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Volcker Questions Value of Financial Innovation

Former Federal Reserve Chairman Paul Volcker in a speech today took an axe to one of the banking industry's most hallowed beliefs -- that financial innovation leads to economic vitality.

"I wish that somebody would give me one shred of information about how innovation helped economic growth," he told attendees at the WSJ's Future of Finance conference in England.

A range of products have emerged in recent decades that, according to proponents, expand and enhance what the financial markets can do. One is securitization, which creates secondary markets for loans and other assets. Others, such as derivatives, focus on diversifying and transferring risk.

More broadly, it's stating the obvious to note that modern economies would be very different beasts if not for the introduction over the millennia of everything from coins and interest rates to securities, credit ratings and mutual funds.

The most basic argument made on behalf of financial innovation is that it makes it easier for lenders to direct capital to the neediest, most productive parts of the economy. Volcker, of course, knows all this. Which is what makes his questioning the relationship between financial innovation and economic growth all the more interesting.

One thing I suspect Volcker is driving at is that, for all the talk of lenders greasing the wheels of finance, big banks don't want an efficient market. That would imply the industry is competitive. And that makes it hard to make money. As a result, many of the products banks come out with are aimed at reducing market efficiency.

Want proof? Try overdrawing your checking account. To heighten efficiency, banks should warn customers before completing a purchase that they're about to spend money they don't have. Efficiency, in this case, would involve the person paying off some bills before doing any further shopping, or at least making an informed choice about whether to incur the penalty charge. But that would interfere with a bank's raking in overdraft fees.

Alternatively, if you have an hour to kill, leaf through the instruction manual that explains your credit card. The 6-point type and legalistic gibberish is no accident -- it's aimed at concealing certain facts about the card. Facts that, unseen and unheeded by account holders, result in higher revenues for banks.

In other words, innovations like securitization, derivatives, overdraft protection and credit cards are chiefly about profits. Fair enough. Whether those products necessarily foster economic growth is another story.

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