Innovate This: What Tim Geithner Still Doesn't Get About Financial Services

Last Updated Aug 4, 2010 7:08 PM EDT

I have a solution for whether Harvard prof Elizabeth Warren or Assistant Treasury Secretary Michael Barr should head the new Consumer Financial Protection Bureau: Give the latter Tim Geithner's job.

Barr appears to have a far better grasp of the pros and cons of financial innovation than his boss. Speaking Wednesday before the North Carolina Chamber of Commerce, Barr offered a nuanced analysis of financial services that acknowledges the benefits of innovation without engaging in the mindless boosterism Geithner is prone to. For instance, Barr noted:

[S]ecuritization helped banks move credit risk off of their books and supply more capital to housing markets. But it also widened the wedge between principals and agents â€"- lowering underwriting standards and the incentives for due diligence.
Tranching of asset-back securities and the assignment of ratings to tranches of structured products by credit rating agencies seemed to give investors more control of the precise risk profile they were taking, but risk managers, corporate directors and regulators did not account for the tail-risk that this crisis so painfully exposed.
Contrast such remarks with the banalities Geithner served up earlier this week at New York University about rebuilding the U.S. financial system. It's amazing to hear this country's most important financial official preaching the gospel of innovation without at least nodding to the idea -- clear as day after the housing crisis -- that some new financial products are good, and some are very, very bad.
Geithner hardly seems to have budged from his pre-crisis certitude that innovation, whatever its form, always makes the financial system stronger. Here he is as president of the Federal Reserve Bank of New York in 2006:
Let me conclude by reiterating the fundamental view that the wave of innovation underway in credit derivatives offers substantial benefits to both the efficiency and stability of our financial system.
Those should've been famous last words. As we know, credit default swaps, collateralized debt obligations and similar mutations had exactly the opposite effect on the financial system. But no. After everything that's happened, Geithner still sees the link between innovation and economic growth as a necessarily virtuous one.

In fact, the relationship is much more complicated. First of all, financial innovation isn't some sort of growth supplement guaranteed to build bigger muscles, as Geithner seems to think. It's a process of change. As financial expert Robert Litan has explained, that process is governed by what's called the "regulatory dialectic."

Here's how it works: Some problem or abuse in the financial world spawns new rules. Innovations emerge aimed at circumventing the rules. That can cause new problems and, repeating the cycle, spur new regulations.

This dynamic goes back at least to the birth of finance during the Italian Renaissance. You can't stop it. What you can do, Litan notes, is try to nudge innovation in socially useful directions and, when things fall apart, develop new rules to correct existing problems.

This process has yielded all sorts of useful financial products over the years: checking accounts, credit and debit cards, money market funds, indexed mutual funds, exchange-traded funds, Treasury Inflation-Protected Securities (TIPS), home equity lines, securitization and many others. Such products increase access to credit, make it easier to save and even boost GDP.

But innovation in recent years has taken a dangerous course -- and not only in the propagation of, say, "CDO squared" securities, structured investment vehicles and adjustable-rate mortgages. Innovation also has made financial firms more complex and opaque. Just as determining the underlying value of a CDO can be next to impossible, so can judging the value of the firms that trade in these instruments.

That's largely by design. As financial products grow popular, they become commoditized and less profitable to sell. What's a banker to do? Let the capital markets provide these less lucrative offerings and focus on developing new products, new forms of risk that command a premium. Thus are markets born, with all of the wealth-creating and -destroying potential that implies.

Innovation is no more a force for good or evil than nature is. The real issue is how new financial products are designed and regulated. Barr seems to get that; Geithner doesn't.

Image from U.S. Treasury Department via Flickr

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    Alain Sherter covers business and economic affairs for