workers—suffered.)
Some of the innovations, had they been appropriately used, might have enabled the better management of risk. But, as Warren Buffett has pointed out, the derivatives were financial weapons of mass destruction. They were easier to abuse than to use well. And there were incentives for abuse. They made it easier too to engage in non-transparent transactions; and lack of transparency never helps markets to function better. Some of the financial products increased the problems of information asymmetry, exacerbating problems of moral hazard. Indeed, much of the growth of some of these products can be attributed to these information problems, and perhaps to the deliberate exploitation of the uninformed: it is hard otherwise to explain the expansion of products that, it should have been clear, were so toxic.
Regulatory reform is important not just to ensure that the economy does not have another crisis. Better regulations, including regulations that help align private rewards and social returns, could and probably would direct the sector's creativity in ways that lead to more socially productive innovation.